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BFF5926 Australian Capital Markets Lecture Four Regulation 24 March 2017
Lec. 4 - Learning objectives From this lecture, students should be able to
Explain the basics of regulatory theory and financial regulation (why we regulate banks). Outline Australia’s regulatory structure and its different roles and responsibilities. Discuss key regulatory issues (financial institution ownership, large exposures, 4 Pillars, governance, holding companies and compensation). Identify the role of international regulatory bodies.
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Lecture outline 1. Regulatory theory 2. Australia’s main financial regulators Reserve Bank of Australia Australian Prudential Regulation Authority Australian Securities & Investments Commission 3. Other Australian regulatory bodies 4. Specific Australian regulations/policies 5. International regulatory bodies.
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Lecture references
AFF9260 Reading list topic 4 Australian Prudential Regulation Authority (2016), Annual Report Reserve Bank of Australia (2016), Financial Stability Review, October Aust. Securities & Investments Commission Financial Services Inquiry (2014), Final Report.
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Valentine et al. (prescribed textbook) has some coverage of the GFC and the payments system respectively in Chapter Twelve, pp. 325-343, and Chapter Five pp. 106-107 Viney & Phillips textbook has some coverage of financial regulation of banks in Chapter Two, pp. 56-59 and 70-73 (7th ed. 59-61 and 76-7). The lecture notes are more important in the coverage of this topic than in other weeks. Textbook readings
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Regulation Theory
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Regulation Regulation is used to address: Natural monopoly Imperfect information Presence of externalities Market failure Social objectives Consumer protection
Note: a single regulation may often address more than one of the above
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Finance & regulatory economics The traditional view is that regulation serves the public good. Stigler found no correlation between electricity prices and regulatory policies. He concluded that regulation might well be developed for the benefit of the regulated industry, or politicians, rather than the public. Prosner expanded these views into a theory of financial regulation.
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Why regulate banks? Banks are special institutions as they finance illiquid assets with liquid liabilities. Banks also overcome information problems associated with smaller borrowers. If banks are the only institution to perform these services and they are destroyed, then the overall economy will suffer. Their role in the payment system similarly requires protection.
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Academic justifications Systemic Stability Financial instability can easily move from one financial institution to another (contagion). This process may de-stabilise the real economy. Information Asymmetry Even when disclosure is sufficient, consumers may still not understand it.
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Social objective regulations
Government regulations are sometimes used to direct funds into areas not otherwise (or inadequately) served by the market – like housing, small business or agriculture. These may include: Interest rate ceilings on loans Government guarantees for borrowers Government subsidies on interest Government borrowings to fund projects Direction of funds to specific projects or areas Tax exemptions to encourage funding
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Approaches to regulation
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Integrated approach The UK was one of the few examples of an integrated approach. Its Financial Services Authority worked through professional associations to regulate the entire financial sector. In the GFC, it failed to coordinate well with both the central bank, the Bank of England, and the British government. It was replaced in April 2013 by Prudential Regulation Authority (under the Bank of England) and Financial Conduct Authority. Their efforts are coordinated by the Financial Policy Committee (also includes a Treasury rep) which is chaired by the Governor of the Bank of England. These arrangements are now somewhat similar to Australia.
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Institutional approach Each type of institution has its own regulator China – 3 quite separate from central bank* China Banking Regulatory Commission China Insurance Regulatory Commission China Securities Regulatory Commission India – 3 with central bank still involved Reserve Bank of India- banking system Insurance Development & Regulatory Authority Securities and Exchange Board
*This is expected to change later in 2016 but no final indications as to how BFF5926 Lec 4 - 24 March 2017 14
Confusing approach The USA has one of the most complicated financial regulatory systems in the world. Prior to the GFC, banking at the Federal level had five bodies: the Federal Reserve Board and its 12 regional member banks, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC) and the National Credit Union Administration (NCUA) and the Securities and Exchange Commission (SEC). Each of its 50 states and 6 territories have their own separate banking commissioners.
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Post GFC US regulatory reform Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (some 2,300 pages) created even more: Financial Stability Oversight Council –coordinate between agencies in system risk issues. It can designate banks of over USD 50 bn as too big to fail and subject them to specific regulation. It may also levy them to pay for major failures as well as initiate bank bankruptcy action. Bureau of Consumer Financial Protection –to help consumers in disputes with banks (Federal Reserve Board). Federal Insurance Office – oversight of state insurance regulation Office of Financial Research – not a regulator but will help verify regulatory policies and risk assessment.
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A simplified view of US reg.
