Michele Bullock: Has the way we look at financial stability changed
since the Global Financial Crisis?
Speech by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of
Australia, at the Bloomberg Breakfast, Sydney, 14 March 2017.
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Good morning and thank you to Bloomberg for the invitation to speak this morning. This is my
first speech as Assistant Governor Financial System. And while I have not been involved in the
Bank's Financial Stability area before, I was part of the Financial System Group when it was
established in 1998 - sitting in its sister department Payments Policy. So reflecting my own
recent journey in getting my head around this area, I thought today I would have a look back at
how the Bank's work on financial stability has evolved over the past 20 years and particularly
since the financial crisis. I have posed the question 'has the way we look at financial stability
changed since the GFC?' I will give you the answer up front. At the big picture level, the way we
look at it hasn't changed that much. But we are even more attuned to the tail risks than we were
and more attuned to the need to take action if we sense that the risks are building. We are, as
are policymakers globally, more sensitive to risk. But first a little history.
Most of you will be familiar with the history of the Reserve Bank of Australia. Briefly, its genesis
was in the Commonwealth Bank of Australia, which was established by legislation in 1911. In this
early incarnation, the Bank only had the ordinary functions of a commercial and savings bank.
But over the succeeding years it gradually took on a number of activities that are typical of central
banks. It was given control over note issue in the 1920s and then progressively acquired
exchange control powers and controls over the banking system. The Bank's powers in relation to
the administration of monetary and banking policy and exchange control were formalised in
legislation in 1945. Then in 1959, the Commonwealth Bank was effectively split into two. The
original institution became the Reserve Bank of Australia, whose role was to carry out central
banking functions, while the commercial and savings bank functions were transferred to a new
institution that kept the name Commonwealth Bank of Australia.
Why this brief history lesson? I thought it was worth highlighting up front that the Reserve Bank
has always had financial stability as one of its core functions. The focus on the activities of
private banks and the ways in which they could be influenced or controlled grew in part out of the
experiences of the Depression in the early 1930s and the major banking crisis in Australia in the
1890s.
Since its establishment as a stand-alone central bank, there have been two key changes to the
way the Reserve Bank approached its financial stability obligations. The first was in the early
1980s when, following the financial system inquiry undertaken by the Campbell Committee, the
Australian financial system was deregulated. Previously banks had been heavily regulated so
were limited in their ability to take risks. In the new deregulated environment, the Bank built up a
banking supervision framework. Prudential standards were introduced and the focus was on the
risk management frameworks of the banks.
The second key change followed another financial system inquiry undertaken by the Wallis
Committee. As a result of the inquiry, the banking supervision function was transferred to a new
institution - the Australian Prudential Regulation Authority (APRA). The Reserve Bank, however,
retained a role focusing on 'overall financial system stability'. How did we interpret this? I think it
was set out well in the Bank's 1999 Annual Report, the first year of these new arrangements. The
Bank stated that its 'objective is to ensure that financial disturbances in any part of the financial
system do not ultimately threaten the health of the economy.' It went on to set out the foundations
for financial stability: low inflation; a safe and robust payments system; efficient and smoothly
functioning financial markets; and a sound framework of prudential supervision.
Since then, we haven't changed the way we interpret our mandate for financial stability. We are
somewhat more explicit about recognising the potential human cost of financial instability in
terms of financial distress and unemployment and are more attuned to the behavioural risks
associated with risk cultures and financial innovations. But we have substantially increased our
communication on financial stability issues. For example, in 1999, when we first started reporting
formally on financial stability, we published 10 pages in the Annual Report, of which only around
half were actually an assessment of financial stability. There were six charts - credit spreads in
overseas bond markets, credit to GDP, credit growth, house prices, banks' impaired assets and
risk-weighted capital ratios. In March 2004 when we first published the Financial Stability Review,
the assessment was around 40 pages, including over 40 charts, and it is now routinely between
50 and 60 pages with upwards of 60 charts. We also give a lot more speeches covering financial
stability issues, such as this one. But while we publish much more detailed analysis, the
substance of the core issues has not changed substantially. The global financial environment
was considered in the 1999 assessment as was credit, household balance sheets, property
prices, and the resilience of the banks.
