The Regulation of Financial Markets and Interest Rates

Australia’s financial system was once divided into banks and non-banks, however this convention has disappeared over time and now many financial intermediaries offer almost all services banks do. However, as banks still control the majority of the financial system, they remain the most important asset to the financial system.

One of the two major changes Australia’s financial system has undergone through recent decades is the involvement of financial regulation. This important development in the late 1990s aimed to improve the efficiency of the system by reacting to changes to financial markets that have occurred since deregulation.

Although there are many regulators in Australia, the three main ones include the Reserve Bank of Australia (RBA), the Australia Prudential Regulation Authority (APRA) and the Australian Securities and Investments Commission (AISC).

As Australia’s central bank, the RBA has the important role of controlling Australia’s money and banking system. The RBA is responsible for formulating and implementing monetary policy, the regulation of the payments system as well as maintaining systemic stability of a volatile Australian economy.

The RBAs decision making involving monetary policy involves setting the cash rate on overnight loans in the money market. The RBA uses its domestic market operations to determine the cash rate in the money market as a result of the interaction of demand for and supply of overnight funds.

On the days when monetary policy is being changed, market operations are aimed at moving the cash rate to the new target level. By accomplishing this, other interest rates in the economy are influenced.

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A lowering of the cash rate will lead to a cheaper cost of borrowing funds in the cash market, and this leads to banks reducing their borrowing and lending rates while an increase in the cash rate, will lead to a higher cost of borrowing funds, where banks will raise their borrowing and lending rates. This controlling of interest rates influences the behaviour of borrowers and lenders in the financial market thus contracting and expanding the financial flows within the economy. (See flowchart)

Being responsible for the regulation of the payments system, the RBA ensures the efficiency and stability of the payments system including maintaining various payment methods by the Payments Systems Board. In recent years the maintenance of financial stability has shifted to the APRC, the RBA still maintains the overall stability of the financial system.

The APRC is responsible for the prudential regulation of financial intermediaries involves in deposit taking, life and general insurance and superannuation. The APRC was founded to take over responsibility from the RBA for the supervision of all financial intermediaries. Its two main roles include supervising and ensuring financial intermediaries meet their obligations and sorting out the intermediaries’ financial position and their funds are received equally. Adopting the prudential standards formed by the RBA, the APRA supervises building societies, credit unions and friendly societies transferred from other states. APRA aims to achieve a system of regulation that is designed to protect depositors and maintain stability and confidence in the financial system.

The AISC is an independent government body that holds the responsibility for market integrity, consumer protection, dispute resolution across the financially system including investment, life and general insurance and superannuation and banking. The ASIC enforces and regulates companies and financial services laws to protect consumers, investors and creditors and aims to reduce fraud and unfair practices in the financial system. These three bodies (RPA, APRA and ASIC) form the Council of Financial Regulators, which meets regularly to discuss and co-ordinate policies for prudential supervises of the financial system.

Financial intermediaries act as borrowers of funds when they make profit on saving deposits. The rate of interest charged is known as the borrowing rate. Similarly when making loans financial institutions charge a rate of interest known as the lending rate. Profit is made in the financial sector, when the lending rate exceeds the borrowing rate. Short and long term interest rates depend on the length to maturity of financial assets or securities. Short term interest securities can include Treasury notes issued for 13 or 26 weeks while long term securities can include treasury bonds that can be issued for 5,7 or 10 years.