Glenn Stevens: Observations on the financial system
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian
Financial Review Banking & Wealth Summit, Sydney, 28 April 2015.
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I thank Elliott James for assistance in compiling these remarks.
Good morning and thank you to the Australian Financial Review for inviting me to speak here
today. Your conference comes at an opportune time, since there are plenty of things to talk
about.
Global financial markets are still in the grip of a pervasive search for yield.
Major regulatory reform proposals are still being designed and implemented at the global
level.
Meanwhile, technological change is continuing to offer new opportunities for businesses to
serve customers and disrupting established ways of doing things.
And, not least, the Financial System Inquiry released its Final Report late last year.
You have a very extensive list of speakers over the next two days who will no doubt cover all
this territory and more. So my remarks will be fairly general only. Ahead of next week's
meeting of the Reserve Bank Board, I have no comments to offer today on monetary policy.
Perhaps I might begin with a few remarks about the Financial System Inquiry.
The Reserve Bank welcomes the Inquiry's Report. The Inquiry had a distinguished
committee, a capable secretariat, and an effective and robust process of discussion and
engagement. The Bank found its own engagement with the Committee very constructive.
The Report is comprehensive and shows the Inquiry grappling with the big issues of our time.
I hope the Chairman will not mind me saying that all Inquiries are, inevitably, shaped to some
extent by the circumstances they face.
The Campbell Inquiry came at a time when the weight of informed opinion had already
shifted quite a way towards favouring deregulation. After a long period of experience with a
highly regulated system, the limitations were, by the mid 1970s, increasingly apparent. So
the push was towards a financial system where market forces dictated more of the terms of
engagement. That deregulatory mindset helped prepare the ground for two of the most
significant - and beneficial - changes our financial system has seen in modern times.
Floating the exchange rate was one of them. The other was removing constraints on
competition in the banking system.
By the time the Wallis Inquiry came around in the mid 1990s the financial system had
undergone significant change. There had been an influx of new banks. There had been a
sharp run-up in credit, a boom in asset prices, a bust and a painful recession in the early
1990s. The importance of capital and supervision had been reinforced. But by the mid 1990s,
developments in technology and the anticipated growth of capital markets loomed large and
shaped the environment for that Inquiry. The importance of payments systems was much
more on the radar screen.
As you know, the Wallis recommendations transformed the regulatory architecture. APRA
(Australian Prudential Regulation Authority) was created and took charge of bank
supervision, a function previously performed by the Reserve Bank, and a new Payments
System Board was created in the Bank with a mandate for efficiency and competition in the
payments system as well as controlling risk and contributing to financial stability. ASIC
(Australian Securities and Investments Commission) was given a stronger consumer
protection mandate.
That regulatory architecture continues today. There is no serious discussion about major
change to it. Indeed, as has been noted before, the regulatory set-up and the Australian
financial system more generally came through the most severe international financial crisis
since the Great Depression very well. Not unscathed, not without some missteps or liquidity
pressures and not without some credit losses. And not without some important supportive
policy actions. But overall, we can certainly hold our heads up when the crisis narrative is
told.
At the same time, there are critical learnings for Australia from the experiences of those who
had a worse time of it than us through the past seven years. We survived the crisis pretty
well, but how do we avoid that leading to complacency? What do we have to do to protect
against a future crisis? How should we respond to the wave of changes to global regulatory
standards?
Meanwhile, the technological frontier continues to move ahead quickly, even if in ways that
Wallis could not foresee. And Australia's privately funded retirement income system -
growing at the time of Wallis but by now amounting to about 100 per cent of GDP - could not
be omitted from any comprehensive review of the system.
This, then, was the backdrop when the Murray Committee set to work.
The Inquiry has eschewed wholesale changes in favour of more incremental ones. I do not
intend to offer a point by point response to all the recommendations. Let me touch on just a
few themes.
The first is enhancing the banking system's resilience. There are a few issues here, the most
contentious of which is whether banks' capital ratios, which have already risen since the
crisis, should be a little higher still. The Inquiry concluded that they should.
There has been a lot of debate about just where current capital ratios for Australian banks
stand in the international rankings. The reason there is so much debate is because such
comparisons are difficult to make. There seems little doubt, though, that most supervisory
authorities (and for that matter most banks) around the world have, since the crisis, revised
their thinking on how much capital is needed and none of those revisions has been
downward. So wherever we stood at a point in time, just to hold that place requires more
capital. And it's likely to be demanded by the market. There's generally not much doubt
about which way the world is moving.
