Council of Financial Regulators Annual Report – 1998 3. Major Issues for the Council in 1998

Year 2000 Problem

The ‘Year 2000 problem’ – the possibility that computer systems will be unable to deal correctly with dates beyond 31 December 1999 – has the potential, if not addressed fully, to create serious disruption to the financial system and it has rightly been a preoccupation of each of the Council members. Recognising the importance of the problem, the Council itself decided to establish a Year 2000 ‘co-ordinators group’ of relevant staff from each member. The aims of this group are to:

• share information on Year 2000 developments between Council members;
• encourage a consistent approach to supervising Year 2000 preparations across the financial sector;
• co-ordinate the regulators' involvement with domestic financial industry groups and participation in international regulatory groups; and
• co-ordinate the disclosure of Year 2000 preparations in the financial sector.

The group met for the first time in August 1998 and now meets formally on a regular basis; the participants are also in frequent contact to share information and to co-ordinate input into various domestic and international initiatives. A participant in the group reports to the Council at its meetings.

The group also works closely with industry bodies, including the Interbank Working Group (IWG), which was established in August 1997 by the four major banks and the RBA to address Year 2000 issues affecting the banking community. The APRA representative also attends meetings of the Joint Year 2000 Council. This gathering, set up by international financial supervisors in April 1998, consists of representatives from the Basle Committee on Banking Supervision, the Committee on Payment and Settlement Systems, the International Association of Insurance Supervisors (IAIS) and the International Organisation of Securities Commissions (IOSCO). Its aim is to ensure a high level of attention is focussed on the Year 2000 problem by international supervisors, to discuss possible contingency measures and to serve as a point of contact with national and international private-sector initiatives.

The Council of Financial Regulators has taken a number of initiatives to address the various ramifications of the Year 2000 problem. It has, in particular, been encouraging banks and other financial institutions to disclose their progress towards achieving Year 2000 readiness. In January 1999, the Council published a booklet, Year 2000 Preparations in the Australian Banking and Financial System, which updates an earlier edition issued jointly by the RBA and APRA in July 1998. The booklet, which will be updated regularly during 1999, outlines the activities of all Council members and the Year 2000 preparations being undertaken by regulated institutions. The Council believes it is important that all businesses and infrastructure providers (such as electricity, water, gas and transport) disclose the measures they are taking to address the Year 2000 problem.

The Council has also been considering contingency plans to deal with problems that may impact on individual institutions or have broader systemic implications. The RBA, for example, has already indicated that it is taking steps to supplement its holdings of currency notes to meet a potential increase in demand for currency as the Year 2000 approaches.

In addition, the Council has considered the issue of public holidays around the Year 2000 date change. At present, all States in Australia, except Victoria and New South Wales, have declared Monday, 3 January to be a public holiday. Friday, 31 December 1999 will be a normal working day in all States. Council members wrote to a number of financial institutions and industry bodies seeking their views on this issue. There was strong support for a national public holiday on the Monday, to give institutions an extra day to deal with any problems which might arise over the date change and simplify their business operations on the day. However, there was minimal support for a public holiday on the preceding Friday. The Council agrees that there would be considerable merit in having a public holiday in all States on the Monday. A split holiday on that date would be an unwelcome complication in what will be a period of uncertain pressures on financial and non-financial institutions alike. The Council has taken up this matter with the Government.

International Financial Instability in 1998

The financial disturbances and economic crises which have plagued a number of countries over the past eighteen months – firstly in Asia but later spreading to other regions – have led to a range of proposals for improving domestic regulatory structures and the international financial architecture. Reforms inevitably take time to implement, so the likelihood of further bouts of instability will remain high. In global financial markets, participants react very quickly to new information, however complete and accurate it may be.

The Australian economy and its financial system have performed robustly in the face of the ‘Asian crisis’, despite close geographical and economic ties with the region. This has not simply been a result of good fortune. The pre-existing strength of the domestic economy and the soundness of macroeconomic policies have been important contributing factors. So too has been the high level of international confidence in Australia's regulatory and legal structures – an area where some Asian (and other) countries have been marked down heavily. Council members are aware of the need to maintain this confidence in Australia's financial infrastructure, particularly as the new regulatory structure is bedded down. Plaudits hard earned can be too easily lost.

