VOLUME SEVEN

THE RELATIONSHIP WITH THE RESERVE BANK

CHAPTER 15

THE RELATIONSHIP WITH THE RESERVE BANK OF AUSTRALIA

TABLE OF CONTENTS

15.1 INTRODUCTION
15.1.1 GENERAL
15.1.2 SCOPE AND FORMAT OF THE CHAPTER
5.1.3 RESERVE BANK DOCUMENTS

15.2 THE ROLE OF THE RESERVE BANK
15.2.1 INTRODUCTORY COMMENT
15.2.2 RESERVE BANK - GENERAL ROLE
15.2.2.1 The Reserve Bank - An Evolving Role in Bank Supervision
15.2.2.2 The Reserve Bank - Role In Bank Supervision after Deregulation
15.2.3 PRUDENTIAL SUPERVISION - THE RESERVE BANK APPROACH

15.3 THE STATE BANK'S RELATIONSHIP WITH THE RESERVE BANK
15.3.1 THE BASIS OF THE RELATIONSHIP
15.3.2 HOW THE RELATIONSHIP WORKED IN PRACTICE
15.3.3 PROVIDING STATISTICAL DATA
15.3.4 PROVIDING ADDITIONAL INFORMATION TO THE RESERVE BANK
15.3.5 THE CONDUCT OF COMMUNICATIONS BETWEEN THE STATE BANK AND THE RESERVE BANK

15.4 REVIEW OF COMMUNICATIONS BETWEEN THE STATE BANK AND THE
RESERVE BANK IN FOUR AREAS OF PRUDENTIAL ASSESSMENT
15.4.1 INTRODUCTION
15.4.2 LIQUIDITY MANAGEMENT GUIDELINE - RESERVE BANK OBJECTIVES
15.4.2.1 Chronology of Key Events - Reserve Bank's Prudential Guideline Concerning Liquidity Management
15.4.2.2 Liquidity Management - Conclusions
15.4.3 REPORT TO THE RESERVE BANK BY THE STATE BANK'S EXTERNAL AUDITORS - RESERVE BANK OBJECTIVES
15.4.3.1 External Auditor's Report to the Reserve Bank - Chronology of Key Events
15.4.3.2 Conclusions - External Auditors Report to the Reserve Bank
15.4.3.3 The External Auditor's Reserve Bank Reports
15.4.4 LARGE CREDIT EXPOSURES - THE RESERVE BANK'S OBJECTIVES
15.4.4.1 Chronology of Key Events - Reserve Bank Prudential Guideline - Large Credit Exposures
15.4.4.2 Further Dealings Between the State Bank and Equiticorp
15.4.4.3 General Observations - Large Credit Exposure Guideline
15.4.5 CAPITAL ADEQUACY - RESERVE BANK OBJECTIVES
15.4.5.1 Chronology of Key Events - Reserve Bank Prudential Guideline - Minimum Capital Adequacy
15.4.5.2 Capital Adequacy Guideline - Conclusions

15.5 REPORTING TO THE STATE BANK BOARD - A REVIEW AND COMPARISON
OF RECORDS OF PRUDENTIAL CONSULTATIONS 1985-1990
15.5.1 INTRODUCTION
15.5.2 BACKGROUND
15.5.3 THE FIRST PRUDENTIAL CONSULTATION - 1985
15.5.4 THE SECOND PRUDENTIAL CONSULTATION - 1986
15.5.5 THE THIRD PRUDENTIAL CONSULTATION - 1987
15.5.6 THE FOURTH PRUDENTIAL CONSULTATION - 1988
15.5.7 THE FIFTH PRUDENTIAL CONSULTATION - 1989
15.5.8 THE SIXTH PRUDENTIAL CONSULTATION - 1990
15.5.9 OTHER MAJOR MEETINGS WITH THE RESERVE BANK
15.5.9.1 The November 1990 Meeting
15.5.9.2 Meeting with the Reserve Bank Governor - December 1990
15.5.10 COMMUNICATION BREAKDOWN - WHY DID IT HAPPEN?

15.6 THE STATE BANK'S RELATIONSHIP WITH THE RESERVE BANK - CONCLUSIONS
15.6.1 INTRODUCTION
15.6.2 SUMMARY OF BACKGROUND MATTERS
15.6.3 CONCLUSIONS

15.7 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT
15.7.1 TERMS OF APPOINTMENT A
15.7.2 TERM OF APPOINTMENT C
15.7.3 TERM OF APPOINTMENT D

15.1 INTRODUCTION

15.1.1 GENERAL

The State Bank did not operate in a banking regulation vacuum. As is explained in this Chapter, the Bank, while not formally subject to the supervisory jurisdiction of the Reserve Bank of Australia ("the Reserve Bank"), had extensive contact with the Reserve Bank, and stated publicly that it was complying with the Reserve Bank's prudential guidelines. To my mind, this link with the Reserve Bank was an important matter. It allowed the State Bank to be made aware of the Reserve Bank's general prudential objectives and concerns, and also to be made aware of how the Reserve Bank viewed matters arising in the wider banking environment and how those matters might affect the State Bank's operations and affairs.

An analysis of the Bank's relationship with the Reserve Bank is relevant to matters referred to in my Terms of Appointment A(a)(b)(c), C and D. Taken alone, the issues arising from the Reserve Bank relationship are not causative of loss in themselves. Nonetheless, when aggregated with the other deficiencies within the Bank's management and operational systems, those issues were important matters, and had a close relationship with the causative chain of events that led to the Bank's reporting the financial position of February 1991. In this sense, these issues arising in the course of the relationship are "matters" or "a matter" within my Term of Appointment A(a), and the relationship itself is part of the Bank's "operations and affairs" for the purposes of my Terms of Appointment.

In the period 1984-1990, the State Bank operated in a rapidly changing commercial and social environment. Several factors were responsible for the extent and pace of that change. They included the effects of financial system deregulation, globalization of the financial community, technological developments, and a period of economic instability marked by increased volatility in interest rates and asset values. As noted above, another important element in the State Bank's operating environment was the Reserve Bank's prudential supervision framework, applying primarily to those banks authorised under the Banking Act. Apart from the need to be conscious of the changes occurring in the State Bank's operating environment, it was important, for the purposes of the Investigation, to have a proper understanding of the Reserve Bank's role in supervising banks, and to understand how that role affected the State Bank. The review of the State Bank's relationship with the Reserve Bank has been helpful in obtaining an understanding of the State Bank's internal processes.

15.1.2 SCOPE AND FORMAT OF THE CHAPTER

Having regard to the above mentioned matters, this Chapter has, as its focus, three areas:

(a) It considers the nature of the relationship between the Reserve Bank, as prudential supervisor of banks authorised under Commonwealth law, and the State Bank, a corporation established by Act of the South Australian Parliament (and, because of constitutional reasons, not subject to Commonwealth law);

(b) It assesses the extent of the State Bank's voluntary compliance with the Reserve Bank's recommendations and requirements on prudential matters by looking, in detail, at the communications between the State Bank and the Reserve Bank in four areas of prudential concern; and

(c) It identifies the matters and concerns raised by the Reserve Bank in consultations with the State Bank, and the information thereafter communicated by State Bank officers to the Board of Directors.

The Chapter then draws conclusions in two areas. These are:

(a) the adequacy of reports and information given to the Board; and

(b) the adequacy of the supervision, direction and control of the relationship:

(i) by the State Bank's Board of Directors;

(ii) by its Chief Executive Officer; and

(iii) by other Bank officers.

The Chapter also offers some observations about the supervisory arrangements between the State Bank and the Reserve Bank.

15.1.3 RESERVE BANK DOCUMENTS

To understand the relationship between the State Bank and the Reserve Bank, the Investigation reviewed the following material:

(a) Relevant records maintained by the Bank Supervision Unit of the Reserve Bank, particularly documents used by the Reserve Bank in preparation for prudential consultations, diary notes recording the outcome of such consultations, and correspondence relating to the consultations; and

(b) State Bank records, usually comprising diary notes, Executive Committee minutes, Board Papers and minutes, and related correspondence.

Having determined that the Reserve Bank was likely to hold relevant documents and other relevant information, the Investigation so advised the Reserve Bank. The Reserve Bank, while wishing to co-operate with the Investigation, was also concerned not to breach the confidence and trust it has established with banks and other financial institutions that it supervises.

To achieve those objectives the following procedures were, therefore, agreed:

(a) All Investigation officers engaged on the task of identifying which of the available Reserve Bank documents were required by the Investigation signed undertakings, prepared by the Reserve Bank, to satisfy its particular concerns about confidentiality. Relevant parts of its documents were `covered' by the Reserve Bank to comply with the Financial Corporations Act prohibition on disclosure of information obtained under that Act.

(b) The Reserve Bank was concerned that the State Bank be aware of, and agree to, the Reserve Bank supplying documents relating to the State Bank. To that end, the Investigation requested the State Bank to provide an appropriate authorisation. That consent, given immediately, is in the following terms:

"TO THE RESERVE BANK OF AUSTRALIA

WHEREAS The Auditor-General has requested information and documentation from the Reserve Bank of Australia pursuant to his inquiry under s. 25 of the State Bank of South Australia Act, 1983.

AND WHEREAS The Reserve Bank of Australia is concerned to maintain confidentiality as between the Reserve Bank of Australia and banks under its supervision including the State Bank of South Australia and has requested that the State Bank provide this release.

NOW THEREFORE the State Bank of South Australia authorises the Reserve Bank to supply to the Auditor-General and officers authorised by him under the Public Finance and Audit Act 1987 information and documentation sought by the Auditor-General and/or his authorised officers for the purpose of his inquiry AND RELEASES the Reserve Bank of Australia to the full extent permitted by law from any liability whatsoever that may, but for this waiver and release, have attached to the Reserve Bank of Australia.

The State Bank of South Australia acknowledges that the Reserve Bank of Australia reserves the right to resist production of certain information in the possession of the Reserve Bank of Australia on the basis of statutory and/or public interest grounds.

Dated this 19th day of June, 1991

(Signed)

..........................................

ECJ (TED) JOHNSON

GROUP MANAGING DIRECTOR

(c) After reviewing the Reserve Bank documents, the Investigation wrote to the Reserve Bank specifying what documents were required. This was done to enable the Reserve Bank sufficient time to consider whether it should resist the production of any document on the basis of public interest immunity.

(d) Following further discussions with the Reserve Bank, the Investigation issued a formal request for the required documents. This formal request was by way of summons, issued pursuant to Section 34 of the Public Finance and Audit Act, 1987.

(e) The Reserve Bank complied with that summons, and requested that none of the Reserve Bank documents be disclosed to any person (including the Royal Commission), or be publicly reported on, without prior consultation with the Reserve Bank. That request was agreed to, and has been adhered to. As a result of that request, and to satisfy other procedural requirements, the Reserve Bank reviewed a draft of this Chapter in order to identify any matters of fact that it may have wished to question. Accordingly, I now report on the basis that the Reserve Bank has been made aware of, and does not contest, any relevant matter of fact relating to the Reserve Bank as reported in this Chapter.

Before examining the three areas referred to at 15.1.2 above, I have briefly reviewed the role of the Reserve Bank. This will enable the issues considered in this Chapter to be placed in context.

15.2 THE ROLE OF THE RESERVE BANK

15.2.1 INTRODUCTORY COMMENT

To properly understand the nature of the relationship between the State Bank and the Reserve Bank, some understanding is required of the Reserve Bank's general role in Australia's financial system. I offer the following (brief) overview of that general role, and of the Reserve Bank's role in supervising those banks authorised under the Banking Act, (Commonwealth).

15.2.2 RESERVE BANK - GENERAL ROLE

The Reserve Bank's functions and responsibilities are set out in three Commonwealth Statutes, namely, the Reserve Bank Act, 1959, the Banking Act, 1959, and the Financial Corporations Act, 1974, and in regulations made pursuant to those Statutes. In addition, the Banks (Shareholdings) Act, 1972 (Commonwealth) imposes restrictions on ownership of banks.

In relation to the role and responsibilities of the Reserve Bank, this Investigation has examined the Interim (1980) and Final (1981) Reports of the Committee of Inquiry into the Australian Financial System ("the Campbell Committee"), where the Reserve Bank's four essential responsibilities were "broadly summarised" as follows:

(a) to advise the Government on economic stabilisation policy generally, and to formulate and implement monetary policy;

(b) to protect the stability of the financial system by various means, including determining appropriate standards of financial practice and management for banks;

(c) to provide banking and other financial services to Government and to other banks; and

(d) to monitor economic and financial conditions.⁽⁾

There are two features of the Reserve Bank's legislative framework worthy of mention in this context.