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Australia’s Regulatory Structure
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Twin peak approach Australia is often given as an example of a twin peak approach in that APRA is the prudential regulator of financial institutions and ASIC covers market conduct. The Reserve Bank, however, is a very important third regulator in respect to its payment systems role and systemic risk responsibilities. There are also a range of smaller regulatory bodies.
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Specific responsibilities
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Source: Charles Littrell, APRA , 22 March 2013
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Australia’s financial regulation The relative success of Australia’s financial sector, particularly during the GFC was considered at least partly a function of its regulatory system. The World Economic Forum’s Global Competitiveness Report 2016-2017 ranked it 6th place in overall financial market development. More specifically, it ranked 5th in the soundness of the banking system (after Finland, South Africa, Canada and New Zealand) and 8th in the regulation of the securities exchanges. BFF5926 Lec 4 - 24 March 2017 22
Reserve Bank of Australia Australia’s central bank is responsible for: monetary policy systemic risk (with APRA) foreign exchange matters issue of the currency the committed liquidity facility (CLF) lender of last resort (Treasurer directs) payment system (Payments Systems Board) Its target inflation band of 2% to 3% inflation tries to maximise employment while not hurt price stability. BFF5926 Lec 4 - 24 March 2017 23
RBA & financial institutions
The RBA is not responsible for regulating any one financial institution, but rather the financial sector’s overall financial stability – systemic risk. Its coordination and memorandum of understanding (MOU) with APRA is part of that responsibility. Its sixmonthly Financial Stability Report is another. The RBA governor also chairs the Council of Financial Regulators, the Payments System Board and the Financial Stability Board Standing Committee for Assessment of Vulnerabilities.
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Aust. Prudential Reg. Authority ARPA was created in 1998 to consolidate the prudential financial regulation of banks, credit unions, building societies, superannuation funds, life insurance companies, general insurers, friendly societies and in 2015-16 health funds. It also enforces the Financial Sector (Collection of Data) Act 2001, and Financial Sector (Shareholdings) Act 1998 as well as specific industry legislation like the Banking Act 1959. www.apra.gov.au BFF5926 Lec 4 - 24 March 2017 25
APRA & financial institutions Authorised financial institutions are regulated by APRA for prudential purposes: protecting depositors and policy holders Registered financial institutions are those that APRA only collects statistical information: money market corporations and finance companies are the largest group.
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APRA’s approach to regulation
As APRA is directly responsible for regulating almost 1,000 financial institutions, it can only be effective if it directs attention to specific problems. It selects those institutions requiring additional attention (Supervisory Oversight and Response System – SOARS) through its own internal ratings system (Probability and Impact Rating System - PAIRS).
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APRA intervention In response to a potential problem at a regulated institution, APRA may direct "replacing people, freezing assets, directing certain business lines to be stopped or exited and ultimately applying for wind-up." APRA required National Australia Bank, for example, to hold more capital and cease currency option trading until its internal control systems were improved after a currency trading breach leading to a AUD360milion FX exposure (WSJ 15/03/2004). BFF5926 Lec 4 - 24 March 2017 28
Depositor protection in Australia Should an ADI fail, the Banking Act (Section 12) requires APRA "to protect depositors“ but does not say how. Section 13A(3) allows it to take over a bank to protect their interests. While no depositors had lost money, they could. It was not a guarantee. During the GFC, the Australian government, like many other countries, temporarily guaranteed ADI deposits but the Financial Claims Scheme replaced it. The Financial Claims Scheme allows administrators to pay depositors some funds prior to the bank’s full liquidation. 29BFF5926 Lec 4 - 24 March 2017
Financial Claims Scheme The FCS differs from deposit insurance schemes overseas as it currently entails no premiums or other inspections – APRA administers it. The government will fund APRA so that the administrator can pay the first $250,000 of deposits shortly after an ADI failing. The failed ADI would then be liquidated and the government repaid from the proceeds. If insufficient, the remaining ADIs would be levied to cover the shortfall. Depositors could still lose any amounts in excess of $250,000 with that institution. The FCS covers 99% of Australian bank accounts and 82% of household deposits. BFF5926 Lec 4 - 24 March 2017 30
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FCS developments The FCS has so far entailed no direct charge either to depositors or financial institutions. The government suggested a charge of perhaps 5 basis points in 2013 based on the amount of deposits covered in 2015. This was postponed until the Financial Systems Inquiry reported on the matter. The FSI recommended the current post-event charges system be continued. As of early 2017 no changes have been made.
