The reregulation of banking: its implications for the industry and derivatives markets

The early 1980s saw the sweeping away of the remnants of the system of regulation which applied to Australian banking in the postwar period. The most notable elements of this cleansing process were the removal of the ceilings on the interest rates which banks can pay on deposits or charge on loans, the freeing up of entry to ban.king and the deregulation of the foreign exchange market, including the floating of the Australian dollar. the removal of restrictions on capital flows into and out of the country and the granting of a large number of additional foreign exchange dealers' licences.

Few commentators at the time regretted the demise of the old system of regulation and fewer still would argue for its reinstatement now. The regulations rarely achieved their objectives. Indeed. in many cases the original objectives of the controls had been forgotten. More importantly, they often had undesirable effects. For example, the banking industry made an inefficient use or resources and offered a very restricted range of products and services. For an extensive discussion of these problems, see the Campbell Report (Australian Financial System Inquiry (1981)).

Deregulation did, however. create concerns that banks would take excessive risks, leading to failures. These fears were magnified by the large loan losses suffered in the 1980s by banks in most countries with developed financial systems and they have created a predisposition towards the reregulation of banking. The process began with the BIS capital adequacy controls introduced in 1988 to protect banks against credit risk. Another major stage was initiated in 1993 with the release of proposals by the BIS to take account of market risk and to monitor interest rate risk. All of these controls or potential controls are based on a capital adequacy requirement. That is. banks are required to hold a level of capital commensurate with the risk arising out of their activities and portfolio composition.

The aim of this paper is to examine these controls, both actual and prospective. and their impact on banks and financial markets. Most attention will be focused on the new controls, but as they will (if introduced) interact with the existing controls, the latter will also be considered. The controls will also have en impact on the markets for derivatives and this question will be considered as well.