First, until December 1989, the Reserve Bank's regulatory powers in respect of banking arose out of two of its basic responsibilities, namely:

(a) To exercise the various powers and functions conferred on it by the Banking Act "for the protection of the depositors of the several banks" (Section 12, Banking Act, 1959).

(b) To give effect to Section 10(2) of the Reserve Bank Act, 1959, which provides:

"It is the duty of the Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank under this Act, the Banking Act, 1959 and the regulations under that Act are exercised in such manner as, in the opinion of the Board, will best contribute to:

(a) the stability of the currency of Australia;

(b) the maintenance of full employment in Australia; and

(c) the economic prosperity and welfare of the people of Australia."

Second, the Banking Legislation Amendment Act, 1989 (Commonwealth), the relevant part of which, it should be noted, came into force only on 28 December 1989, is the first explicit Reserve Bank power to conduct prudential supervision of banks authorised under the Banking Act. That Amendment Act enables the Reserve Bank to make regulations dealing specifically with, and requiring authorised banks observance of, "requirements in relation to prudential matters" (Section 11A, Banking Act, 1959).

Section 11B provides:

"The functions of the Reserve Bank include:

(a) the collection and analysis of information in respect of prudential matters relating to banks;

(b) the encouragement and promotion of the carrying out by banks of sound practices in relation to prudential matters; and

(c) the evaluation of the effectiveness and carrying out of those practices."

Bearing in mind that "bank" is defined to mean a body corporate authorised under the Banking Act 1959, the Banking Act defines "prudential matters" as:

"... matters relating to the conduct by the bank of its affairs (whether or not relating to the banking business of the bank):

(a) in such a way as:

(i) to keep itself in a sound financial position; and

(ii) not to cause or promote instability in the Australian financial system; and

(b) with integrity, prudence and professional skill:"

The provisions contained in Section 11B provide a useful framework to analyse and assess the relationship between the State Bank and the Reserve Bank, as will be evident from the structure of the following parts of this Chapter.

The Reserve Bank recently had the opportunity to explain how it saw its relationship with the Australian banking industry. In its January 1991 submission to the Inquiry into the Australian Banking Industry by the House of Representatives Standing Committee on Finance and Public Administration ("the Standing Committee Inquiry"), the Reserve Bank described that relationship in the following terms:

"The Reserve Bank's relationship with the Australian banking industry is necessarily very close, given its direct responsibility for the prudential supervision of Australian banks and the protection of their depositors and, more generally, for the integrity of the payments system and overall stability of the financial system."

15.2.2.1 The Reserve Bank - An Evolving Role in Bank Supervision

Because of its obligation to exercise its Banking Act powers "for the protection of the depositors of the several banks", the Reserve Bank has long performed the function of supervising banks subject to the Banking Act. Nevertheless, it is important, for present purposes, to emphasise the evolutionary nature of that bank supervision process.

(a) Central banking in Australia traces its roots to the establishment of the Commonwealth Bank in 1911. Although the Commonwealth Bank Act did not contain explicit central banking powers, the first Governor saw central banking as an objective of the Commonwealth Bank. In 1924, the Commonwealth Bank Act was amended to explicitly encourage the development of central banking functions.

The next significant event occurred with the making of Regulations under the National Security Act, 1939-1940 requiring anyone wishing to carry on the business of banking to obtain an authority from the Governor-General. This requirement was carried over into the Banking Act, 1945. This Act also imposed a duty on the Commonwealth Bank to protect the depositors of banks subject to the Act. Between 1900 and 1945, however, there was no formal mechanism for supervising financial institutions, apart from those in the general body of law relating to the administration of the affairs of companies. In 1959, the general banking and central banking functions of the Commonwealth Bank were separated, and the Reserve Bank was constituted as Australia's central bank.

(b) The system of regulation which applied to authorised banks from the late 1940's to the early 1980's was designed to enable a Commonwealth government to determine the amount of private sector bank lending (through quantitative controls and interest rate ceilings), and the direction of that lending (through qualitative controls). In his recent paper dealing with deregulation and banking, Professor I Harper⁽⁾ described that important historical fact in the following terms:

"The war ended and rationing of food, petrol and other essential items was lifted. The emergency regulations imposed on banks, however, remained in force. This was not because the authorities still needed command over private financial resources to sustain the war effort (although the need to pay for post-war reconstruction no doubt influenced official thinking on the desirability of a captive market for government securities), but because the climate of intellectual opinion demanded it. The imposition of direct controls on banks, eg interest rate ceilings and portfolio restrictions, while precipitated by the exigencies of war, was the logical outworking of long-held beliefs that governments should exercise control over the banking system as part of their responsibility to manage the macro-economy."

The accepted view, amongst academic and other commentators, is that one effect of those direct quantity constraints and qualitative controls was a need for banks to ration the amount of credit they provided. As a consequence of the need to ration credit, banks generally chose to direct their lending to more secure and financially viable areas, thereby avoiding potentially high risk exposures in the financial markets. Accordingly, there was less need for the systematic supervision of each bank's activities.⁽⁾

⁽c) In 1979, the Commonwealth Government announced the Campbell Committee Inquiry into the Australian Financial System, partly in recognition of the rapid change occurring in the financial system. In announcing the Inquiry, the then Federal Treasurer said:

"... the last inquiry into the workings of the financial system had been the 1937 Royal Commission into Monetary and Banking Systems. In the forty years which had elapsed ..., there have been massive changes in both the domestic and international financial environment.

The Treasurer said that the objective of the inquiry was not more regulation by the Government. Indeed, one of the important issues to be canvassed by the inquiry would be whether present levels of regulation and government involvement were appropriate." ⁽⁾

The basic philosophy espoused in the final Report of the Campbell Committee (1981) was that the community would be best served by a deregulated financial system, that is, one subject to market discipline, and with a minimum amount of government intervention and regulation. That Report acknowledged, however, that there are several reasons why banks need to be put in a special category for prudential policy purposes, and that, in general terms, governments have a responsibility to ensure the stability of the financial system through the use of prudential guidelines for financial institutions.⁽⁾

The Campbell Committee comprehensively reviewed Australia's financial system; it had a wide ranging brief to look at the overall effectiveness and efficiency of the financial system, and the appropriateness of the regulatory framework. The Martin Review Committee Report ("the Martin Report"), published in 1983, was commissioned to review the findings of the Campbell Committee Inquiry, and to make recommendations in the light of the newly elected Federal Government's social and economic objectives. These inquiries were significant catalysts for change. Both recommended a substantial programme of deregulation. The Commonwealth Government and the Reserve Bank adopted most of the Martin Report recommendations, with progressive announcements made to: float the Australian dollar; remove interest rate and deposit maturity restrictions on banks; permit the establishment of sixteen new banks; emphasise more market oriented instruments for controlling the level of credit creation; and introduce prudential guidelines on banks authorised under the Banking Act as a means of protecting depositors.

(d) The evolutionary nature of the bank supervision process is aptly summarised in the following statements. The first is from a paper presented by the Reserve Bank Governor in 1990:

"Gradually, responsibility for the stability of the financial system devolved to the Commonwealth Bank. The 1930's Royal Commission on Money and Banking recommended that "in the public interest, the Commonwealth Bank should take control of the affairs of any bank which is unable to meet its immediate obligations". This recommendation was substantially incorporated in the Banking Act and the responsibility passed to the Reserve Bank in 1959.

Until the 1980's, however, specific arrangements for supervising banks were not well developed. Various regulations, including those geared to monetary policy objectives, had the effect of protecting banks from risk. The number of banks was small and supervision could be conducted in a relatively informal way.

The present situation is very different. There are more banks and the banking system has diversified its activities, both domestically and abroad. Deregulation and financial innovation have taken banks into new areas of risk. Off-balance sheet transactions have grown rapidly and are now very large relative to business on-balance sheet. The internationalisation of banking has encouraged the adoption of common prudential standards by supervisors in major countries." ⁽⁾

The same theme is evident in the Reserve Bank submission (page S1122) to the Standing Committee Inquiry:

"Prudential supervision was not mentioned specifically in the post-war legislation but it was implicit in the "Protection of Depositors" Division of the Banking Act. In any event, the Bank was able to keep itself well informed of bank's operations and the body of regulations was sufficiently restrictive that there was little incentive, or room, for banks to engage in excessively risky behaviour. It was not until 1989 that specific responsibility for prudential supervision was included in the Act, by which time the Reserve Bank had developed - and was applying -a range of prudential guidelines."

15.2.2.2 The Reserve Bank - Role In Bank Supervision after Deregulation

The so-called deregulation of Australia's financial system, beginning in the late 1970's, and accelerating rapidly after the Federal election in 1983, had profound implications for banks and for their prudential supervision. A chronology of the major regulatory reforms, which together constitute the deregulation of the Australian financial system, was appended to the Reserve Bank submission to the Standing Committee Inquiry. A slightly more detailed chronology, but for a shorter period, is appended to the Industry Commission Report No 18, `Availability of Capital', 9 December 1991. I do not consider it necessary, for the purposes of this Report, to include such a chronology.

The Reserve Bank response, as bank supervisor, to the changed financial environment is explained in its submission to the Standing Committee Inquiry in the following terms (page S1144):

"During the 1980's, a number of factors persuaded the [Reserve] Bank that greater formality, based on publicly available guidelines, was needed in pursuing its supervisory role. A Bank Supervision Unit was established by the [Reserve] Bank in 1980, which has subsequently developed into the Bank Supervision Department. The reasons for this change in approach included:

. recognition that the process of deregulation would involve banks in greater operating risks, increasing the importance of adequate capital and liquidity and effective management controls;

. the growth in banks' overseas operations gave risk management an added dimension and meant that overseas banking supervisors would be looking for evidence of effective supervision in Australia;

. a strong move internationally towards consistent minimum standards of banking supervision in all major banking centres; and

. the close contacts needed to underpin an informal supervisory system became more difficult as the number of banks increased and there was greater devolution of authority within banks."

It is appropriate to emphasise, and expand, the Reserve Bank's comment on the increase in the number of banks in Australia after deregulation. That increase was dramatic, and, in my opinion, is a matter to be borne in mind by anyone attempting to understand the bank supervision system that existed in Australia in the period 1984-1990. The basic facts are set out in a June 1991 paper by the Reserve Bank Assistant Governor (Economic):

"... between 1983 and 1988, the number of banking groups operating in Australia went up from 15 to 34, and the number of merchant banks from 48 to 111. Not only did the numbers increase, but the financial resources at their disposal also increased; the amount of capital devoted to banking rose from $4.5B in 1983 to $20.0B in 1988. At the same time as the resources devoted to financial intermediation were rising, banks' ability to compete with each other and with non-bank financial institutions was greatly increased by the removal of interest rate ceilings."

In their paper referred to above, Professors Hogan and Sharpe explain the continuing evolution of the Reserve Bank prudential supervision capacity in the following terms:

"Bank supervision began to play a more significant role in Australian banking policy in the early 1980's. Although the RBA established a bank supervision section within the Banking and Finance Department in the 1979-80 fiscal year, it was not until its 1981-82 Annual Report that mention was made of these supervisory activities. Then in 1983-84 the RBA established the Supervision Unit as an autonomous group within its administrative structure. Finally, in July 1988 the RBA announced that it was coordinating its supervision activities in a Financial System Division in which the Bank Supervision Department would be one of two departments, the other being the Financial Institutions Department."

Reserve Bank's May 1991 Bulletin records that, in 1980, the Reserve Bank established an embryonic supervision group, which began thinking about what statistics might be useful for assessing a bank's health. By 1985, the Bank Supervision Unit had 30 staff.

15.2.3 PRUDENTIAL SUPERVISION - THE RESERVE BANK APPROACH

Following recommendations of the Campbell Committee, and of the subsequent Martin Report, broad principles of prudential supervision policy were agreed between the Federal Treasurer and the Reserve Bank, and published by the Reserve Bank in several of its publications. These publications were designed to indicate and explain criteria guiding the exercise of the Reserve Bank's discretion, and the Reserve Bank's prudential supervision objectives.

