In 1998, following the release of the Financial System (‘Wallis’) Inquiry’s final recommendations on financial system regulation, the Australian Government implemented a new organisational framework for the regulation of the financial system.
Prior to the Wallis Inquiry, regulation was either governed by the states for some products or based on a sectoral approach with industry specific regulation. The Inquiry recommended that regulation be nationalised and based on functional objectives, with three ‘peaks’ — a single prudential regulator (the Australian Prudential Regulation Authority (APRA)), a regulator for consumer protection and market integrity (the Australian Securities and Investment Commission (ASIC)), and an institution responsible for systemic stability and payments, as well as setting interest rates (the Reserve Bank of Australia) (RBA) (see below graphic).
These arrangements were designed to ensure that regulation was consistent for similar financial products. And having lost its responsibility for bank prudential supervision, the RBA was left to focus more or less exclusively on inflation targeting.
For the first decade or so, the new structure appeared to work well, with the Australian economy growing strongly whilst inflation remained stable, in line with the ‘The Great Moderation’ taking place across the developed world.
But over recent years, the cracks in Australia’s financial regulatory model have appeared, particularly in relation to the separation of powers between APRA and the RBA.
APRA is responsible for prudential regulation and maintaining lending standards, whereas the RBA is largely responsible for managing the cost of credit via interest rates.
Following the end of the last mining boom in 2012, the RBA lowered the cost of credit (via dropping interest rates) in a bid to lower the Australian dollar and improve the competitiveness of the non-mining trade-exposed economy.
However, this lowering of interest rates also blew-up Australia’s housing and private debt bubble, skewing resource allocation and leaving the economy and financial system vulnerable to a bust.
The primary reason why the housing market inflated so much was because APRA was completely delinquent in acting to bolster lending standards, which fell to horribly low levels, as revealed during the recent banking Royal Commission.
Now the lack of coordination between APRA and the RBA is being exposed again, with the RBA unable to lower interest rates due to fears that it would drive household debt and house prices higher:
RBA governor Philip Lowe said the threat posed by a sharp lift in borrowing by already heavily indebted Australians was a key factor in not taking official interest rates even lower…
“Would we enhance the medium-term outcomes for the Australian economy by lower interest rates today? I think in the short term we’d be probably a bit better off,” he said.
“Over the next five or 10 years would we be better off today if the main effect is we encourage people to borrow more?
“Lower interest rates could encourage more borrowing by households eager to buy residential property at a time when housing debt is already quite high and there is already a strong upswing in housing prices in place. If so, this could increase the risk of problems down the track.”
Recall that just three days after last year’s federal election, APRA relaxed its interest rate buffer, which enabled banks to extend bigger mortgages to more customers.
Thus, APRA’s macro-prudential loosening is working against the RBA’s efforts to stimulate the economy via rate cuts. Once again, APRA/RBA are not coordinating and are instead working at cross-purposes.
Perhaps, then, it is time Australia adopted the New Zealand approach, whereby the Reserve Bank of New Zealand (RBNZ) has responsibility for both monetary policy and prudential regulation.
This joint responsibility has seen the RBNZ take a much more ‘hands-on’ and transparent approach to managing housing risks, including the early implementation of macro-prudential curbs and frequent adjustments, along with frequent stern ‘jawboning’ of housing risks to the community.
It is also worth pointing-out that in 2011, the Bank of England resumed responsibility for both monetary policy and prudential supervision, taking back control from the failed Financial Services Authority (FSA) after 14 years following a post-mortem review of the financial crisis.
In short, there are two strong precedents for the RBA resuming control of both monetary policy and prudential supervision, in a bid to centralise responsibility. This way, the RBA would ‘own the bubble’ and would be forced to stem the flow of mortgage credit as it cuts interest rates.