The Changing Role and Importance of Deposits

01 October 2006

Greg Hammond (Sydney) and Rowan Russell (London), Mallesons Stephen Jaques

The Australian financial system has seen considerable change since the government introduced a policy of deregulation in 1985 (in conjunction with the floating of the Australian dollar and the opening of the financial sector to greater competition). The Reserve Bank of Australia has recently noted that one of the fundamental changes has been the shift away from the use of intermediated finance to finance sourced directly from the capital markets:

In part, this is a natural outcome of financial development. Most countries start off relying heavily on banks for their financing and, as they grow, they put in place the financial infrastructure that is necessary to support the operation of capital markets. In Australia, a little under 50 per cent of financing is still done through the banking system, though it is declining.

Contributing to the trend towards direct capital market financing has been the growth of the superannuation industry, which is simultaneously creating an avenue for household saving outside of bank deposits and a demand for securities by the superannuation funds.

One consequence of this can be seen in the changing composition of household financial assets. Australian households now hold only 25 per cent of their financial assets in deposits and bonds, down from 40 per cent 20 years ago. This is quite low by international standards, and on a par with US households. The largest increases in households’ financial assets have been in direct equity holdings and superannuation.

This change in the composition of households’ financial assets has produced corresponding changes in the way banks fund themselves. The share of their funding coming from retail deposits has fallen from 40 per cent 20 years ago to 25 per cent today. This decline has mainly been accommodated by increased use of offshore bond raisings by banks.

[‘Developments in Australian Retail Finance’, an address by the Reserve Bank’s assistant governor (financial markets) to the Retail Financial Services Forum in Sydney on 22 August 2006.]

This shift to the capital markets can also be seen in the rapid increase in the volume of debt securities issued by the Australian private sector domestically and internationally. The total volume outstanding has increased during the past six years from approximately A$170 billion to A$560 billion. Offshore issuance, largely by banks and other financial institutions, accounted for around two-thirds of this increase.

In addition to a greater supply of private sector debt securities, there has been an increase in demand from investors. This has been fuelled by a significant decline in commonwealth and state government borrowings, and the increase of funds available for fixed-income investment from superannuation and other fund managers. According to the latest APRA statistics, total Australian superannuation assets increased during the March 2006 quarter by 6.6 per cent, to A$905.4 billion. This is primarily due to compulsory superannuation contributions. Employers in Australia are required to contribute 9 per cent of an employee’s salary (subject to a cap) into superannuation on behalf of the employee. One of the responses of the banks to compulsory superannuation has been to move into the funds management industry. The largest fund managers in Australia, and around 50 per cent of total funds under management, are now controlled by the major banks.

The past 10 years has also seen the ‘kangaroo’ bond market grow from total issuance of A$500 million in 1996, to A$25.1 billion in 2005 (with A$17.9 billion issued in the first six months of 2006). Kangaroo bonds are issued by non-Australian entities (including foreign governments and international organisations) in the domestic capital markets, denominated in Australian dollars, usually governed by Australian law and cleared in the domestic system operated by Austraclear.

The decline in both the importance of deposits in bank funding (and to a lesser extent, other ADI funding) and the percentage of household financial assets held in deposits, together with the increase in the amount of debt securities (often issued by ADIs) held indirectly through superannuation, raises questions as to the significance of, and protection accorded to, ‘deposits’ in the regulation of Australia’s financial system.

In Australia, the concept of a ‘deposit’ has been, and remains, not only at the core of the activities but also the regulation of ADIs. APRA has a duty to exercise certain powers and functions under the Banking Act for the protection, or in the interests, of depositors. Curiously, there is no accepted definition of a ‘deposit’ or ‘depositor’ for these purposes.

Dictionary definitions of ‘deposit’ include: to place for safekeeping or in trust; to give as security or in part payment; anything laid away or entrusted to another for safekeeping; or money placed in a bank. The term has a wide meaning both in general usage and banking practice. The language of the Banking Act also suggests a wide meaning. Some examples include:

• APRA may give an ADI certain directions if it considers that the direction is necessary in the interests of depositors.

• The directions that may be given include directions (i) to remove a director, auditor or employee from office (or to ensure such a person does not take part in management), (ii) to appoint such a person, (iii) not to give any financial accommodation, accept any deposit, borrow any amount or repay any money, (iv) not to redeem any shares or pay any dividend, and (v) to do anything else in relation to the conduct of the affairs of the ADI.

• If an ADI becomes unable to meet its obligations or suspends payment, the assets of the ADI in Australia are to to meet its deposit liabilities in Australia in priority to all other liabilities, although this depositor preference does not apply to most foreign banks authorised to carry on banking business in Australia through a branch (foreign ADIs). A separate jurisdictional preference applies to a foreign ADI’s liabilities in Australia (see below). The rationale for this depositor preference is because historically most of an ADI’s debt was owed to relatively small depositors. It was essential that such depositors be protected from mismanagement to ensure a general level of confidence in the individual ADI and the financial system. The depositor preference is not, however, limited in amount or by reference to the residency of the depositor. All that is required is that the preferred liabilities are ‘in Australia’. These provisions can retsrict the activities of an ADI: for example, APRA has recently determined that the issue of ‘covered bonds’ by an ADI is contrary to the depositor protection provisions of the Banking Act. Also, contrary to some community perceptions, these provisions do not constitute a guarantee of the repayment of depositors’ funds.