In a paper entitled `Prudential Supervision of Banks', issued on 25 January 1985, the Reserve Bank explained its approach to supervision:

"The Bank's approach to supervision is predicated on the view that the prime responsibility for the prudent management of a bank's business lies with the bank itself. The Bank's system of supervision is directed towards satisfying itself that individual banks are following management practices which limit risks to prudent levels; and that bank's prudential standards are being observed and kept under review to take account of changing circumstances."

At page 36 of its `Report and Financial Statements' for year ending 30 June 1991, the Reserve Bank spelt out its "three primary (prudential supervision) objectives", namely:

"...

. preservation of confidence in the banking system as a whole;

. the stability and integrity of the banking system and of the domestic and international payments systems; and

. the protection of bank deposits."

I note the Reserve Bank has emphasised (in its June 1991 Report) what were not objectives of prudential supervision. At page 36, the Report states:

"Prudential supervision does not have as an objective the immunisation of banks from the risk of loss, the economic cycle, or from the mistakes of their managers. Managers and shareholders should factor the inevitability of the economic cycle into their decision-making, and they must pay the price for errors of judgment and carelessness."

I also note that the Reserve Bank's view is that bank supervision involves "trade-offs" between competing objectives. The Reserve Bank submission to the Standing Committee puts it in the following terms (at page S1145):

"Settling on the right amount and intensity of prudential supervision involves some important trade-offs. Arrangements are required that bolster community confidence and support the reliability and viability of the banking system and the payments system. The framework needs to be simple, logical and practicable on the one hand and, on the other, it needs to minimise artificial distortions in financing.

Banks should practice prudent risk management but we also need a dynamic innovative financial system. It would be inappropriate to bear down excessively on the former at the risk of damaging the latter. Risk is an essential part of financial markets just as it is an essential part of the economic development process. It should be managed sensibly but it would be a delusion to believe it can, or indeed should, be removed altogether.

The (Reserve) Bank has been very aware of these trade-offs in developing its approach to banking supervision. Its primary concerns are to protect the depositors of banks and to maintain stability in the banking and financial system. Underpinning its approach is a belief that the main responsibility for the prudent conduct of a bank's operations rests with the board and management of that bank. It has developed a set of general guidelines against which to assess a bank's operations and, through statistical collections, consultations and continuous assessment of bank's risk management systems, it monitors each bank's performance. Banks' external auditors report to the (Reserve) Bank on each bank's observance of the prudential guidelines, and on whether its management systems are effective, its statistical reports are reliable, and statutory requirements have been met."

Bearing those objectives in mind, the Reserve Bank has sought, following consultation with banks generally and individually, to establish a framework of prudential standards within which individual banks exercise their commercial judgement.

The supervisory arrangements are described by the Reserve Bank, in a number of its publications, as relatively informal, flexible, and consultative, and designed to enable the Reserve Bank to satisfy itself individual banks are adhering to management practices which limit risks to the prudent levels determined by management. Prudential standards are reviewed periodically to take account of changing environmental conditions.

In short, even where the Reserve Bank has legal power to compel, it seeks to persuade by weight of experience and argument. To adopt language used by the Royal Commissioner during evidence given to the Commission by the Head of Reserve Bank's Supervision department (Mr L Austin), the Reserve Bank seeks to use diplomacy rather than confrontation. Mr Austin stressed, however, that a "persuasive" rather than a "direction giving" approach was meant to maximise the impact of the Reserve Bank view, that is to say, by persuading managers of its correctness.

The system developed by the Reserve Bank to enable it to assess the operation of a bank comprises:

(a) the periodic collection and analysis of statistical data from individual banks;

(b) monitoring banks' observance of agreed prudential standards;

(c) assessing the adequacy of individual banks' management systems for controlling exposures and limiting risk;

(d) regular consultations with a bank's senior management to review each bank's operations; and

(e) each bank having its external auditor report, to the bank itself, and to the Reserve Bank on the bank's observance of the prudential guidelines, on management systems, and on the accuracy of statistical data.

The Reserve Bank has, in consultation with banks, developed and published a series of prudential standards known as Prudential Statements. Main aspects of banking operations covered in Reserve Bank's Prudential Statements are:

(a) Minimum Capital Requirements: Banks are expected to maintain defined capital resources which are agreed by the Reserve Bank as adequate. The Reserve Bank has expressed the view that a bank requires capital:

(i) as a cushion to absorb losses;

(ii) to evidence the willingness of shareholders to commit their own funds on a permanent basis;

(iii) to provide resources free of fixed financing costs; and

(iv) to provide investment in infrastructure and associates.

(b) Liquidity Management: The policy objective is that a bank hold an agreed amount of defined assets which can be quickly and assuredly converted to cash, so as to engender public confidence in banks.

(c) Large Credit Exposures: Undue concentration of risk exposes a bank to an increased likelihood of severe loss and diminution of capital. A bank reduces such risk by working towards, and maintaining, a loan portfolio diversified in terms of individual counterparties, geographical region, and industry. The Reserve Bank looks to banks to establish systems to control, monitor, and limit, risk exposures in domestic and off-shore operations. Those systems are reviewed by the Reserve Bank in discussions with individual banks.

(d) Associations with Non-Banks: The Reserve Bank has no responsibility for the supervision of non-bank subsidiaries of banks, but nevertheless seeks to satisfy itself that banks' subsidiaries are not a danger to the financial well being of the parent bank and that, in general, such associations are with compatible financial institutions.

(e) Ownership and Control of Banks: The Reserve Bank favours a wide spread of ownership of banks with control in the hands of a board of directors representative of the shareholders as a whole. This reflects a concern that banks should avoid potential problems associated with control by a large shareholder. Similar concerns gave rise to the Bank's (Shareholdings) Act, which places limitations on the voting shares in a bank held by any one person.

(f) External Auditors: The Reserve Bank receives information from a bank's external auditors on observance of prudential standards, on the effectiveness and the observance of risk management systems, on the reliability of statistical data provided by the bank to the Reserve Bank, and, generally, on compliance by the bank with statutory or supervisory requirements. There is also provision for external auditors to notify the Reserve Bank of matters which have the potential to prejudice the interests of depositors in the particular bank.

To this point, this Chapter has outlined why the Reserve Bank has a system for assessing each bank's performance, what the Reserve Bank objectives are, and how the Reserve Bank monitors the banking industry. The next part of the Chapter describes the relationship between the Reserve Bank (as the body responsible for supervising banks authorised under the Banking Act), and the State Bank, during 1984-1990.

Before turning to consider that relationship, and by way of summarising the nature of the bank supervision process and the Reserve Bank role in that process, I set out the following description from E Carew's 1991 book, "Fast Money 3 - The Financial Markets in Australia":

"The Reserve Bank has emphasised that prudential supervision is not intended to replace the banks' individual sense of responsibility. The Reserve Bank is not in the business of stopping banks from making bad decisions or losses but it is in the business of trying to ensure that banks conduct themselves prudently, ie, to avoid undesirable consequences.

A fundamental tenet of the Reserve Bank's approach to supervision is that the prime responsibility for the prudent management of a bank rests with the individual bank's management. The Reserve Bank operates at arm's length; it is concerned to reach agreement with banks about standards for key elements of a bank's business, such as adequate capital, holding a stock of prime assets, assessing the risk associated with other assets, general liquidity management supervision and the concentration of large exposures to particular borrowers that could leave a bank vulnerable to loss.

Within this framework, bank management is left to run the bank in a prudent fashion."

That explanation needs to be borne in mind when considering the Reserve Bank's relationship with the State Bank in the period 1984-1990.

15.3 THE STATE BANK'S RELATIONSHIP WITH THE RESERVE BANK

15.3.1 THE BASIS OF THE RELATIONSHIP

I begin with a matter of fundamental significance. Later parts of this Chapter show that the consultative arrangements between the State Bank and the Reserve Bank did not work the way the Reserve Bank would presumably have hoped and intended. In my view, most of those inefficiencies can be, at least in part, attributed to the nature of the legal relationship between those two statutory authorities; one a Commonwealth body, the other a State body.

The constitutional position is that, since federation in 1901, the Commonwealth government has had the power to enact banking legislation, other than with respect to banking by State banks within the boundary of their home state. Accordingly, the Reserve Bank had no express statutory responsibility to exercise any of its powers or functions for the protection of depositors of the State Bank, and no legal means of enforcing its prudential recommendations.

That lack of legal power has, in my view, had a significant bearing on the way the Reserve Bank approached its relationship with the State Bank, and vice versa.

As will be evident from correspondence referred to later in this Chapter, the State Bank's view, largely determined by Mr T M Clark, was that, although it was necessary and appropriate to liaise and co-operate with the Reserve Bank, the State Bank's first responsibility was to the State of South Australia.

Whilst there may be, in theory, no legislative reason to prevent the State Bank from complying absolutely with the Reserve Bank's prudential guidelines and objectives, nevertheless, the material before the Investigation indicates that various people's perception of the constitutional position has been a significant factor in determining the nature of the relationship as it existed during 1984-1990.

In respect of banking business conducted by any State bank outside its home state, I am advised that the Reserve Bank view is that, subject to securing the passage of a relatively minor amendment to the Banking Act, the Reserve Bank's statutory power would clearly encompass such interstate operations. The Investigation, however, has also been advised that, even with such amendment, the Reserve Bank would be able to compel a State bank to produce statistical data only in respect of that interstate component of its operations. Because effective prudential supervision requires an understanding of a bank's whole operation, it would not be practical to formally supervise only the interstate operation of a State bank.

Even though it does not have formal responsibility for supervising State banks, it is, as has been explained above, part of Reserve Bank's responsibilities to protect the stability of Australia's financial system. Consistent with that responsibility, the Reserve Bank has had consultative arrangements with State banks, including the State Bank's predecessors, since the late 1950's.

By letter of 24 July 1984, the Governor of the Reserve Bank suggested to the State Bank that consultative arrangements should continue with the newly constituted State Bank. The basis of the relationship sought by the Reserve Bank is set out in that July 1984 letter as follows:

"The Reserve Bank recognises and accepts that your Board would not forego its power to make decisions for your bank but considers that it is not inconsistent with this position to have close, mutually advantageous relations with the Reserve Bank and, before making such decisions, to give consideration to any views the Reserve Bank may have expressed to your bank. Accordingly, it is proposed that your bank be prepared to agree:

1. to consult with the Reserve Bank periodically with a view to assisting the Reserve Bank to obtain an overall picture of the current and likely future banking trends in Australia, particularly in lending, liquidity, deposits and interest rates and in this connection to provide statistical and other relevant information as agreed from time to time; and

2. to obtain and consider the views of the Reserve Bank before reaching final decisions involving substantial changes in its banking policy, such as lending policy, amounts and composition of liquid assets and interest rates.

In making these proposals the Reserve Bank recognises that your bank's agreement to consult with, or to obtain and consider the views of, the Reserve Bank on any aspect of banking policy in no way involves any abrogation of your bank's rights, powers and responsibilities as a State trading bank."

In return, the Reserve Bank offered the State Bank certain undertakings as follows:

"In addition, the Reserve Bank is prepared to confirm the availability to your bank of the following specific arrangements:

(1) Assistance, upon request, in maintaining a portfolio of Government securities suitable to your requirements.

(2) As bankers' bank, to:

(a) accept deposits, including fixed deposits which may be lodged to mature at nominated dates within a month and to allow interest for the broken part of the month; and

(b) serve as a support to your bank in an emergency, such as a severe loss of deposits by your bank, by any or all of the following means, as appears appropriate to the Reserve Bank at the time,

(i) assistance with the realisation of Government securities by your bank;

(ii) prepayment of fixed deposits lodged with the Reserve Bank; or

(iii) provision of loans to your bank under conditions to be determined.

If these arrangements are acceptable, we propose that they become effective immediately."

By letter of 26 July 1984 to the Reserve Bank Governor, the State Bank's Managing Director (Mr Clark) replied in the following terms:

"The Board of the State Bank had its first full meeting today and I was able to place your letter on the agenda. I would like to confirm that the State Bank of South Australia accepts the understandings outlined in your letter."

