As World Investment markets rattle and shake, nervous “Mum and Dad investors” have been linking the words “Bank” with “Collapse” and wondering whether they should be stuffing the mattress with $100 notes. A spokesperson for the Reserve Bank confirmed that they had noted an increase in the number of calls to the RBA enquiring about the safety of Australian Financial institutions.

Calming words from Politicians and Banking executives alike seem to have marginal impact on depositor’s peace of mind but understanding how the system operates – and its limitations may provide some comfort.

The Banking System in Australia operates under the control of a number of statutory bodies. In simple terms, the Reserve Bank of Australia (RBA) is partly responsible for the stability of the Economic, Banking and Payment Systems with the Australian Prudential Regulating Authority or APRA responsible for the day to day supervision and regulation of Banks.

Dr John Simpson, Associate Professor in economics and finance at Curtin University says that our system compares very well with the rest of the World

“The financial system in Australia is generally well regulated by the Reserve Bank and APRA and generally Australian bankers engage in sound credit risk assessment and credit risk management. In simple terms, our banks don’t usually lend to people who shouldn’t be borrowing money in the first place” Says John Simpson

At the heart of the system are Authorised Deposit-Taking Institutions or ADI’s which collectively refer to the major Banks, Building Societies and Credit Unions. APRA are also responsible for the supervision and regulation of large public offer superannuation funds, Insurance Companies and Merchant Banks. ADIs account for roughly $2 Trillion in Assets, expected to increase as investors flee to safety.

ADIs should not be confused with Merchant Banks, and fund managers. In the past few years, the distinction has been somewhat blurred because many of the major institutions have ADI arms and many of the traditional banks have also established Fund Management and Merchant Banking divisions – a source of much of the profits booked up in recent years. These entities are in the main, regulated by ASIC.

Merchant Banks operate in the “wholesale sector”, providing funding to corporations. Effectively, merchant banks organise marriages between large sources of funds with large borrowers and take “a slice of the action” along the way.

ADI’s can be further broken up into the commercial banks and Non Banking Financial Institutions (NBFIs) which include the Building Societies and Credit Unions.

“One of the measures used to determine the overall health and strength of a Bank is a measure known as the Capital adequacy ratio. In many countries, for a commercial Bank, this ratio is required to be held between four and eight percent. The Australian Capital Ratios are very healthy by comparison”. Says Dr Simpson

In a speech to the Financial Services Forum last month, RBA Assistant Governor Philip Lowe said “The four largest banks all having AA ratings. Consistent with these high ratings, the system is soundly capitalised, with the aggregate regulatory capital ratio around 10.5 per cent, similar to its average level over the past decade. It is notable that amongst the largest 100 banks in the world, there are less than a handful with higher ratings than those of the large Australian banks “

While NBFIs do not have the same level of direct supervision, meaning that potential risk is greater, they do have similar standards to Banks. In some respects, the level of supervision is linked to scale. That is, the larger the amount at risk, the greater the interest by APRA

[ Can we expand on this with some practical stuff ?]

The question remains however, what if “Financial Armageddon” was to occur. In Banking terms, this would entail a run on the institution with depositors demanding the return of funds.

“Events like this would immediately come to the attention of APRA. Remembering that APRA will have a pretty good idea of the institution’s finances anyway, there might be a number of things they could do. This might simply be providing some assurance to depositors. The RBA would be watching closely as well and given that one of their main roles is to ensure stability in the system and this could clearly destabilise the system, they might act as a lender of last resort or facilitate a loan from another institution, a merger or some other remedy. Either way, investors should not think that ATM’s will suddenly have an RBA logo on them. The RBA and APRA will be primarily looking to a market based, commercial resolution to any problem” says John Simpson.

In spite of the assurances, regulators remind investors that the value of investments in superannuation and managed funds are almost always tied to the underlying assets of the fund.

For example, with a superannuation fund that has a large exposure to shares, the value of the superannuation fund on a day by day basis, will closely match the value of the shares. APRA’s role in this case is to ensure that the Superannuation fund is complying with the rules surrounding superannuation laws, not how well the investments perform.