RBA review: Central bank’s financial stability role in the spotlight

A landmark review has urged the government to specify in legislation the RBA’s responsibility to contribute to financial stability, where it has a “powerful toolkit”.

A landmark review has urged the federal government to specify in legislation the Reserve Bank’s responsibility to contribute to financial stability, where it has a “powerful toolkit” to deploy.

A specific recommendation within the review — released on Thursday — said the government should legislate the RBA’s financial stability responsibilities in the Reserve Bank Act 1959, giving it a clear mandate for its role. That follows ructions in global banking markets in the past two months that saw the collapse of several smaller US banks and the takeover of Credit Suisse by UBS.

The federal government has said it will back all recommendations in the sweeping RBA report, after the root-and-branch review. It marks the first independent assessment of the central bank’s operations since the current approach to monetary policy began in the 1990s.

“While these powers give the RBA an important financial stability role, this does not have a clear legislative basis. The Review seeks a firmer foundation for the RBA’s financial stability role and clarification of the scope of its responsibilities,” the document said, noting the RBA could provide liquidity and other support to the financial system in times of stress or instability.

“The complex risks, overlapping responsibilities and distributed tools for financial stability demand clear accountability for the use of tools, and close co-operation between regulators. Co-operation arrangements should be reinforced by: Making it a clear responsibility of the Council of Financial Regulators to ensure there are no gaps in the framework.

“Greater clarity on this issue has the potential to improve the RBA’s decision making, communication and accountability, as well as improving the co-ordination of monetary policy and APRA’s (Australian Prudential Regulation Authority) macroprudential policy. Financial instability and cycles in indebtedness can create significant economic instability that exacerbates economic downturns and impedes recovery.”

The review also urged a greater RBA focus on communicating how financial stability concerns were incorporated into monetary policy decisions. It said the recent stresses in the US and European banking sectors highlighted the “important interactions” between financial stability and monetary policy.

The RBA paused its rate hiking cycle this month in light of volatility in global banking markets and fears of runs on smaller financial institutions.

National Australia Bank’s chief executive Ross McEwan said the broad RBA review marked an “important opportunity” to ensure it was best-placed to serve Australians.

“Critically, the proposals maintain the RBA’s independence from government, while also supporting clearer public communication to improve understanding of decisions made behind closed doors,” he added. “Changes to promote more debate and a wider spread of responsibility within the institution are also welcome and align with the approach of leading central banks overseas.

“It’s important Australians have confidence in the RBA, and we expect the proposed actions will help strengthen trust in the institution.”

The RBA review called for the central bank and APRA to update their memorandum of understanding, including the way the latter consults on macroprudential policy settings. The MOU has not been refreshed since it was created in 1998.

The document also recommended scrapping the RBA’s power to direct the lending policies of commercial banks, noting it was without purpose.

“The RBA does not need, nor should have access to, powers that enable it to direct the lending activities of banks. The RBA no longer has supervisory responsibilities for the banking sector – banks are licensed and supervised by APRA,” the review said.

RBA governor Philip Lowe said the direction of lending power had not been used by the central bank for many years, agreeing it should be removed.

“It’s a relic from a previous generation and it’s good housekeeping to remove a relic from legislation,” he told reporters on Thursday.

On the RBA’s Covid-19 response measures, including the Term Funding Facility for banks and a bond purchasing program, the review said the RBA’s processes for monitoring ongoing financial risks “were incomplete”.

“In particular, the RBA’s regular risk assessments did not pay sufficient attention to the risks posed to the RBA’s earnings if the cash rate increased by more than expected,” the document said. “These risk assessments, including written material that went to the Audit Committee, did not contain any scenario analysis detailing the earnings impact of unexpected movements in the cash rate arising from these programs until August 2022.”

The $188bn Term Funding Facility provided ultra-cheap three-year funding to banks during the pandemic.

The review said the RBA projected the cumulative financial cost of the bond purchase program to its underlying earnings over the next decade as likely to be between $35bn and $58bn. The central bank indicated the cost of the Term Funding Facility to be about $8bn.

“These programs incur a substantial cost because the interest rate paid by the RBA on reserves used to fund bond purchases and the Term Funding Facility are linked to the cash rate (and so have increased significantly recently), while the returns on the corresponding assets are fixed,” the document said. “At the same time, the market value of bonds purchased by the RBA have declined as bond yields have risen, resulting in large unrealised valuation losses.

“The ultimate financial gain or loss for both programs is not yet certain, however, and will depend on the path of the cash rate in coming years.”

An ANZ spokeswoman said the bank looked forward to reviewing the detail within the landmark RBA assessment and seeing how changes progressed.