Although that July 1984 exchange of correspondence sets out the basic terms of the arrangements, those arrangements between the State Bank and the Reserve bank were modified and extended during the relevant period. In relation to the Reserve Bank liquidity management guideline, for example, the Reserve Bank sent a discussion paper to the State Bank on 5 October 1984, and, by letter of 8 May 1985, sought that Bank's co-operation in implementing that prudential standard. By letter of 1 July 1985, the State Bank advised the Reserve Bank that the State Bank had adopted (a modified version of) the prudential standard (this matter is considered later in this Chapter, at section 15.4.2). Similar correspondence in other areas of prudential concern is noted in following parts of this Chapter.

To better understand the relationship, the Investigation looked beyond correspondence recording the terms of the arrangement. Mr Clark offered the following description in the course of a formal interview with the Investigation on 28 January 1992. Mr Clark said a "very important" background matter was that:

"... we had no legal liability to the Reserve Bank. It was purely an arrangement that was a gentleman's agreement. We had no liability or no legal reason to follow any request from the Reserve Bank, Even though that was the legal significance, we certainly didn't act that way. We bent over backwards to try to act as if we were a nationally operating bank fully under the control of the Reserve Bank." ⁽⁾ [Subsequent parts of this Chapter show that State Bank did not comply fully with the Reserve Bank's recommendations. Mr Clark's statement is considered further at Section 15.6].

The Investigation also approached the task of understanding the nature of the relationship by looking at the descriptions of the relationship used by the State Bank and the Reserve Bank during 1984-1990. I set out the following self explanatory extracts from State Bank and Reserve Bank publications:

(a) The State Bank's 1985 Annual Report described its relationship with the Reserve Bank in the following terms:

"The Bank continued to maintain a close relationship with Federal monetary authorities. The Reserve Bank was kept fully informed on all aspects of operations and internal prudential controls were framed in the light of changing Reserve Bank guidelines." (Emphasis Added)

(b) The State Bank's 1986 Annual Report notes:

"While it is not subject to the Federal Banking Act, the Bank continues to maintain a close relationship with the Reserve Bank, applying internal prudential controls in line with Reserve Bank guidelines." (Emphasis Added)

(c) The Reserve Bank's June 1986 `Report and Financial Statements', at page 15, states:

"The Reserve Bank has responsibilities relating to the protection of depositors with banks authorised under the Banking Act ... Although the Reserve Bank does not have formal responsibility in respect of State banks, it looks for parallel relationships with them." (Emphasis Added)

and at page 38:

"The Reserve Bank is responsible for the supervision of banks authorised under the Banking Act and also has the co-operation of the State banks on prudential matters." (Emphasis Added)

(d) In its 1987 booklet, `Reserve Bank of Australia - Functions and Operations', the Reserve Bank described its relationship with State banks in the following way:

"The (Bank) Supervision Unit is responsible for the prudential supervision of banks subject to the Banking Act. ... The Unit also maintains close contact with State banks on prudential matters." (Emphasis Added)

The Reserve Bank exercises prudential supervision over the operations of banks subject to the Banking Act. State banks operate under State legislation but the Reserve Bank receives a high degree of co-operation from them on prudential matters."

In retrospect, it is evident that language used by both the State Bank and the Reserve Bank in those public statements can be reasonably understood by different people to mean different things. Indeed, the public utterances by both the State Bank and the Reserve Bank appear to have been interpreted differently by Commonwealth Government agencies, on the one hand, and State Government agencies, on the other, as illustrated by the following.

Bearing in mind both `interpretations' are offered well after February 1991, it is, nevertheless, illuminating to contrast evidence given to the Royal Commission by Dr G Bethune, the General Manager of the South Australia Financing Authority ("SAFA"), with advice offered to the Federal Treasurer by the (Commonwealth) Industry Commission's December 1991, `Report on the Availability of Capital for Australian Business'.

In his evidence to the Royal Commission dealing with his visit to the Reserve Bank on 23 August 1990, Dr Bethune said:

"I think our assumption had always been that the arrangements were the same (as for the private banks), and therefore that the Reserve Bank was undertaking detailed supervision of the State Bank ...".

That assumption should be contrasted with the Industry Commission advice, at page 205 of its Report, that:

"State banks have been subject to a different regulatory regime to other banks. ... The conduct of the State banks has been the responsibility of their State Government, and have not been fully subject to Commonwealth banking legislation."

While those two `positions' may not be entirely inconsistent, they, nevertheless, help illustrate the point that, had anyone been interested to find out, it would not have been possible to easily discover the practical effect of consultative arrangements between the State Bank and Reserve Bank in the period 1984-1990.

Before turning to look in detail at certain key areas of prudential concern, there are further general features of the relationship worth explaining and emphasising at this point:

(a) In order to establish offices overseas, for example, in New York and Hong Kong, the State Bank (along with all other Australian banks) needed Reserve Bank's endorsement that State Bank was adequately complying with the Reserve Bank prudential guidelines.

This Reserve Bank `endorsement' does not reflect a legal power of the Reserve Bank but, rather, the need for the State Bank to have the approval of the central banking authority in that overseas location. In short, overseas central bank authorities would not permit any Australian or other foreign bank to operate in that jurisdiction unless, in the case of an Australian bank (including State banks), the Reserve Bank confirmed to such authority that the bank was properly complying with Reserve Bank's prudential requirements.

On the basis of the information considered by the Investigation, it is clear that suggestions made by Reserve Bank officers to State Bank officers that such endorsement could be withheld was an important means for the Reserve Bank to secure the State Bank's undertakings to comply with the Reserve Bank's requirements, particularly minimum capital requirements, liquidity management, and the involvement of external auditors.

(b) Another important feature of the relationship to be noted at this point is the Reserve Bank undertaking (outlined in its letter of July 1984 referred to above) to provide emergency liquidity support to the State Bank. At the first prudential consultation with the State Bank in October 1985, the Reserve Bank said that it would review that undertaking if the State Bank failed to comply with the Reserve Bank guidelines in respect of liquidity management. (This matter is further considered at paragraph (9) of the chronology in relation to liquidity management, ie Section 15.4.2.1) The same stance was adopted by the Reserve Bank, for similar reasons, at the 1987 prudential consultation (discussed in Sections 15.4.3.1 and 15.5.5).

The Investigation understands that removal by the Reserve Bank of that emergency liquidity facility could have had a significant impact on the State Bank. If financial markets became aware of any such removal, the reaction would, in my view, be unfavourable to the State Bank. The point to be noted is, whilst the Reserve Bank had no specific legal power or responsibility to supervise the State Bank, the Reserve Bank did use the means described above in an attempt to secure the State Bank's full co-operation and compliance with Reserve bank recommendations.

By way of summary, I note that the State Bank was keen to be perceived as meeting and maintaining prudential standards consistent with banks authorised under the Banking Act. That was the position throughout 1984-1990. During the later part of that period, State Bank was also keen to be seen as being subject to Reserve Bank supervision.

So much is clear: the balance of this Chapter seeks to measure the extent to which the State Bank did comply with the Reserve Bank's prudential requirements. The Chapter considers whether the information and reports concerning the Reserve Bank were, under all the circumstances, timely, reliable, and adequate, and sufficient to enable the Board to adequately discharge its statutory functions. In that process, the Chapter seeks to identify whether this aspect of State Bank's operations, affairs, and transactions, were adequately or properly supervised, directed, and controlled, by the State Bank's Chief Executive Officer, by other Bank officers, and by the Board.

15.3.2 HOW THE RELATIONSHIP WORKED IN PRACTICE

Communications between the Reserve Bank and the State Bank had two essential components:

(a) The State Bank provided periodical statistical data to the Reserve Bank covering the full range of Reserve Bank's prudential requirements; the State Bank also provided other information originally generated for internal management information purposes.

(b) More significant were the meetings between Reserve Bank's Bank Supervision staff and senior State Bank executives to discuss prudential matters, particularly the formal annual meetings known as the annual prudential consultation.

That structure reflects the Reserve Bank's approach to supervision published in its 1985 Prudential Statement, No A1:

"The performance of each bank is continuously assessed, having regard to its global operations. Close attention is paid to capital and liquidity adequacy, earnings, loan loss experience, concentration of risks, the maturity structure of assets and liabilities, potential exposures through equity associations and international banking operations. To this end, the Bank looks for timely information from individual banks and regularly discusses with them both their domestic and international operations from a prudential viewpoint".

15.3.3 PROVIDING STATISTICAL DATA

Subject to the reservation as to the accuracy and reliability of information referred to below, I am satisfied, subject to my comments immediately hereunder, that the State Bank can be said to have complied with Reserve Bank requests to provide statistical data and other relevant information. The State Bank's attitude to supplying information to the Reserve Bank is, in my view, properly represented by the following minute of a State Bank Board meeting held on 22 August 1985:

"Reserve Bank- Provision of Information	A request has been received from the Reserve Bank that the Bank provide a schedule of off-balance sheet commitments and return of large commitments on a quarterly basis.
	The Board affirmed the policy that any information concerning the Bank required by the Reserve Bank of Australia will be provided."

I am not satisfied, however, about the accuracy and reliability of at least some of the data that was provided. As noted elsewhere in this Report, there were several significant deficiencies with various State Bank information systems which were used to provide information to senior management. It is, in my view, unlikely that the data provided to the Reserve Bank was entirely reliable, particularly with respect to measuring capital adequacy and liquidity. These particular deficiencies are considered at Chapter 6 - "The Funding of the State Bank" and Chapter 7 - "Treasury and the Management of Assets and Liabilities at the State Bank".

On various occasions, the Reserve Bank raised concerns it had about the accuracy of data and, less occasionally, concerns about adequacy of information systems providing that data. These concerns were usually expressed at annual prudential consultations, and were sometimes raised directly, as illustrated by the following extract from Reserve Bank diary note of 31 March 1987:

STATE BANK OF SOUTH AUSTRALIA (SBSA)

STATISTICAL REPORTING

SBSA have had difficulties accurately completing end-December quarterly returns, as they did completing end-September returns. In some cases problems identified on the end-December 1986 returns led to revisions of previous quarters' returns.

The problem apparently lies with SBSA devoting insufficient resources to the completion of these returns and the direct responsibility for their compilation and accuracy resting at too low a level within SBSA's management structure.

Still we ... feel that senior management takes little interest in the accuracy of the quarterly returns. We, as yet, lack reliable independent tests of the accuracy of these returns. We rely on comparison with other returns and independent information to identify errors, in this regard we were fortunate 31 December coincided with the last Wednesday of the month."

A senior officer in Reserve Bank's Supervision Unit responded (internally) to that diary note of 31 March 1987 by way of handwritten note. It is worth emphasising that response, because it affords an insight into the way in which the Reserve Bank perceived its relationship with the State Bank, and it also illustrates how the Reserve Bank approached its dealings with the State Bank. The handwritten note is in the following terms:

"This is an ideal matter to raise across a table, such as at a consultation, but no such meeting is in sight. I agree that the time has come for a `letter of concern' but we need to be conscious of the sensitivities that may be involved."

The Reserve Bank then wrote (on 8 April 1987) to the State Bank (Mr K S Matthews) in the following terms:

"PRUDENTIAL REPORTING

Over recent quarters there has been a number of instances of inaccuracies in your bank's prudential reports to the Reserve Bank. As you know our approach to prudential supervision places great importance and reliance on the accuracy and timeliness of information supplied by banks.

We have been most grateful for your co-operation in the past in relation to the provision of prudential data and would ask that appropriate steps be taken to ensure the accuracy of the information provided by your bank."

The Investigation has not located any State Bank response to this important letter from the Reserve Bank. Nor has the Investigation been able to identify that Bank officers, particularly Mr Matthews, did any thing to respond to the Reserve Bank's clear signal that the State Bank's management information systems were not producing sufficiently accurate or timely information. In responding to my provisional conclusions, Mr Matthews advised that it was his practice to follow up Reserve Bank comments such as this, and that he believes he would have taken whatever action was appropriate.

The Board, on the other hand, advised that they were not aware of the deficiencies, that they had no reason then to suspect the existence of such deficiencies, and that neither the Reserve Bank concerns about the accuracy of data nor the content of the Reserve Bank letter (of 8 April 1987) were communicated to the Board.

A related issue which the Investigation has addressed is - `How did the State Bank compare with other banks in respect of providing information to the Reserve Bank?'