Council members have been involved in a number of multilateral initiatives aimed at improving the functioning and stability of international financial markets and strengthening regulatory frameworks. The main initiatives are summarised below. The Council itself sees its role in this area as a ‘clearing house’ for sharing information on international financial reform and ensuring a consistent and co-ordinated approach. To this end, it has recently established an ‘international officers group’ of staff from each member who deal with international relations.

Taking the individual Council members in turn, the RBA participated at the Meeting of Finance Ministers and Central Bank Governors (the so-called ‘G22’) held in Washington in April and October 1998 and was represented on one of the three Working Parties set up to help develop the new international financial architecture. That Working Party, on ‘Managing International Financial Crises’, made several recommendations designed to ensure that private-sector providers of loans share in the cost of the resolution of a crisis, not just the taxpayers of the country in crisis. Another working party (where Australia was represented by the Commonwealth Treasury) made recommendations to improve the usefulness, accuracy and timeliness of information disclosed by the private sector and of data on foreign exchange reserves, external debt and financial sector soundness. It also encouraged the compilation of data on the international exposures of investment banks, hedge funds and other institutional investors, and called on the International Monetary Fund to prepare a Transparency Report summarising the extent to which an economy meets internationally recognised disclosure standards. Work on disclosure is now being carried on at the Bank for International Settlements (BIS) under the auspices of the Committee on the Global Financial System (previously the Euro-currency Standing Committee) in two different working groups, both of which have RBA representation.

The RBA was also a member of the Prime Minister's Task Force on International Financial Reform, which reported in December 1998. The Task Force identified an number of key principles and elements for reforming the international financial system to produce greater stability in capital flows, minimise the risk of future financial crises and provide a more effective mechanism for managing them when they occur. The main elements include improved transparency by corporations, governments and international financial institutions; stronger standards for financial supervision in countries, which should be subject to external surveillance; supervision of highly leveraged hedge funds and large institutional investors; improved management of future crises with effective involvement of the private sector; maintenance of trade finance during a period of crisis management; and strengthening of national insolvency regimes.

On the bank supervision front, APRA took over the RBA's membership of the Core Principles Liaison Group of the Basle Committee on Banking Supervision. This Group is responsible for developing strategies to encourage countries to embrace the Core Principles for Effective Banking Supervision, promulgated by the Basle Committee in 1997. Through this Group, APRA is also participating in the Basle Committee's reviewof the 1998 Capital Accord.

In October 1998, APRA and the RBA co-hosted in Sydney the bi-annual International Conference of Banking Supervisors, held under the auspices of the Basle Committee. The Conference, which involved banking supervisory authorities from about 120 countries, reaffirmed the importance of the Core Principles and discussed the range of operational risks facing banks.

APRA is also represented on the Executive Committee of IAIS. During 1998, IAIS approved three new supervisory standards, covering licensing requirements for insurance companies; procedures and standards for on-site inspections; and the supervision of insurers' derivatives activities.

ASIC continued to play an active role in IOSCO. ASIC is a member of both the Executive and Technical Committees and is represented on the latter's five working parties, which cover multinational accounting and disclosure; regulation of secondary markets; regulation of market intermediaries; enforcement and exchange of information; and investment management. (ASIC chairs this last working party.) Towards the end of 1998, IOSCO established a task force to deal with issues posed for securities regulators by highly leveraged institutions; ASIC is a member. In 1998, IOSCO published its Principles of Effective Securities Regulation; ASIC was represented on the task force which prepared these Principles, and is serving on the implementation task force.

ASIC contributed to the Corporate Governance initiative of the Asia-Pacific Economic Cooperation (APEC) forum, in particular through a Symposium held in Sydney in November 1998. Eight countries from the region as well as representatives from the Asian Development Bank took part. ASIC is a participant in the APEC Securities Regulators' Training Advisory Group. APRA has also made contributions to the APEC Banking Supervisor's Training Advisory Group.

Financial Conglomerates

Financial conglomerates are groups of companies under common ownership whose functions encompass two or more financial services such as banking, insurance and securities. In recent years financial conglomerates have become more prominent in the domestic financial system, where they now account for around 80 per cent of total assets, and in international markets. They have proven a very competitive means of providing a broad range of financial services to their customers.