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Aust. Securities & Invest. Com. ASIC enforces and regulates company and financial services laws to protect consumers, investors and creditors. It covers the licensing and regulation of all financial service and credit providers as well as their staff and financial products; financial markets; and clearing and settlement work. ASIC assumed the securities market monitoring functions previously performed by the Australian Securities Exchange in 2010.
www.asic.gov.au
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ASIC licensing & regulation An Australian Financial Services license requires the applicant have evidence of appropriate conduct; compliance, training and supervision of staff; minimum financial requirements*; adequate resources*; and product disclosure information. Once licensed, a financial service provider must comply with its industry code of conduct and dispute resolution; provide financial services guides to its clients as well as a statement of advice and product disclosure statements.
*APRA regulated institutions have separate requirements. BFF5926 Lec 4 - 24 March 2017 33
Consumer Credit Institutions providing credit must also obtain a credit licence from ASIC under the National Consumer Credit Protection Act of 2009. It requires lenders make reasonable inquiries about the consumer’s finances, their requirements and objectives; verify the consumer’s financial situation; and ensure that the credit contract being offered is ‘not unsuitable’
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Future of Financial Advice (FoFA) FoFA legislation require advisors to act in the “best interests” of their clients and a better disclosure of fees and charges. The government would like to see future licenses holding suitable university degrees. While life insurance outside of superannuation was initially exempted from these reforms, changes are expected there, too. The question over the same institution providing both the product and distribution is often raised.
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The FSRA requires each type of financial institution type to have its own industry code of conduct and dispute resolution system. In 2008, these merged into the Financial Ombudsman Service (FOS); from the Swedish word for mediate. The FOS now handles complaints from individuals and small business for amounts up to $500,000 regarding banking & lending, financial planning, insurance, managed investment, stock & mortgage broking, and time shares. The financial institution must accept the FOS’ rulings but dissatisfied customer can still sue in the courts. Financial Services Ombudsman
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Other regulatory related bodies Council of Financial Regulators Payment Systems Board (RBA) Aust. Competition & Consumer Commission* Aust. Transaction Reports & Analysis Centre Australian Taxation Office Australian Federal Treasurer Australian Parliament (standing committees) *Some APRA documents gives ACC an equal status – so four key regulators - but the ACCC activities are generally confined to the approval or not of financial institution mergers.
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Financial Services Inquiry The FSI (Chaired by David Murray) reviewed of the financial sector over 2014 and made 44 recommendations: Stronger and more transparent bank capital Increase Internal Ratings Based (IRB) risk weights toward standard ones Default retirement income product in super 2020 review of MySuper on fees and products Disallow SMSF borrowings Financial advisors need better education
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FSI – guide to final report
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Government response to FSI The government responded to the FSI recommendations on 20 October 2015. It responded positively to most of the recommendations, but not all have been implemented as of 2016. Some delays reflect the need for industry consultation but others relate to the Senate’s unwillingness to pass the relevant legislation. The govt. did not remove non-recourse borrowings by super funds, create a Financial Regulator Assessment Board or promise more frequent post-implementation reviews.
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Other inquiries
The Labor Party’s call for a royal commission investigation into banking practices has been blocked by the Liberal National government. A host of other inquiries have been or are being conducted by various parties into various aspects of banking. A parliamentary inquiry into small business lending has just reported. The Senate’s Lending to Primary Production Customers is the next expected.
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Key Regulatory Issues
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Specific regulatory issues Financial institution ownership Large exposure controls Macro prudential measures Major banks mergers (Four Pillars) Corporate governance of financial institutions Non-operating holding companies Remuneration and culture Investment versus commercial banks Living wills (Each discussed next on separate slides) BFF5926 Lec 4 - 24 March 2017 43
Financial institutions ownership The Financial Sector (Shareholdings) Act limits the shareholding any one investor (or group) in an authorised financial institution to 10%. Up to 15% can be approved by Treasurer. It is designed to stop non-financial corporations or families acquiring banks and using them to their advantage. It is not normally applied to other banks – for example Citigroup owns 100% of Citibank Australia Ltd. The act also helps ensure that any new potential owners are suitable to own a financial institution and promotes independent institutions.
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Large loan exposure controls
ADIs are discouraged from lending too much to any one borrow or group of borrowers. They are required to report any loans equal to 10% or more of their shareholders’ funds. Such large loans are discouraged.