In evidence to the Royal Commission, the head of the Reserve Bank's Supervision department (Mr Austin) confirmed that the range of information provided by the State Bank was generally the same as information provided by all banks. He noted the State Bank was not required to, and did not, submit certain returns known as `Form A (Balance Sheet)' or `Form B (Profit and Loss Statement)' but the Reserve Bank obtained effectively the same information from Annual Reports published by the State Bank and from quarterly operating reviews made available to the Reserve Bank by the State Bank.

Set out hereunder is a list, provided to the Royal Commission through Mr Austin, of statistical returns submitted by the State Bank to the Reserve Bank.

It should be noted that the number and content of these prudential returns has been evolving during the relevant period; the State Bank, particularly in earlier years, sometimes modified the return to meet its perception of its needs. An example of such modification is provided in the analysis later in this Chapter (at Section 15.4.2) of communications between the State Bank and Reserve Bank in relation to liquidity management.

A further point to be noted at this point, in connection with these statistical returns, is that neither the Executive Committee, nor the Board, saw, or asked to see, these returns, or, more importantly, a summary or analysis of the information going to the Reserve Bank. That remained the case throughout 1984-1990, even though, at the prudential consultation in 1987, the Reserve Bank reminded Mr Clark that it expected all prudential returns to be seen by a Bank's Chief Executive Officer and its Board. This matter is further considered in the later part of this Chapter dealing with the 1987 prudential consultation (beginning at Section 15.5.5).

The Investigation ascertained that two other statistical returns, lodged by selected banks subject to Reserve Bank's formal supervision (namely the four major nationally operating banks), were not required to be lodged by the State Bank. Those returns are:

(a) `Selected Banks - Advances Classified by Industry'; and

(b) `Selected Banks - Finance Limits Classified by Industry'.

Those two returns enabled the Reserve Bank to gauge (albeit, very broadly) the amount of funds advanced by `selected banks' to various industry segments, including the commercial property area. The Reserve Bank advised the Investigation that it is presently developing a more effective statistical return, for completion by all banks, to measure the amount of exposure to a given industry.

Under consultative arrangements then in force, the State Bank could have been invited to prepare and submit such returns; in the light of the evidence to this Investigation demonstrating that the State Bank became overly `exposed' to the construction and commercial property industry, it is clear that a return containing data which more effectively measured the extent of the State Bank's exposure to any given industry would have been useful. The matter of the processes within the State Bank to measure these exposures is considered in Chapter 5 - "The Management of the Bank Group's Diversifiable Credit Risk".

The Reserve Bank has advised the Investigation that, while it could have been possible to ask the State Bank to complete such returns, there are other matters which need to be taken into account:

(a) it would have been difficult to single out the State Bank;

(b) such returns would not have captured credit advanced by Beneficial Finance or other `off-balance sheet' entities;

(c) the returns would have been ambiguous in relation to the classification of advances secured by property.

There is one other aspect of the Reserve Bank's relationship with the banking industry that is relevant in this context. During 1985-1990, the Reserve Bank Governor met separately with individual chief executive officers of the four major banks. These meetings were held quarterly from the beginning of 1985 (prior to that, meetings were held on a group basis).

The Reserve Bank advised that, although specific prudential issues were raised from time to time by both parties, these meetings were not regarded by the Reserve Bank as forming part of the prudential supervision framework. The major focus was monetary policy issues, including economic conditions and the demand for finance.

Apart from 1990, the Governor or another senior officer also met, at least once a year, with chief executives of all State banks as a group for discussions with a monetary policy focus. There were no regular meetings between the Governor and other banks subject to the Banking Act.

15.3.4 PROVIDING ADDITIONAL INFORMATION TO THE RESERVE BANK

In addition to statistical data, the State Bank provided the Reserve Bank with other information about the State Bank's operations. In his statement to the Royal Commission, and to this Investigation, Mr Austin confirmed that the State Bank's practice of providing the Reserve Bank with information, such as strategic plans and group operating reviews, was not common amongst banks.

Set out below is the list, compiled by the Reserve Bank, of additional information received from the State Bank:

Strategic Plans: 1985, 1986-91, 1987-92, 1990-94

Strategic Programs Supplement: 1986

Profit Plans: 1984-85, 1985-86, 1990-91

Group Operating Review:

. August, September 1984

. March, April, June, September, December 1985

. June, December 1986

. March, June, December 1987

. March, June, September, December 1988

. March, June, September, December 1989

. March, September 1990

. March 1991

Of that additional information provided by the State Bank, it is appropriate to note that, prior to September 1989, certain information was deleted before the documents were given to the Reserve Bank. The information excised included data on loan approvals, accounts gained or lost, losses written off, and fraud and other losses.

In October 1984, the Reserve Bank received the State Bank's Monthly Operating Review and profit plan for 1984-85. A Reserve Bank diary note of 10 October 1984 records that:

"The documents provide considerable detail on group operations ... "Measures of profitability, capital adequacy and liquidity are in easily digestible form ... "regular receipt of these documents would be more than generous in terms of our understanding ... to consult periodically."

I am satisfied this additional information assisted the Reserve Bank in obtaining a broad understanding of the State Bank's strategies and operations. There are other examples of the State Bank's co-operation with the Reserve Bank. One such example is that of the visits to the Reserve Bank, beginning in March 1988, by Mr Matthews, often accompanied by another senior State Bank officer. Mr Matthews went to the Reserve Bank's Sydney head office on approximately a quarterly basis to discuss prudential matters, and other matters of interest. This arrangement was in line with the Reserve Bank's expectation that it would have discussions with those banks formally subject to its supervision as matters arose. Apart from some occasions, when Mr Matthews' lack of substantive knowledge about the detail of State Bank operations caused a small degree of frustration for the Reserve Bank's Supervision Unit, these visits were generally of assistance to the Reserve Bank.

A further example is the secondment of a Reserve Bank officer (Mr C W Guille) to the State Bank in the period April to December 1985. Mr Clark, who was instrumental in that appointment, wrote to the Reserve Bank's South Australian manager on 9 December 1984:

"I understand that occasionally the Reserve Bank seconds one of its officers to a trading bank for experience.

In the State Bank of South Australia we want to guard our independence, but at the same time want to develop a close relationship and understanding with the Reserve Bank.

It seems to me that this could be accomplished if one of your officers were seconded to us for a period of six or twelve months. I am sure we could learn from him and he from us."

Mr Guille returned to the Reserve Bank, but resigned from the Reserve Bank and took up employment with the State Bank in August 1986.

5.3.5 THE CONDUCT OF COMMUNICATIONS BETWEEN THE STATE BANK AND THE RESERVE BANK

A further feature of the relationship process is the organisational level at which communications between the Reserve Bank and the State Bank were conducted. Based on the Reserve Bank approach that it is for senior bank officers to manage a bank, and for its board to oversee management, Reserve Bank's Supervision department conducted the consultative arrangements by communicating, in the first instance, with the State Bank's senior managers, including its Chief Executive Officer.

The Reserve Bank explained to the Investigation what its general practice would be in circumstances where its supervision officers were not satisfied with what a bank's senior managers advised about that bank's operations. In that event, a more senior Reserve Bank officer (in extreme cases the Governor or Deputy Governor) would communicate directly with the Chairman of the Board of Directors.

In relation to the State Bank (and apart from the specific instance of the advance to the Equiticorp Group), it was not until shortly after the prudential consultation of 29 August 1990 that the Reserve Bank considered making contact with the State Bank's Board Chairman. Those Reserve Bank arrangements were `overtaken' by subsequent events, in particular, a suggestion by Mr Clark that he and the Chairman (Mr D W Simmons) should call on the Governor of the Reserve Bank. That meeting took place in December 1990, and is considered later in this Chapter.

The Reserve Bank also advised the Investigation what its general practice would be in relation to State banks, in circumstances where, having made an approach to the chairman of a bank's board, the Reserve Bank continued to hold sufficiently serious concerns. In such circumstances, the Reserve Bank's Governor would approach the shareholder(s) of the bank (which shareholder, in the case of the State Bank, would of course be the South Australian Government). In the normal course, however, the Reserve Bank view is that a shareholder of any bank is represented by the board of directors, and that the extent of reporting between shareholder(s) and board of directors is a matter for the board of directors to decide.

Mr Austin's evidence to the Royal Commission was that, to his knowledge, the Reserve Bank never initiated contact with the State Bank's shareholder prior to January 1991.

The Investigation also addressed the question - Which State Bank officer was responsible for the conduct of the relationship?

As with certain other aspects of the State Bank's operations, there is no simple answer.

The following review leads me to conclude that no one officer at the State Bank during 1984-1990 perceived themself as having that responsibility. The following extracts and summary of statements to the Investigation by Mr Clark and Mr Matthews illustrate the point. Mr Clark explained his position to the Investigation at a formal interview on 28 January 1992:

"I think the history you have to look at is that the bank tried to have a very good and close relationship with the Reserve bank. Ken Matthews was basically always responsible for that connection. In the initial stages letters would come addressed to the Chief Executive and I would hand them to Ken Matthews and he would process them. Often I wouldn't even see the reply. If it was a minor matter he would handle it direct. Certainly all verbal communications between our bank and the Reserve Bank were handled by Ken Matthews. Everything went through Ken." ⁽⁾

When asked whether the correct description would be to say that he had the responsibility overall, but that Mr Matthews had the day to day responsibility for arrangements, Mr Clark explained:

"I guess I never thought it was defined as having the responsibility. The Reserve Bank just wrote to the Chief executive and I pushed it out to Ken Matthews and he handled it. We did formalise it in 1987 and I wrote to the Reserve bank and formalised an informal arrangement, formalised what had been happening." ⁽⁾

and that,

"... I was a actually a post box. They'd send things to me and I would pass them to Ken (Matthews). He was in the office next door and he would handle it. ....".⁽⁾

In a supplementary written submission (dated 26 February 1992) Mr Clark said that, as Chief Executive Officer, he was responsible to the Board for everything that occurred in the Bank, but that the "day to day responsibility for all Government relations - both Reserve Bank and Treasury matters - was Mr Matthews', even before this was formalised in 1987."

When responding to my provisional conclusions, Mr Clark advised:

"When I came to Adelaide it is important to emphasise again that I was on a three year contract, with no discussion or thought of going past three years. My role was to merge the banks, get them up and going and leave. That was what I was hired for. With that sort of brief one does delegate various responsibilities, which was my approach.

As far as the Reserve Bank relationship was concerned, the old Savings Bank had a relationship with the Reserve Bank and that was always handled by Ken Matthews. When I arrived on 1 February 1984 Ken Matthews was appointed general manager of the Savings Bank and he continued the Reserve Bank relationship. I was chief executive officer (merger) for the first five months, then chief executive of the new bank on 1 July. So when I first arrived Ken Matthews continued the Reserve Bank relationship.

When I became chief executive on 1 July Ken continued to be responsible for the Reserve Bank relationship. He maintained that liaison and relationship right through until he retired".⁽⁾ [in July 1990]

The Investigation discussed the issue with Mr Matthews during formal interview on 12 December 1991. Mr Matthews explained that, until 1988, he had no specific responsibility in respect of the Reserve Bank, and, even after 1988, his responsibility was not a substantive one, but was to channel all communication from the Reserve Bank through to the relevant officer of the State Bank. Mr Matthews stressed that, although the State Bank organisational charts may have indicated he was "number two in the bank", he had no people of substance reporting to him, and had no control over other line divisions.

"They reported to Tim Clark, so while on an organisational chart I may have been number two, I couldn't affect decisions in the operational area." ⁽⁾

When questioned about the 1985 and 1986 prudential consultations, and, in particular, why no report of the 1986 consultation had been given to the Board, Mr Matthews said it was not at that stage his responsibility to record or report on those meetings. Mr Matthews explained that all State Bank officers at the 1985 and 1986 prudential consultations simply assumed, because the Chief Executive Officer, Mr Clark, was present at those meetings, it was Mr Clark's responsibility to determine whether any record or report would be made.

Mr Clark's statement in relation to the absence of those reports to the Board was:

"I think I'd have to say that at that stage I hadn't specifically appointed Ken Matthews in a responsible Reserve Bank relationship, but everybody knew he handled it all." ⁽⁾

In their response to my provisional conclusions, the Board advised their understanding was that the responsibility for liaison with the Reserve Bank fell to Mr Clark as Chief Executive Officer, but that, in respect of those meetings when Mr Matthews attended as the Bank's representative, it was Mr Matthews, at Mr Clark's direction, who had the carriage of those meetings.