Financial conglomerates were a particular focus of the Council's predecessor because their various activities were regulated by each of the member agencies. They remain a focus of the Council because, under the new financial regulatory structure, financial conglomerates span the responsibilities of both APRA and ASIC; they are also of potential systemic interest for the RBA because of their dominant position in the Australian financial system.

The Financial System Inquiry suggested that the new prudential regulator should issue standards for the operation of financial conglomerates covering holding company structures, firewalls, internal controls, intra-group activity reporting and requirements for independent boards of directors on subsidiary entities. APRA turned to this task early and has finalised a set of draft policy proposals which, when implemented, will apply to all conglomerates which have an ADI – including groups which also contain a commercial or non-financial sector entity. (These proposals were made available for public comment in March 1999.)

At the same time, the Council has maintained its close interest in the work of the Joint Forum on Financial Conglomerates (the Joint Forum). The Joint Forum was established in 1996 by the Basle Committee, IOSCO and IAIS (collectively referred to as the ‘parent bodies’) to develop principles and techniques for the supervision of internationally active financial conglomerates. The Joint Forum consists of up to nine representatives of each of its parent bodies. Australia has been an active participant and its insurance and securities representatives have been members of the Joint Forum since its establishment. Currently, the Joint Forum is chaired by the Chairman of ASIC, and ASIC provides a Secretariat in conjunction with the Basle Committee.

In early 1999, the Joint Forum completed work on a package of papers setting out principles and techniques on:

• capital adequacy of conglomerates, including detecting excessive gearing;
• the fitness and propriety of managers, directors and major shareholders of conglomerates; and
• the exchange of information and co-ordination between supervisors.

The papers followed extensive consultation with supervisors and industry on a global basis; the Joint Forum also drew extensively on the work of its Mapping Task Force, which carried out an intensive study of fourteen major international financial conglomerates. The papers have been endorsed by the Basle Committee and the Technical Committees of IOSCO and IAIS.

In regard to capital adequacy, the Joint Forum has established measurement techniques and principles to facilitate the assessment of capital on a group-wide basis. The techniques recognise that the capital requirements of banking, securities and insurance supervisors differ in their definitions of capital and in the valuation of assets and liabilities. The techniques are based on and intended to complement these individual requirements; there is no single technique for universal application. The guiding principles on assessing capital adequacy are aimed at assisting supervisors in the exercise of their discretion, so that the measurement techniques will yield broadly equivalent results. The Joint Forum tested its capital adequacy principles on nine international financial conglomerates.

The Joint Forum's ‘fit and proper’ principles recognise that the qualifications of the top management of banks, securities firms and insurance companies are critical to the objectives of supervision. The principles:

• encourage the application of fitness, propriety or other qualification tests to managers and directors of other entities in a conglomerate, and to key shareholders if they exercise a material influence on the operations of regulated entities; and
• promote arrangements to facilitate consultation and the exchange of information between supervisors with respect to those managers and directors of other entities in a conglomerate who have a material influence.

The Joint Forum's work on information-sharing has resulted in the development of a general framework and guiding principles for facilitating information-sharing between supervisors of regulated entities within internationally active financial conglomerates. The framework gives particular attention to the organisation of business activities along business lines, rather than along the lines of the corporate legal structure, and the organisation of corporate control functions on a global or centralised basis rather than on a local basis.

In May 1998, G7 Finance Ministers issued the Ten Key Principles on Information Sharing, which are largely directed at the legislative framework within which information sharing takes place. In a self-assessment exercise, the Joint Forum found there was generally a high level of compliance with the Principles in Joint Forum countries, including Australia; however, some conflicts with local legislative frameworks were identified.

In regard to regulatory co-ordination, the Joint Forum has developed guidance to supervisors on how co-ordinators (one or more) might be identified and on their roles and responsibilities in emergency and non-emergency situations. The intention in designating a co-ordinator is to facilitate timely and efficient information-sharing between supervisors covering different entities within a financial conglomerate. The Joint Forum's approach to co-ordination was also endorsed by G7 Finance Ministers in May 1998.

Though it still has work in progress on intra-group transactions and exposures and on the transparency of conglomerate structures, the Joint Forum has largely fulfilled its original mandate and its parent bodies are expected to decide its future during 1999. However, a recent report by the President of the Deutsche Bundesbank, International Cooperation and Coordination in the Area of Financial Market Supervision and Surveillance (February 1999), has suggested that the work of the Joint Forum should continue.