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Macro prudential measures These are regulatory measures designed at an industry wide exposure problem rather than a bank specific one. The RBNZ did this with Auckland home lending. Australia followed in 2014 with request to limit lending on intercity flats and then on housing loans to Sydney and Melbourne buyers. Initially it was simply to tighten lending standards. In 2015, however, ADIs had to limit their growth in investor home loans to 10% per year. Some suggest that this might be dropped to 7% and higher equity in LVRs be required. BFF5926 Lec 4 - 24 March 2017 46
An ASIC chair quote Investors are suffering from FOMO – fear of missing out – of the property price increases, but “you don’t know you are in a bubble until it is over.”
ASIC says bubble but APRA says there is none.
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Major bank mergers Since 1990, the Australian government has precluded mergers between the major financial institutions. Now known as the “Four Pillar” policy, it applies to mergers between the ANZ , CBA, NAB, and Westpac. The government have promised its removal, but only when banking competition was sufficient, particularly in consumer and small business finance. In December 2014, the FSI Final Report recommended the policy be retained to preclude further market concentration. BFF5926 Lec 4 - 24 March 2017 48
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Corporate governance APRA supervised financial institutions should have a board of directors where: The chair must be an independent, non-executive director. There should be at least five directors with a majority of independent, non-executive directors. At least one of these must have financial expertise. The board must have an audit committee, board risk committee and a dedicated internal audit function. All directors should be “fit” and “proper.” Most countries now have similar policies.
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Non-operational holding companies The major banks in Australia list on the stock exchange with the bank as the parent company and the other institutions (fund managers, stock brokers & insurers) as subsidiaries. With a NOHC, a holding company would be listed and own all the subsidiaries. The bank might benefit if APRA then applied its regulatory controls only to each financial institution separately. APRA might benefit in that a failure by one subsidiary would not directly impact on other subsidiaries. Macquarie Bank restructured from a listed bank to a NOHC structure in 2007 with the Macquarie Group Limited listed on the ASX. BFF5926 Lec 4 - 24 March 2017 50
AUTHORISED BANK
LIFE COMPANY
FUNDS MANAGEMENT COMPANY
STOCK BROKER
Listed bank group
NOHC
AUTHORISED NOHC
AUTHORISED BANK
LIFE COMPANY
FUNDS MANAGEMENT COMPANY
STOCK BROKER
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Remuneration and culture USA, UK and, to a lesser extent, Australian politicians have criticised the high salaries earned by finance executives. APRA will force ADIs with high short term executive incentives to hold more capital. The view is that these ADIs will take more risk in the hope of obtaining these short term returns. Instead longer term performance measures and require longer vesting periods are desired. Regulators are also concerned about a bank culture focused on profit maximisation rather than customers. A bank code of conduct or oath is one measure the industry is implementing to address this.
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Source: ABA newspaper advert March 2017
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Investment vs. commercial banks The USA’s Glass Steagall Act of 1933, which separated investment and commercial banking, was removed in 1999. The Bank of England in 2009 suggested that UK commercial banks be “ring fenced” from any investment banking operations. The so called “Volker Rule” in the Dodd-Frank legislation initially took this direction, but only limits bank involvement in risky activities like trading in derivatives and private equity investments. BFF5926 Lec 4 - 24 March 2017 54
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Living wills Another regulatory response to the GFC is the requirement for ADIs (Big 4 banks at least) to have a “living will” or a crisis resolution and recovery plan (RRP). Living will must explain what assets or businesses should be sold first to raise cash if the company experiences problems. This removes that responsibility for the regulator.
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International Regulatory Related Bodies
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Intl. regulatory related bodies
International Monetary Fund (IMF) World Trade Organisation (WT0) Basel Committee on Banking Supervision (BCBS) at the Bank for International Settlements (BIS) Financial Stability Board (FSB) & G-SIBs/SIFIs The Group of 20 (not a true regulator) Other international regulatory bodies: IAIS, IOSCO, and JFFC.
(Each discussed next on separate slides)
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International Monetary Fund The IMF is the international currency and balance of payments regulator for its 188 member countries. It fosters global monetary cooperation, financial stability, international trade, and sustainable economic growth. It makes regular visits to its member’s central banks and makes constructive reports on their economic policies.
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World Trade Organisation Australia signed the General Agreement on Trade in Services (GATS) in 1995 and its Fifth Protocol in 1998. The latter requires the removal any foreign ownership restrictions on banks, insurance companies, and financial services. It is overseen by the World Trade Organisation (WTO). Bilateral trade agreements are also important in gaining access to other markets.