As was the case with certain other aspects of State Bank operations, there was no clear statement of responsibility in respect of the conduct of the relationship with the Reserve Bank. Although it is reasonably clear that Mr Matthews was, and was perceived by his colleagues in the Bank to be the State Bank officer responsible for liaison with the Reserve Bank, the extent of those responsibilities was not, and is not, clear.

On the basis of the matters discussed above, I am of the opinion that this aspect of the State Bank's operations and affairs was not adequately or properly supervised, directed and controlled, by the Chief Executive Officer (Mr Clark) or by Mr Matthews. Whilst both the Bank and Mr Matthews submitted that Mr Matthews should not be criticised in this respect because Mr Matthew's responsibilities had not been clearly defined, I remain of the opinion that Mr Matthews should bear some of the responsibility for the seriously inadequate reports going to the Board, particularly in 1986 and 1988.

The consequences of that inept management are further explored as part of the analysis of the annual prudential consultations set out later in this Chapter, at Section 15.5. There are two matters to be noted at this point:

(a) There is no basis for believing that the structure implemented by Mr Clark to manage the relationship with the Reserve Bank meant that Mr Clark was not made aware of the prudential concerns raised by the Reserve bank from time to time. In my opinion, the arrangements that were in place did not have the effect of excluding Mr Clark from the more significant matters that arose. In any event, Mr Clark attended (except in 1988 and 1989) the annual prudential consultations, where the Reserve Bank concerns were raised and discussed.

(b) In relation to this aspect, the Investigation has spoken with Reserve Bank Supervision Unit officers present at the relevant prudential consultations. From the Reserve Bank's point of view, it was important that the State Bank sent its 'top team' to the prudential consultation. The Reserve bank was comforted that the State Bank did so, other than in 1988 and 1989. Indeed, prudential consultations were specifically timed to enable a bank's chief executive or deputy chief executive to be present. The Reserve Bank officers specifically confirmed that, so far as they were aware, they were talking to the State Bank's number one and number two. The Reserve Bank saw Mr Matthews as the substantive number two, and did not regard him as someone whose role was limited to a conduit for information.

15.4 REVIEW OF COMMUNICATIONS BETWEEN THE STATE BANK AND THE RESERVE BANK IN FOUR AREAS OF PRUDENTIAL ASSESSMENT

15.4.1 INTRODUCTION

This part of the Chapter comprises a review of the communications between the State Bank and the Reserve Bank in respect of four important areas of prudential concern. These four areas are liquidity management, involvement of external auditors, large credit exposures, and capital adequacy, and I examine them in that order.

At the risk of reporting too much detail, I have set out a chronology of key events rather than my summary of them, or my conclusions arising out of that review. To my mind, the chronologies speak for themselves, and afford a useful insight into how the State Bank conducted its relationship with the Reserve Bank and, therefore, how the State Bank generally conducted its operations and affairs. Even though my approach necessarily means duplication of some aspects, it is preferable to take this approach to enable each chronology to stand alone.

I emphasise that the chronologies do not attempt to deal with technical matters such as the substantive aspects of the State Bank's actual capital or liquidity position. Where appropriate, such matters are dealt with elsewhere in the Report; for example, Chapter 6 - "The Funding of the State Bank" and Chapter 7 - "Treasury and the Management of Assets and Liabilities at the State Bank" deal with the technical aspects of the State Bank's capital and liquidity.

Each of the four chronologies is structured as follows:

(a) a statement of the Reserve Bank objectives and requirements;

(b) a list of what, to my understanding, were the key communications in the period 1984-1990; and

(c) conclusions and comments arising out of issues and matters referred to in (a) and (b) above.

15.4.2 LIQUIDITY MANAGEMENT GUIDELINE - RESERVE BANK OBJECTIVES

The Reserve Bank `prudential objective' is to engender public confidence in the banking industry by requiring banks to hold a defined amount of assets which can be converted into cash quickly and assuredly.

Two documents set out the basic Reserve Bank objectives and requests in this area of prudential concern.

(a) By letter of 10 July 1984 to the State Bank's Managing Director, the Reserve Bank noted:

"... the progressive deregulation of the financial system has brought into focus the need to consider arrangements for the prudential supervision of the adequacy of banks' liquidity".

That letter attached a discussion paper which had been circulated to nationally operating banks, sought the State Bank's comment on the approach outlined in the discussion paper, and also noted:

"... the discussion paper takes the view that the prime responsibility for prudent management of their liquidity rests with banks themselves; however it asserts that the holding of an adequate stock of liquefiable assets of the highest quality is fundamental to prudent funds management".

On 8 May 1985, the Reserve Bank wrote to all State banks with the following request:

".... to the extent that your bank is able to do so within its own statutory obligations, we would welcome your co-operation in implementing the prudential standards set out in the paper."

(b) As noted above, the Reserve Bank, by letter of 24 July 1984, sought confirmation that arrangements between the State Bank and the Reserve Bank would continue. It is worth repeating the relevant parts of that letter.

Whilst acknowledging that the agreement would not in any way involve any "abrogation of your bank's rights, powers and responsibilities as a State trading bank", the Reserve Bank sought the State Bank's agreement on the following matters:

"(1) to have close, mutually advantageous relations with the Reserve Bank;

(2) before making decisions which affect the bank to give consideration to any views which the Reserve Bank may have expressed to SBSA;

(3) to consult with the RBA periodically to assist the RBA to obtain an overall picture of the current and likely future banking trends in Australia, particularly in lending, liquidity, deposits and interest rates;

(4) to provide statistical and other relevant information as agreed from time to time; and

(5) to obtain and consider the views of the Reserve Bank before reaching final decisions involving substantial changes in banking policy such as lending policy, amounts and composition of liquid assets and interest rates."

Mindful of those objectives in respect of liquidity management, the terms of the arrangement, and the nature of the arrangement between the State Bank and the Reserve Bank, the next part looks at what actually took place between the State Bank and the Reserve Bank in the period 1984-1990.

15.4.2.1 Chronology of Key Events - Reserve Bank's Prudential Guideline Concerning Liquidity Management

Communications between the Reserve Bank and the State Bank in this, as in other areas of prudential interest, were extensive. The following chronology sets out what the Investigation regards as the significant events for its purposes.

(1) By letter of 10 July 1984, the Reserve Bank sought the State Bank's comment on a possible framework for prudential supervision of banks' liquidity arrangements.

(2) In the exchange of correspondence of 24 and 26 July 1984, (referred to above in relation to the Reserve Bank objectives), the State Bank agreed with the Reserve Bank's proposed consultative arrangements.

(3) By letter to the Reserve Bank of 17 September 1984, the State Bank's Managing Director acknowledged the importance of prudential supervision of bank liquidity as a matter of principle, but pointed out:

"... because of the newness of the bank and the changing nature of our business, we have yet to determine our final stance in relation to liquidity management".

The letter states it was important that the public have confidence in the banking system, and continues:

"... it follows that for this reason we are also keen to co-operate with the Reserve Bank to ensure that we are perceived as meeting and maintaining prudential standards consistent with those of the other banks".

The discussion paper issued by the Reserve Bank on 10 July 1984 explained a concept eventually known as the `Prime Assets Requirement'. The State Bank did not accept certain definitions suggested by the Reserve Bank and, in this regard, the State Bank's letter of 17 September said:

"... our definition of each of those categories will be discussed in more detail later".

(4) On 5 October 1984 and 7 May 1985, the Reserve Bank sent further discussion papers to the State Bank, and, on 8 May 1985, the Reserve Bank wrote to all State banks seeking their co-operation with the Reserve Bank's prudential supervision of liquidity; this letter provided as follows:

"... to the extent that your bank is able to do so within its own statutory obligations, we would welcome your co-operation in implementing the prudential standards set out in the paper".

(5) The State Bank's Managing Director responded by letter of 10 May 1985::

"We have read the paper with interest and are currently undertaking a review of our policy against the policy as annunciated in your paper".

(6) The issue was discussed at the June 1985 Board meeting. Board Minute 85/169 records that the Reserve Bank had determined a new formula to measure bank liquidity, termed the `Prime Assets Ratio'. That Board Minute states that a ratio "of 12% will be a fixed minimum to be observed at all times". The Board Minute then notes "It was proposed that it is in the (SBSA's) best interests to adopt a similar liquidity approach ..."

The Board resolutions were: "The Bank adopt a prime asset ratio of 12% as a base minimum measure of liquid adequacy ...", and, "The proportion of S.A. Government securities included not to exceed 25% of total prime assets."

The five page analysis of the implications of the Reserve Bank's prudential recommendation, prepared and presented by Mr G S Ottaway in his capacity as Chief Manager, Finance, did not explain to the Board that the State Bank investments in SAFA were not regarded by the Reserve Bank as within the Reserve Bank's definition of "Prime Asset", nor that their inclusion meant State Bank was not complying strictly with the Reserve Bank prudential guideline.

Furthermore, page 4 of Mr Ottaway's paper states that "loans to S.A. Government Financing Authority" were "liquid assets", and that:

"The inclusion of state government loans recognises the particular responsibility, of the Bank to support and contribute to the financial well being of the State."

It is proposed to only include State government paper to a level not exceeding 25% of total prime ratio assets."

That is not to say the Board was entirely unaware of the position. Mr Ottaway advised the Investigation that the Board was aware that the State Bank investments in SAFA were not within the Reserve Bank definition of "Prime Asset".

The Board confirmed to the Investigation that they were aware that the manner in which the State Bank held liquid securities differed from the way in which the nationally operating banks were required to comply with the Reserve Bank guideline. The Board advised that it accepted management's explanation for the non observance of this guideline, and accepted management's assurances (supported by the Reserve Bank's apparent agreement) that the State Bank's position was acceptable to the Reserve Bank.

(7) By letter of 1 July 1985, the State Bank's Chief Manager, Finance (Mr Ottaway) advised the Reserve Bank:

"... the Bank has adopted the Prime Assets Ratio as a measure of prudential liquidity management. However, in doing so, special consideration has been given to the role of the Bank as an instrumentality of the State."

The letter went on to describe the relationship between the State Bank as a significant investor in liabilities of the South Australian Government Financing Authority ("SAFA") and continues:

"In view of this arrangement .... the Bank has considered it appropriate to include some proportion of the holdings (in SAFA) as eligible PAR assets."

In effect, the State Bank agreed, in general terms, to comply with the Reserve Bank's prudential guideline on liquidity management, but, in so doing, adopted a definition of `eligible PAR asset' different from the Reserve Bank definition.

(8) A Reserve Bank diary note of 7 August 1985, noted:

"... under Australian banking legislation, and the `co-operative' arrangements, SBSA are free to follow the liquidity policies of their choice."

"Should they decide to adopt the PAR approach, however, it should not be open to them to seek to adopt different definitions to those which apply to other banks."

The Reserve Bank was concerned not to allow an arrangement:

"... which could be interpreted as implying that the RBA was prepared to adopt differing definitions of Prime Assets or which might lead to confusion in depositors' minds as to what constituted Prime Assets."

This item was listed by the Reserve Bank as one which should be discussed with the State Bank at "a prudential consultation in the near future".

(9) A Reserve Bank diary note of 16 August 1985 records that the Bank Supervision Unit spoke with State Bank (Mr Matthews) to ensure the State Bank's June 1985 Annual Accounts would contain a note explaining that the State Bank had adopted a definition of "Prime Asset" different from the Reserve Bank definition.

Note 10 to the State Bank Accounts for June 1985 stated:

"Prime Assets

The State Bank is not obliged to conform to the P.A.R. but considers it prudent to do so. While the Reserve Bank does not include securities issued by State Government authorities in its definition of liquid securities, the Bank as a significant investor in liabilities of South Australian Government authorities, considers it appropriate for its purposes to include a proportion of the State Government guaranteed securities as part of its holding of Prime Assets."

A subsequent Reserve Bank diary note records that Note 10 "preserves our own position satisfactorily". The Investigation understands this Reserve Bank note to mean the Reserve Bank "position" was "preserve(d)" in that Note 10 makes it reasonably clear that the State Bank has adopted a definition of "liquid securities" different from the definition the Reserve Bank required Banking Act banks to adopt.