So how, if at all, has the GFC changed the way we look at financial stability? It hasn't
fundamentally changed the way think about financial system stability, though we now have a
deeper understanding of the nature of the risks and the potential channels of contagion. We have
also built significant capacity to better monitor risks both in the banking and non-bank sectors.
Overall, I would say that policymakers around the world have become more alert to system-wide
risks.
Prior to the GFC, there was a common, but not universal, view that the system was fairly stable.
While there were some concerns about growth in credit and asset prices, there were a number
of plausible explanations suggesting that the stability of the global financial system would
continue. Among these were the long period of global macroeconomic stability and low inflation
that was expected to continue and that low yields were a natural consequence of the flow of
savings from Asian economies. There were alternative, more pessimistic views centred around
the view that investors were seriously underestimating risk and taking on too much leverage. But
the more prevalent view seemed to be that the diversification of risk made possible by financial
innovation, and the relative strength of capital and liquidity levels, would stand the system in good
stead. You could say it had a 'this time is different' flavour.
While recognising these arguments, policymakers in Australia never entirely bought into this. The
experience with losses in commercial property in the late 1980s, the collapse of HIH in 2001 and
the housing boom in the early 2000s perhaps made Australian regulators a little more
circumspect. APRA had therefore maintained a strong supervisory focus on the Australian
financial institutions. But we were also fortunate in Australia that the boom in commodity prices
and substantial rise in the terms of trade through the 2000s produced a very favourable
economic environment at a time when many of the major economies moved into recession. It
was probably also fortuitous that there had been a bit of a shake-out in the housing market in
Australia in 2004/05 so we were not in a boom phase when the GFC hit. All of these factors
resulted in the Australian financial system coming out of the GFC in relatively good shape.
Post-GFC, however, policymakers globally (including Australia) are more exercised about
system-wide risk. This has resulted in three changes: more scrutiny of the global financial
system, strengthened regulation and a greater willingness to respond when risks appear to be
rising.
One concrete outcome of this at the global level was the creation of the Financial Stability Board
(FSB) in 2009, successor to the Financial Stability Forum (FSF). The FSF had been set up by
the G7 finance ministers and central bank governors in 1999 to enhance international
cooperation to promote stability in the international financial system. Australia was a member of
the FSF. Following the GFC, the G20 called for the FSF's membership to be broadened and its
effectiveness to be strengthened. This resulted in the establishment of the FSB with a broader
membership and mandate. Specifically, it was to promote international financial stability by
coordinating national financial authorities and international standard-setting bodies as they have
worked toward developing strong regulatory, supervisory and other financial sector policies. This
involved assessing vulnerabilities affecting the global financial system and proposing actions to
address them, promoting implementation of financial sector regulation and policies and
monitoring implementation of the agreed reforms. This has taken the FSB into such areas as
supervision, resolution regimes, derivatives markets, shadow banking, compensation practices,
data and disclosure, and legal and accounting issues. And the FSB is actively looking for the next
potential source of systemic risk. At its most recent meeting, for example, it considered issues
raised by FinTech, misconduct and climate-related financial exposures.
On the regulatory side, the international standard-setting bodies looked to lessons learnt from the
crisis and in some cases revised their standards. The Basel Committee on Banking Supervision
introduced a significantly strengthened capital and liquidity framework for banks, with additional
requirements for the global systemically important banks, or G-SIBs. Minimum capital levels
were increased, capital buffers incorporated, and leverage ratios and liquidity requirements
introduced. Disclosure requirements in banking and the financial markets increased. Australia
has followed this international move. APRA increased capital requirements, and applied the
liquidity coverage ratio (from 2015) and net stable funding ratio (to commence from 2018) to
larger and more complex Authorised Deposit-taking Institutions (ADIs). And it is working on
implementing the recommendation of yet another financial system inquiry, undertaken by David
Murray, that Australian banks' capital ratios should be 'unquestionably strong'.
Standards covering financial market infrastructure were also strengthened and supervisory
oversight increased. Central counterparties (CCPs) and securities settlement facilities generally
performed well through the GFC. CCPs in particular withstood the default of Lehman Brothers,
although the complete resolution was complicated and took some time. This resulted in
increasing regulatory pressure for securities and derivatives to be cleared through CCPs, making
them even more systemically important. Regulatory oversight increased along with this increase
in importance, with attention focused on risk management and loss absorbance capability of
CCPs, recovery plans and resolution in the event that the CCP was unable to recover.