• An ADI is guilty of an offence if it does not hold assets (excluding goodwill) in Australia of a value equal to or greater than its total deposit liabilities in Australia.

• Most foreign ADIs may accept deposits and other funds from incorporated entities, non-residents and their own employees in any amount, but may only accept deposits and other funds from other individuals in amounts of A$250,000 or more.

• A foreign ADI is guilty of an offence if it accepts a deposit from a person in Australia without informing the person that it is not subject to the depositor preference provisions

• If a foreign ADI (whether in or outside Australia) suspends payment or becomes unable to meet its obligations, its assets in Australia are to be made available to meet its liabilities in Australia in priority to all other liabilities of the foreign ADI. It is interesting to note that this jurisdictional preference (or ring fencing) applies to all liabilities in Australia not just the foreign ADI’s deposit liabilities in Australia.

• A person (other than an ADI) is guilty of an offence if the person carries on a financial business, whether or not in Australia, and the person assumes or uses, in Australia, expressions such as ‘bank’, ‘authorised deposit-taking institution’ and ‘ADI’ (and other restricted words) in relation to that financial business without APRA’s approval.

Definitions of ‘deposit’ in other legislation or jurisdictions are unlikely to be determinative as the context is often different. Australian judicial authorities that cast any light on the concept of a deposit are few in number. The leading authority is Commissioners of the State Savings Bank of Victoria v Permewan Wright & Co Ltd where it is stated:

The essential characteristics of the business of banking may be described as the collection of money by receiving deposits upon loan, repayable when and as expressly or impliedly agreed upon, and the utilisation of the money so collected by lending it again in such sums as are required [...] The method by which the functions of a bank are effected [...] are merely accidental and auxiliary circumstances, any of which may or may not exist in any particular case.

Again, these remarks suggest that the term has a wide meaning. Similarly, the judgments of the High Court in Yango Pastoral Co Pty Ltd v First Chicago Ltd contemplate a wide meaning for ‘depositor’.

Some commentators have suggested that any indication in the business records of a bank evidencing a right of action against the bank that is associated with the giving of credit by a customer to the bank is an indication of a deposit. In other words, there may be no effective distinction between loans to a bank and deposits.

This uncertainty may once have been thought to be helpful in giving discretion to the prudential regulator of Australia’s financial system, but in our view the balance is tipping. As the percentage of household financial assets held in deposits declines; Australian banks and other ADIs expand outside Australia and increasingly fund their activities by issuing debt securities in the domestic and international capital markets; and Australian investors (the small depositors of the past) increasingly hold such debt securities through superannuation, it is appropriate to review whether the concept of a ‘deposit’ should continue to be at the core of the regulation of ADIs in Australia. Is Australia’s statutory depositor preference the most effective way to protect depositors, lenders and holders of bank debt securities from mismanagement to ensure a general level of confidence in Australian ADIs?

The answer to this question may come from an unlikely source. In his report into the March 2001 collapse of the HIH Insurance Group, Justice Owen recommended the Commonwealth government introduce a systematic scheme to support the policyholders of insurance companies in the event of the failure of any such company. A particular focus of concern was the delay in policyholder claims being paid in a timely fashion.

The Insurance Act 1973 contains policyholder protection provisions similar to those in the Banking Act to protect depositors. Recent press reports indicate that the Australian government is planning to introduce new depositor and policyholder protection schemes to ensure that customers of ADIs and authorised insurers are not left completely out of pocket if an ADI collapses in the future. Any scheme that removed the current uncertainty as to the meaning of the terms ‘deposit’, ‘deposit liabilities’ and ‘depositor’ in the prudential regulation of banks and other ADIs would be welcomed.

Of course, such a scheme is not the only means to protect ADI customers from mismanagement. In April and July 2005, APRA released draft Basel II prudential standards covering credit and operational risk. As is well known, the updated framework for deposit-taking institutions released by the Basel Committee on Banking Supervision has three key elements: more sophisticated minimum capital requirements, including capital charges for operational risk (Pillar 1), new requirements for self-assessment of capital adequacy and self-supervision of capital management (Pillar 2), and increased disclosure requirements (Pillar 3). The Basel II framework will be implemented in Australia from 1 January 2008.

APRA has also recently released harmonised prudential standards on governance for ADIs and insurers, and revised prudential standards and guidance notes following the adoption of International Financial Reporting Standards in Australia.

The immediate future will see further development in the regulation of the Australian financial system. The nature and type of work undertaken by banking lawyers for their clients is also likely to change. Although some of the present uncertainties may be resolved or cease to be relevant, it is likely that new uncertainties will emerge for banking lawyers to consider.

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