(10) At the first annual prudential consultation between the Reserve Bank and the State Bank on 23 October 1985, the Reserve Bank welcomed the State Bank's advice that it was generally willing to adopt the liquidity prudential measure, and inquired about the State Bank's intention to comply with the Reserve Bank's definition of PAR assets. The Reserve Bank diary note of the consultation records that:

"... PAR Assets were of the highest quality, and readily liquefiable"; SAFA paper did not fully meet these requirements".

Mr Ottaway is recorded in the Reserve Bank diary note as having said:

"(SBSA) acknowledged the spirit of the PAR arrangements and will look towards complying more closely with them. However, for the time being, they may not be able to comply as they would not see it as appropriate to move out of SAFA paper at a loss."

and that:

"(SBSA) had no specific commitment to hold SAFA paper and that there were no particular liquidity requirements in SBSA's legislation or regulations. The timing of any reduction in their holdings of SAFA paper would depend on interest rates and the maturity schedule which extended well into the 1990's. He confirmed, in response to questions from Mr Marcus Clark, that SBSA was under no pressure from the State Government to roll over their SAFA investments at maturity; they were not seeking a letter from the Reserve Bank to support their redemption of this paper."

The Reserve Bank note records that the State Bank was reminded that the Reserve Bank's general offer of emergency liquidity assistance to State banks was at Reserve Bank discretion, and on Reserve Bank terms. Mr Clark is recorded as responding "by referring to (the Reserve Bank) letter of 1965 and saying that, if we wished to change the rules, he would like a letter to that effect".

The Reserve Bank diary note continues:

"Mr Brady indicated that the new arrangements were not necessarily inconsistent with the earlier letters."

(11) State Bank Board Minutes of the Board meeting held the following day, 24 October 1985, record four paragraphs in relation to the prudential consultation. Even though the Reserve Bank had alluded to a review by the Reserve Bank of its undertaking to provide emergency liquidity assistance to the State Bank, the Board Minute, in relation to this aspect, (85/169) records only:

"Discussions centred on prudential arrangements in place by the SBSA to prevent business risk.

The Reserve Bank noted the higher proportion of semi-Government securities making up the Bank's Prime Asset Ratio. The Bank will work towards reducing the proportion, but this is expected to eventuate over a long period."

(12) The November 1985 Board meeting received a paper (85/330) on the matter of the Reserve Bank's prudential guideline on liquidity. The paper, dated 28 November 1985, prepared by Mr Ottaway, and apparently presented by him in his capacity as Chief Manager, Finance, is in the following terms:

"Under current policy (SBSA) observes the broad intent of the Reserve Bank prudential guidelines by holding a range of high quality liquefiable assets to the stipulated proportion (not less than 12%) ...

By the (SBSA's) definition, these "prime assets" (include) our investments in SAFA despite their ineligibility under the Reserve Bank specifications.

Our recent meeting with the RBA made two points quite clear:-

1. The definition of "prime assets" is proprietary to the RBA and while we are free to arrange appropriate internal liquidity guidelines our description should reflect the integrity of the RBA definition.

2. The inclusion of South Australian semi-government debt as a component of primary assets/liquidity is understood, and the reasoning put forward was accepted by the Reserve Bank. However, it was evident that compliance with the letter of defined prime assets guidelines was a preferred course and, without commitment, we have indicated a willingness to work towards that position as and when appropriate opportunities arise. (The implication here is a progressive sell-off of SAFA paper and substitution with Commonwealth Bonds)".

A minute (85/330) of the November 1985 Board meeting records:

"Prime Assets/ Definition and Management

An information paper which outlined discussions between State Bank and Reserve Bank officials on the matter of defining prime assets for prudential control was noted."

No mention is made in Mr Ottaway's paper of the nature of the concerns raised by the Reserve Bank, nor of Reserve Bank's suggestions that it might need to review its offer of emergency liquidity assistance. That failure to properly inform the Board is considered further in the subsequent part of this Chapter dealing with the 1985 prudential consultation - see Section 15.5.3.

In his submission (dated 24 September 1992) to the Investigation, Mr Ottaway offered the following explanation in support of his view that there had been no intention to mislead the Board. It is appropriate to set out Mr Ottaway's explanation as I regard it as a useful example of how communications between the Reserve Bank and the State Bank worked (or didn't work).

"The Reserve Bank did not at any stage threaten to withdraw emergency liquidity assistance. In their softly softly way they simply used certain expressions to emphasise a point. In this case the point was well understood that the desired course was the achievement of "true PAR" and if we were not committed to that then they "might need to review its offer of emergency liquidity assistance". I doubt that anyone present would have seen this as a warning of which the Board should be made aware.

I can see how a purist might have a different, more cynical view. The Reserve Bank has always had its own, special way of doing things, communicating, and to use such an approach often led to some doubt as to true intentions. However, in this case, if they had ruled our approach simply not acceptable, I am sure they would have said so."

(13) Against that background, the Chairman's Report in the State Bank's Annual Report for year ending June 1985, records:

"... the Bank continued to maintain a close relationship with Federal monetary authorities. The Reserve Bank was kept fully informed on all aspects of operations and internal prudential controls were framed in the light of changing Reserve Bank guidelines."

(14) By letter of 6 May 1986, the Reserve Bank sought information from all banks on the policy of its board in respect of large exposures to individual clients or groups of related clients, and also a description of management systems for assessing and controlling credit risk.

(15) By letter dated 20 May 1986, the State Bank's Managing Director replied in the following terms:

"The State Bank of South Australia acknowledges the role of the Reserve Bank of Australia as a prudential supervisor, but we are concerned that your requirements now and in the future do not prejudice our role and responsibilities as a state bank. In this regard, we remind you that the Bank does not come within the formal jurisdiction of the Reserve Bank in other than selected issues, and we reserve that position where circumstances are in our view prudent and appropriate."

In respect of the Reserve Bank definition of Prime Assets Ratio the letter says:

"In terms of our earlier discussions the Bank presently includes a component of State Government paper (State of South Australia only) within its internal definition of Prime Assets. We have indicated to you a willingness to move towards full conformity with the Reserve Bank guidelines, provided that this does not prejudice our ability to serve the State in accord with our charter.

In summary, the Bank is committed to respond to the Reserve Bank in its role as a prudential supervisor so far as we are able, but we must make firm our independence from formal jurisdiction where our role and status as a state bank may be prejudiced."

(16) By letter dated 27 May 1986, the State Bank (per Mr Ottaway) sent details of State Bank systems for controlling exposures and limiting risks in respect of credit, liquidity and foreign exchange operations. In relation to liquidity, the statement of policy provides as follows:

"(1) State Bank, as a significant investor in S.A.F.A. and other SA Government guaranteed securities considers it appropriate to include a proportion of such securities in its measurement of liquidity adequacy. However, although not obliged to conform to the Prime Assets Ratio, State Bank in consultation with the Reserve Bank has agreed that over a period of time it will increase its holdings of prime assets as defined in order to meet RBA guidelines of a PAR of 12.0%.

At 31 March 1986

PAR Ratio (excl. SA Semi Government Stock) 10.1%

PAR Ratio (incl. SA Semi Government Stock) 12.4%"

(17) The second annual prudential consultation between the Reserve Bank and State Bank was held on 12 September 1986. The Reserve Bank's Long Diary Note records that the Reserve Bank outlined the aims of prudential supervision, and acknowledged the co-operation of State banks with the Reserve Bank. It then records that Mr Clark:

"... confirmed that SBSA will try to co-operate with the Reserve Bank's prudential guidelines; but he would not want the Bank to assume that it could give the same instructions to state banks as it does to Banking Act banks."

The note records Mr Kelleher:

"... accepted the point but explained that there were times (for example, with SBSA's current plan to establish a representative office in Hong Kong) when overseas supervisory authorities sought from the Reserve Bank a statement that it was satisfied with the systems and management of a particular bank. In order to give such statement (RBA) needed to know that a bank's systems were adequate and were being observed".

In relation to the matter of the Prime Assets Ratio, the Reserve Bank's Long Diary Note records:

"...

7. PAR

Mr Matthews said that they have put to the Board a proposal that they move more actively to meet PAR and that they aim to achieve it as quickly as possible. They do not expect the Board to oppose this recommendation"

(18) The Investigation can find no report to the Executive Committee of the September 1986 prudential consultation, nor any report to the State Bank's Board. The absence of a report is, in my view, surprising, given the discussions at the consultation relating to State Bank compliance with the Reserve Bank's prudential requirements, and, especially, given the Reserve Bank's suggestion that it might not be able to give the approvals required to enable State Bank to establish a representative office in Hong Kong.

For the second time in two years, the Reserve Bank had been moved to make not very subtle observations in order to secure State Bank co-operation. For the second time in two years, Mr Clark and Mr Matthews did not inform the Board or the Executive Committee of these matters. As a result, the Board was unaware that the Reserve Bank was concerned about the State Bank's lack of complete observance of the Reserve Bank's prudential guideline concerning liquidity.

(19) The matter of liquidity was raised at the Board's next meeting, held on 25 September 1986. A paper (dated 10 September 1986) entitled `Liquidity Ratio' was presented by the General Manager, Treasury and Capital Markets (Mr J T Hazel) and was `supported by' the Chief General Manager, Mr Matthews.

The paper recommended:

"... the Bank set its minimum liquidity ratio at 12% of net Australian Dollar assets in Australia, held in a form complying with the guidelines set by the Reserve bank, ie Prudential [sic] Assets Ratios (PAR)"

The `discussion' section of the paper explained that the State Bank's guideline on liquidity was to hold "12% of net A$ assets on the Australian books" invested in "PAR assets or marketable South Australian Semi-Government securities (the latter to a limit of 3 per cent)", but that the:

"... the Reserve Bank definition of PAR Assets is given as:

Notes and Coins

Balances with the Reserve Bank of Australia

Treasury Notes

Commonwealth Government Securities

Loans to authorised money market dealers secured against Commonwealth Government

The paper continues:

"In differing from "true PAR", the (State) Bank has recognised that South Australian Government securities are:

(i) an investment consistent with the Bank's charter;

(ii) liquid (in this regard we have arranged overdraft facilities from Treasury)."

"The Reserve Bank of Australia has sought and received agreement from all State banks that the PAR convention set for banks under the Commonwealth Banking Act will be adopted for their own liquid assets in due course.

In ongoing dialogue with the Reserve Bank of Australia this Bank has indicated that it will move toward compliance with the PAR convention by December 1986. It is recommended that we move to compliance with the PAR convention forthwith."

"Whilst the recommendation is that we make these moves forthwith, it is recognised that there will be a transition period. This transition period, encompassing the rundown by way of maturity/sale of Semi-Government securities ... will by necessity, take some time."

The Board Minute in respect of this item (86/364) recites some of the points made in the paper and then notes:

"In State Bank's case, the Reserve bank has accepted a wider definition of liquids in meeting their prudential guideline.

The Reserve Bank has sought and received agreement from the [State] Bank that the PAR convention will be adopted for liquidity control in due course. In ongoing dialogue with the Reserve Bank, State Bank has indicated that it will move towards compliance with the PAR convention by December 1986."

The formal resolution of the Board was:

"... the Bank set its minimum liquidity ratio at 12% of net $A assets in Australia, held in a form complying with the guidelines set by the Reserve Bank of Australia, ie Prudential [sic] Assets Ratio (PAR) ..."

The Board resolution can be usefully contrasted with the advice given by Mr Matthews to the Reserve Bank during the prudential consultation of 12 September 1986 (referred to at paragraph (17) of this Section, above) that State Bank senior management did not expect the Board to oppose the recommendation. Apart from Mr Matthew's suggestion to the Reserve Bank, there is nothing before the Investigation to indicate that the Board had perceived the matter as one that it might oppose. It is also noteworthy that the above Board approval was not communicated to the Reserve Bank until fourteen months later when, in November 1987, the State Bank sought the Reserve Bank support for the State Bank's plans to operate in New York (see paragraph (23) of this Section, below).

The effect of the communications in relation to the PAR ratio was that, the Reserve Bank thought the State Bank Board was resisting total co-operation because of a Board view that absolute compliance with the prudential guideline was not consistent with the State Bank's legislative charter. On the other hand, the Board thought the Reserve Bank had simply accepted a "wider definition of liquids", and was not aware the Reserve Bank had raised any concerns about the issue.

(20) The next significant event was the next prudential consultation, held in October 1987. In the intervening period (between September 1986 and October 1987) the State Bank continued to submit to the Reserve Bank the required statistical data on its liquidity position.