International work in this area is ongoing, with the FSB releasing a consultation paper on CCP
resolution in February. As overseer of the stability of central counterparties in Australia, the
Reserve Bank has been applying these new standards to domestically operating CCPs, the
most prominent ones being the ASX CCPs for equities and derivatives.
Finally, there seems to be more willingness for regulators and policymakers to take action if they
see risks building. Prior to the GFC there was a school of thought that because asset price
bubbles could not be detected in advance, it was better to clean up after any bust, rather than
lean against the cycle with policy. This was not the only view, however, and some policymakers
had argued for a number of years that there were indicators that could be used to detect financial
imbalances and that in some circumstances policy settings should take these imbalances into
1
account.
Post-GFC, there has been some swing to this latter view. There is now more acceptance of the
need to take action when system-wide risks are rising. This is reflected in the increasing use of
what are commonly known as macroprudential policies.
As my colleagues David Orsmond and Fiona Price note in a Bulletin article in December 2016,
2
there is no universally accepted definition of macroprudential policy. They define it as 'the use of
prudential actions to contain risks that, if realised, could have widespread implications for the
financial system as a whole as well as the real economy.' They also note that the use of such
tools has increased in a number of countries post-GFC.
In Australia, we see macroprudential policy as part and parcel of the financial stability framework.
As we have set out on other occasions, the essence of macroprudential policy is that prudential
supervisors recognise potential system-wide risks in their supervision of individual institutions
3
and react accordingly. APRA can and does take an active supervisory stance, modifying the
intensity of its prudential supervision as it sees fit to address institution-specific risks, sectoral
risks or overall systemic risk. A recent example might help to illustrate this.
In 2014, the Australian regulators took the view that risks were building in the residential housing
market that warranted attention. There was very strong demand for residential housing loans,
particularly by investors. Price competition in the mortgage market had intensified and discounts
on advertised variable rates were common. There also seemed to be a relaxation in non-price
lending terms. The share of new loans that were interest only was drifting up and the growth of
lending for investment properties was accelerating. Unsurprisingly in this environment, the
4
growth in housing prices was strong, particularly in Melbourne and Sydney.
The regulators judged that more targeted action was needed to address the risks - to put a bit of
sand in the gears. So APRA tightened a number of aspects of its supervision. It indicated that it
would be alert to annual growth in a bank's investor housing lending above a benchmark of 10
per cent. It also set some more prescriptive guidelines for serviceability assessments and
intensified its scrutiny of lending practices. ASIC also undertook a review of lending with a focus
on whether lenders were complying with responsible lending obligations.
There is no doubt that the actions did address some of the risks. Nevertheless, the early
experience suggests that, while the resilience of both borrowers and lenders has no doubt
improved, the initial effects on credit and some other indicators we use to assess risk may fade
over time. We are continuing to monitor their ongoing effects and are prepared to do more if
needed.
Where to from here? With the GFC close to 10 years ago now and a substantial amount of
regulatory reform having been undertaken, the focus is turning to implementation and taking
stock of the effectiveness of the reforms. This is reflected in the FSB's current agenda. But there
is also some thinking to be done about how monetary policy considerations should factor in
financial stability issues, and the role that macroprudential policies might play in addressing
system-wide risks in a low interest rate environment.
In conclusion, I would like to return to the question I posed at the beginning of this talk, and in fact
the question I posed myself when I first came into this area a few months ago - has the way we
look at financial stability changed since the GFC? While the basic way we look at financial
stability has not changed, experience with the GFC reinforced the need to focus on system-wide
issues. We need to spend time analysing them and thinking about whether policy responses
might be required. We are still learning how best to do this.
1
Bloxham, P, C Kent and M Robson (2010), Asset Prices, Credit Growth, Monetary and Other Policies: An
Australian Case Study, RBA Research Discussion Paper No 2010-06.
2
Orsmond, D and F Price (2016), 'Macroprudential Policy Frameworks and Tools', RBA Bulletin, December, pp
75-86.
3
Ellis L (2012), 'Macroprudential Policy: A Suite of Tools or a State of Mind? ', Speech at Paul Woolley Centre for
the Study of Capital Market Dysfunctionality Annual; Conference, Sydney, 11 October.
4
RBA (Reserve Bank of Australia) (2014), Financial Stability Review, September.