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Basel Com. on Bkg. Supervision The Basel Committee on Banking Supervision (BCBS) was established by the central bank governors of the Group of 10 counties in 1975 after the collapse of the Bankhaus Herstatt in Germany. It coordinates improvements in the domestic banking prudential regulation among its members and other interested countries. The Bank for International Settlements (the central banks' central bank) provides its secretariat. The BIS is not a regulator, but the press often incorrectly suggest it is.
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The Group of 20 The G20 is an international body comprised the governments and central bank governors from 19 countries (Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom, and United States) and the European Union. It, rather than the G7 or G8, coordinated the international response to the GFC and its post recovery.
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Financial Stability Board The FSB (formerly the Financial Stability Forum) has 24 member countries and some 12 international bodies including the BSBC, IASB, IAIS & IOSCO. It promotes multi-lateral strengthening of financial markets, institutions and regulation. It takes a forward look at potential crises and recommending regulatory reforms accordingly. It identified the 29 global systemically important banks (G-SIBs) for special regulatory treatment. In 2015, there were 30 such institutions. BFF5926 Lec 4 - 24 March 2017 62
G-SIBs Global systemically important banks (G-SIBS) and their domestic counterparts are also known as toobig-to-fail* (TBTF) institutions. Because of their interconnections within international finance, they are also sometimes known as too-interconnected-to fail (TITF) and, given their numbers, too-many-to-fail (TMTF). These institutions will be required to hold additional regulatory capital ranging from 1% to 2.5% more in Common Equity Tier 1 (CET1).
* In countries like Switzerland where their main banks are much larger than their own countries, these institutions may also provide “too-big-to-bail-save.” BFF5926 Lec 4 - 24 March 2017 63
G-SIBs extra capital 11-2015 (2.5%) Citigroup JP Morgan Chase (2.0%) Bank of America BNP Paribas Deutsche Bank HSBC (1.5%) Barclays Credit Suisse Goldman Sachs Indust. & Com. Bank of China Mitsubishi UFJ FG Wells Fargo
(1.0%) Agricultural Bank of China Bank of China Bank of New York Mellon China Construction Bank Groupe BPCE Groupe Crédit Agricole ING Bank Mizuho FG Nordea Royal Bank of Scotland Santander Société Générale Standard Chartered State Street Sumitomo Mitsui FG UBS Wells Fargo
Note: As of 21 November, 2016. There is also a 3.5% bucket but no banks have been assigned to it.
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Global SIFIs in 2016 There are also global systemically important financial institutions in the form of insurance companies (G-SIFIs). These nine include: UK: Aviva and Prudential US: AIG, MetLife and Prudential Financial Germany: Allianz France: Axa Netherlands: Aegon China: Ping An Insurance
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D-SIBs Domestic systemically important banks (DSIBs) have also been foreshadowed. In some countries, such banks will require additional capital, too. APRA has identified that the big 4 banks rank as D-SIBs, and be required to hold an additional 1% in Common Equity Tier 1 capital. This requirement took effect on 1 January, 2016
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Other international bodies The International Association of Insurance Supervisors IAIS (est.1994) coordinates insurance regulation. The USA's National Association of Insurance Commissioners serves as its secretariat. The International Organisation of Securities Commissions IOSCO (est.1984) does the same in regards to securities dealers and stock exchanges. It uses the OECD as its secretariat. The BCBS and these two bodies coordinate their efforts via the Joint Forum on Financial Conglomerates (est.1996).
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International accounting rules While not a bank regulator, the accounting profession has a major impact on bank operations when they change their standards. Recent changes with International Financial Reporting Standards (IFRS 9) is one such example. It is expected to make the provisions for non-performing loans and hence bank earnings more volatile. It commences in January 2018 in Australia (as AASB 9) and so will impact on the banks’ 2019 reporting.
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Changes to accounting standards
BCBS will expect banks to adopt the new standards. Australia 2018 for 2019 reporting
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Review of learning objectives From this lecture, students should be able to Explain the basics of regulatory theory and financial regulation (why we regulate banks). Outline Australia’s regulatory structure and its different roles and responsibilities. Discuss key regulatory issues (financial institution ownership, large exposures, 4 Pillars, governance, holding companies and compensation). Identify the role of international regulatory bodies.
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MISCELLANEOUS ITEM
not part of the unit assessment nor should be included in any exam answer
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Customers’ bank satisfaction
Source: Roy Morgan Research Consumer Banking Satisfaction Report February 2016, average six-month sample n=25,600
Note: The major banks normally have lower satisfaction compared to the regional banks, mutual banks and other ADIs BFF5926 Lec 4 - 24 March 2017 73
Customer satisfaction by product
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Home loan customer satisfaction
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