Of course, capital is not costless. If capital requirements become too onerous then the higher
cost of borrowing could impinge on economic growth. But more capital brings the benefit of a
more resilient system, one less prone to crisis and one more able to recover if a crisis does
occur. Crises are infrequent, but very expensive. So there is a cost-benefit calculation to be
done, or a trade-off to be struck - higher-cost intermediation, perhaps slightly reduced
average economic growth in normal times, in return for the reduced probability, and impact,
of deep downturns associated with financial crises. The Inquiry, weighing the costs and
benefits, concluded that the benefits of moving further in the direction of resilience outweigh
the rather small estimated costs.
The second set of issues surround "too-big-to-fail" institutions and their resolution. The
Inquiry is to be commended for grappling with this. These issues are complex and even after
substantial regulatory reform at the global level, there is still key work in progress. The stated
aim of all that work is to get to a situation where, with the right tools and preparation, it would
be possible to resolve a failing bank (or non-bank) of systemic importance, without disrupting
the provision of its critical functions and without balance sheet support from the public sector.
This is explicitly for globally systemic entities, but the Inquiry has, sensibly enough, seen the
parallel issue for domestically systemic ones as worthy of discussion.
Ending 'too-big-to-fail' is an ambitious and demanding objective. To achieve it, not only must
systemic institutions hold higher equity capital buffers, but more tools to absorb losses are
needed in the event the equity is depleted. Typically envisaged is a "bail-in" of some kind, in
which a wider group of creditors would effectively become equity holders, and who would
share in the losses sustained by a failing entity. For this to work, there needs to be a market
for the relevant securities that is genuinely independent of the deposit-taking sector - we
can't have banks hold one another's bail-in debt. In a resolution, a host of operational
complexities would also have to be sorted out. A resolution needs the support of foreign
regulators if it is to be recognised across borders. It needs temporary stays on derivatives
contracts so that counterparties don't scramble for collateral at the onset of resolution. And it
needs to be structured and governed well enough to withstand potential legal challenges and
sustain market confidence.
A proposal for "total loss-absorbing capacity", or TLAC, was announced at the G20 Summit
in Brisbane last year. Consultations and impact assessments are under way, and an
international standard on loss-absorbing capacity will be agreed by the G20 Summit in
Antalya later this year; guidance on core policies to support cross-border recognition of
resolution actions should be finalised shortly after.
It is fair to say that in its main submission to the Inquiry, the Reserve Bank counselled
caution as far as "bail-in" and so on is concerned. We would still do so. The Inquiry also
favours a cautious approach. Again, though, the world seems to be moving in this general
direction. It isn't really going to be credible or prudent for Australia, with some large
institutions that everyone can see are locally systemic, not to keep working on improvements
to resolution arrangements.
The third set of recommendations from the Inquiry I want to touch on are those related to the
payments system. The Inquiry generally supported the steps the Payments System Board
(PSB) has taken since its creation after Wallis, but raised a few areas where the Board could
consider consulting on possible further steps. As it happens, these dovetail well with issues
that the PSB has been considering for some time. The Reserve Bank has since announced a
review of card payments regulation and released an Issues Paper in early March. Among
other things, it contemplates the potential for changes to the regulation of card surcharges
and interchange fees.
Surcharging tends to be a "hot button" issue with consumers and generated a large number
of (largely identical) submissions to the Financial System Inquiry. But virtually all of the
public's concern is directed at a couple of industries where surcharges appear to be well in
excess of acceptance costs, at least for some transactions. The Bank considers that its
decision to allow surcharging of card payments in 2002 has been a valuable reform. It allows
merchants to signal to consumers that there are differences in the cost of payment methods
used at the checkout. By helping to hold down the cost of payments to merchants, the right
to surcharge can help to hold down the prices of goods and services more generally.
The Bank made some incremental changes to the regulation of surcharging in 2013, but to
date these have had a relatively limited effect on the cases of surcharging that most concern
consumers. Our current review will consider ways we can retain the considerable benefits of
allowing merchants to surcharge, while addressing concerns about excessive surcharges.
One element of this might be, as the Financial System Inquiry suggests, to prevent
surcharges for some payment methods, such as debit cards, if they were sufficiently low
cost. This would mean that in most cases consumers would have better access to a payment
method that is not surcharged, even when transacting online. Other options being considered
are ways to make the permissible surcharge clearer, whether through establishing a fixed
maximum or by establishing a more readily observable measure of acceptance costs.
The capping of card interchange fees is also now a longstanding policy and, we think, a
beneficial one. Nonetheless, it is important to ensure that it continues to meet its objectives.
Caps were put in place in 2003 based on concerns that interchange fees in mature payment
systems can distort payment choices and, perversely, be driven higher by competition
between payment schemes. As suggested by the Inquiry, the Bank's review will consider
whether the levels of the current caps remain appropriate. We know, for example, that lower
caps have now been set in some other jurisdictions.
But there are other elements of the current regime that also warrant consideration. For
instance, while average interchange fees meet the regulated caps, the dispersion of
interchange rates around the average has increased significantly over time. The practical
effect of this is that there can be a difference of up to 180 basis points in the cost of the same
card presented at different merchants. This problem is aggravated by the fact that merchants
often have no way of determining which are the high-cost cards.
Although the wide range of interchange fees is not unique to Australia, we would want to
ensure so far as possible that the regulatory framework does not contribute to this trend or to
declining transparency of individual card costs to merchants. The Bank's review will consider
a range of options, including "hard" caps on interchange fees and hybrid solutions, along with
setting more frequent compliance points for caps. Options for improving the ability of
merchants to respond to differing card costs will also be considered.
While considering interchange fees, it is also appropriate to consider the circumstances of
card systems that directly compete with the interchange-regulated schemes. This means, in
particular, bank-issued cards that do not technically carry an interchange fee, but
nonetheless are supported by payments to the issuer funded by merchant fees.
More broadly, all the elements I have mentioned - interchange fees, transparency and
surcharging - are interrelated, which means that there are potentially multiple paths to
achieving similar outcomes. I encourage those with an interest to engage with the Bank in
the review process in the period ahead.
Turning away from the Financial System Inquiry to other matters, let me mention two.
I said at the beginning that the "search for yield" continues. There is a line of discussion that
tackles this issue from a cyclical point of view, thinking about how the balance sheet
measures taken by the major central banks are affecting markets, the extent and nature of
cross-border spillovers, what happens when the US Federal Reserve starts to tighten policy
at some point and so on. I've spoken about such things elsewhere and have nothing to add
today.
There is another conversation, however, that tends to take place at a lower volume, but
which definitely needs to be had. That conversation is about what all this means for the
retirement income system over the longer run. The key question is: how will an adequate
flow of income be generated for the retired community in the future, in a world in which
longterm nominal returns on low-risk assets are so low? This is a global question. Just about
everywhere in the world the price of buying a given annual flow of future income has gone up
a lot. Those seeking to make that purchase now - that is, those on the brink of leaving the
workforce - are in a much worse position than those who made it a decade ago. They have
to accept a lot more risk to generate the expected flow of future income they want.
The problem must be acute in Europe, where sovereign yields in some countries are
negative for significant durations. But it is also potentially a non-trivial issue in our own
country. In a conference about wealth, this might be a worthy topic of discussion.
And the final issue is misconduct. This has loomed larger for longer in many jurisdictions
than we would have thought likely a few years ago. Investigations and prosecutions for
alleged past misconduct are ongoing. It seems our own country has not been entirely
immune from some of this. Without in any way wanting to pass judgement on any particular
case, root causes seem to include distorted incentives coupled with an erosion of a culture
that placed great store on acting in a trustworthy way.
Finance depends on trust. In fact, in the end, it can depend on little else. Where trust has
been damaged, repair has to be made. Both industry and the official community are working
hard to try to clarify expected standards of behaviour. Various codes of practice are being
developed, calculation methodologies are being refined, and so on.1 In some cases
regulation is being contemplated. Initiatives like the Banking and Finance Oath also can
make a very worthwhile contribution, if enough people are prepared to sign up and exhibit
the promised behaviour.2
In the end, though, you can't legislate for culture or character. Culture has to be nurtured,
which is not a costless exercise. Character has to be developed and exemplified in
behaviour. For all of us in the financial services and official sectors, this is a never-ending
task.
With those few remarks, I wish you a successful conference.
Thank you.