(21) The third prudential consultation was held on 15 October 1987. Mr Matthews was not able to attend, and Mr Clark was not there at the commencement of the meeting. The Reserve Bank diary note records that the consultation opened with:

"Mr Brady indicated that among the matters he wished to discuss with SBSA was the question of establishing better understandings regarding the bank's willingness to observe our prudential guidelines, including PAR and capital ratios".

State Bank's General Manager, Corporate and International Banking (Mr Ottaway), is recorded as saying:

"... he understood (State Bank) had indeed been meeting PAR since the beginning of 1986."

and that:

"... whilst the bank was endeavouring to meet PAR at all times, he would have to say that the banks systems were not sophisticated enough for him to be able to give a categorical assurance that PAR was being met at all times. For this reason, a small liquidity buffer (0.5% to 1 per cent) above PAR minimum was being carried."

Mr Ottaway's response should be contrasted with his letter to the Reserve Bank of 27 May 1986 which notified that, at 31 March 1986, the State Bank's PAR ratio (excluding its SAFA investment) was 10.1 per cent (see paragraph (16) of this Section).

The Reserve Bank's Long Diary Note continues:

"Mr Brady said that our files did not indicate that SBSA had given an undertaking on meeting PAR. Mr Pearson added that the most recent correspondence from SBSA on the matter was that it would meet a wider PAR, one which included S.A. Government paper. Mr Ottaway indicated he believed SBSA would have no problems in giving a commitment to meet PAR.

Mr Brady explained that the PAR requirements called on a bank to meet PAR at all times and to be in touch with Supervision Unit if it considered it was likely to breach PAR. For our part, we treated the requirement that PAR be maintained at all times very seriously and invariably asked the bank's Chief Executive to call in and explain at first hand any breach."

"Mr Brady said we had prepared a draft letter of undertaking on PAR which we would like SBSA to consider. This was passed to Mr Ottaway."

(22) Except to the extent that minutes of the Executive Committee meeting of 16 October (see paragraph immediately following) may have been included in subsequent Board Papers, the Investigation had not been able to locate any report to the Board of the 1987 prudential consultation.

The minutes of the Executive Committee meeting held on 16 October 1987 record the following under the heading `General Discussion':

"Reserve Bank of Australia

The General Manager, Corporate and International Banking (Mr Ottaway) advised that the meeting with the Reserve Bank on 15 October confirmed this Bank's relationship with the Reserve Bank. The Reserve Bank noted the Bank's move towards prudential controls in line with the Reserve Bank policy. There were some outstanding matters to be resolved, particularly in the area of special audit requirements of the Reserve Bank."

Mr Ottaway advised the Investigation that the very brief minute should not be taken to indicate that there was no discussion. His view is that it is most probable that the "outstanding matters" would have been outlined to that meeting.

The above minute, nevertheless, suggests that the Executive Committee had not properly understood the content of the discussions with the Reserve Bank. At the very least, the minute of the Executive Committee, by itself, could not possibly have conveyed an adequate message to the Board. That, together with the absence of any separate report to the Board, constitutes, in my opinion, a breach, particularly by Mr Clark, of the duty to keep the Board properly informed. This matter is further considered later in this Chapter, following the review of the 1987 prudential consultation (see Section 15.5.5).

(23) A Reserve Bank diary note of 27 November 1987, (by Mr Brady as Head of the Supervision department) records that Mr Ottaway rang Mr Brady to inform the Reserve Bank, the State Bank Board had agreed that management should investigate the feasibility of establishing a branch in New York. The note records the following:

"The impression I gained from our conversation was that SBSA (as distinct from Mr Ottaway who was being quite co-operative) was still being very difficult about the question of supervision by the Reserve Bank. I reminded Mr Ottaway that SBSA was the only bank in Australia which had not acceded to our proposal to involve external auditors in the process of supervision (even though we believed that they had so agreed on an earlier occasion). I also reminded him that an unwillingness on the part of SBSA to observe our prudential requirements could have a bearing on the ability of SBSA to establish an operation in New York."

By letter to the Reserve Bank of the same date (27 November 1987), the State Bank (per Mr Ottaway) confirmed, amongst other things:

".... (State Bank) now observes the Prime Asset Ratio guidelines outlined in Prudential Statement No P.S.5 and further confirms its intention to continue to voluntarily adhere to those guidelines".

"In giving these undertakings we reiterate that they remain subject to any considerations relevant to our responsibilities from time to time arising under the State Bank of South Australia Act, 1983."

(24) In the course of formulating a draft response to Mr Ottaway's letter (which draft was for the consideration of senior Supervision Unit officers) the Supervision Unit's analysis (dated 10 December 1987) of Mr Ottaway's letter records that the State Bank:

"... confirms its intention to continue to voluntarily adhere to PAR arrangements"

and that:

"SBSA have qualified their agreement to abide by our PAR, capital and large exposure policies. Given SBSA is not a Banking Act bank and has been reluctant to fully abide by our policies in the past, this is perhaps the best we could have hoped for".

(25) By diary note of 13 January 1988, the Reserve Bank's Head of Supervision records further thoughts about the Reserve Bank's relationship with the State Bank. The diary note refers to a letter dated 28 December 1987 from the State Bank, in connection with the State Bank's intention to establish a New York office and an operation in Cayman Island:

"The Cayman Island supervisory authority is seeking confirmation that the Reserve Bank has no objection to the proposed operation in its territory. The State Banking Department in New York will seek a similar statement. When offering confirmation of this nature in the past in respect of State banks we have usually said that, while we do not have statutory powers over State banks, the bank concerned co-operates in giving effect to our banking and prudential policies.

In the light of recent exchanges between SBSA and ourselves, there is a question as to whether we can make a similar statement in respect of this Bank. The present position is:

There is an exchange of letters between us (dating from 1959/60 and 1965, reconfirmed in 1984) in which SBSA agrees to consult with us on a range of matters (but not on prudential matters specifically) in return for certain assurances from us;"

"In recent correspondence (27 November 1987), which followed our annual prudential consultation with the bank, SBSA has given qualified confirmation of its intention to co-operate with the Reserve Bank's guidelines relating to PAR and capital adequacy. On large exposures SBSA has given a somewhat grudging acknowledgment of our guidelines."

"The major outstanding matter between us relates to arrangements with external auditors."

"Recent history shows that SBSA (or at least its Managing Director) has been grudging in accepting our prudential requirements. I think we should make it clear that our support of applications by SBSA to establish operations overseas is not given lightly - that we should be satisfied that SBSA does co-operate with us in giving effect to our banking and prudential policies. For this reason, I propose to reply to SBSA along the lines of the attached draft."

A hand written note attached to the above Reserve Bank diary note suggests the matters raised in the diary note be discussed by way of a phone call, rather than in writing. The Investigation has been unable to establish whether any subsequent telephone conversation took place.

(26) The view expressed in the above Reserve Bank diary note (of 13 January 1988) as to the State Bank's less than complete compliance with Reserve Bank guidelines can be contrasted with the position presented to State Bank's Board on 8 September 1988.

The Board had asked management to provide information to it, to explain changes (announced by the Commonwealth Treasurer in a Budget speech) to the Reserve Bank's Statutory Reserve Deposit Scheme. The paper (88/393), submitted to the Board in response to that request, discusses whether State banks should be required to pay what the paper (incorrectly in my opinion) describes as a "licence fee" to the Reserve Bank and states:

"... with the State Bank's liabilities being formally guaranteed by the Government of South Australia, and the Bank's strict adherence to the other prudential and capital adequacy guidelines of the Reserve Bank, there appears no need for the State Bank to pay an additional fee to the Reserve Bank for the extra comfort of liability holders". (Emphasis Added)

(27) The Investigation has not identified any document, subsequent to September 1989, signifying that the Reserve Bank had any further material adverse view concerning the State Bank's compliance with PAR.

Reserve Bank diary notes, subsequent to that date, indicate that the State Bank continued to provide statistical data. Although there were occasional reporting difficulties and inefficiencies on the State Bank's part, and some breaches by the State Bank of the PAR ratio, in general terms, the Reserve Bank liquidity guideline appears to have been complied with to the satisfaction of the Reserve Bank. The Investigation is not aware of anything which would suggest that the Reserve Bank view was incorrect.

15.4.2.2 Liquidity Management - Conclusions

The review of the history of the communications between the State Bank and the Reserve Bank in relation to the Reserve Bank prudential guideline concerning "liquidity" was undertaken because it is part of the aggregation of events that allow for an understanding of State Bank's financial position as at February 1991. The review of this matter was also undertaken because it helps to understand a number of matters of fact, namely:

(a) the way the State Bank conducted its affairs and related to the Reserve Bank;

(b) the way the Reserve Bank conducted its affairs in its relationship with the State Bank; and

(c) the extent to which the State Bank's Board was aware of, and involved in, the relationship between the State Bank and the Reserve Bank.

The Reserve Bank's request for the State Bank to co-operate with the liquidity management guideline was made in May 1985. The State Bank's qualified undertaking to "voluntarily adhere to those guidelines" was not given until November 1987 (see paragraph (22) of Section 15.4.2.1 above). Even then, I am satisfied that the primary reason for giving that undertaking at the time was because of the State Bank's need to have Reserve Bank endorsement in order to open a branch office in New York.

It must be borne in mind that the Reserve Bank has never indicated that the State Bank did not hold an adequate amount of readily liquefiable assets. Nevertheless, it is clear, on the basis of the information set out in the above chronology, that the State Bank's delay in giving an undertaking to comply with the guideline was a matter of concern to the Reserve Bank, as was the State Bank's inclusion of its investment in assets which were not within the Reserve Bank's definition for liquidity management purposes.

The important issue, for the purposes of the Investigation, is that the discussions and correspondence between State Bank and the Reserve bank were not properly relayed to the Board. Also of concern is that the conduct of senior State Bank officers created the impression, in the mind of the Reserve Bank officers, that State Bank's Board was party to the relevant discussion. As a result, the Reserve Bank would have seen no point in taking up the matter with the State Bank Board, and did not take it up.

As noted above (paragraph (6) of Section 15.4.2.1 above), Mr Ottaway's June 1985 paper created the impression in the Board's mind that the State Bank was complying with the Reserve Bank requirement to the complete satisfaction of the Reserve Bank.

The position could have been rectified after the prudential consultation in October 1985. The relevant Board Minute from the October 1985, however, suggests to me that, rather than clarify the position, the same incomplete and, therefore, misleading story was again presented to the Board. Mr Clark must have been aware of the fact that other Board members were not properly informed on this issue.

Mr Ottaway's November 1985 Board Paper (see paragraph (12) of Section 15.4.2.1 above) refers to the fact that State Bank's investment in SAFA was "ineligible under Reserve Bank specifications", but then says the inclusion of that investment "is understood, and the reasoning put forward was accepted by the Reserve Bank". His paper then notes that strict compliance was "a preferred course".

This matter is significant for what it reveals about the way State Bank senior managers, particularly Mr Clark, dealt with their Board, and with the Reserve Bank. It is, in my opinion, beyond argument that it was for the Board to determine State Bank policy in respect of the liquidity management guideline. The reports going to the Board did not properly explain the nature or the extent of the Reserve Bank's concerns and were, therefore, plainly inadequate, and not sufficient to enable the Board to discharge adequately its functions under the Act.

The last matter I refer to in this context is to note that the chronology demonstrates that, in its dealings with State Bank, the Reserve Bank was obviously conscious that its consultative arrangements with State Bank were voluntary, and that State Bank's qualified undertaking to comply with the prudential standard was consistent with the legal position.

15.4.3 REPORT TO THE RESERVE BANK BY THE STATE BANK'S EXTERNAL AUDITORS - RESERVE BANK OBJECTIVES

The reasons for introducing a bank's external auditors into the Reserve Bank's prudential supervision process, and a statement of what the Reserve Bank hoped to achieve, were set out in Reserve Bank's `Report and Financial Statements', 30 June 1986:

"External auditors

Supervisory authorities naturally need to know that data on which they make prudential assessments are reliable. In a number of countries this is achieved by examination and inspection of individual financial entities by the supervisory authorities. In Australia, the Reserve Bank does not have legal authority to inspect individual banks. As a middle way, in the past year the Bank commenced discussions with banks about establishing links between the Reserve bank and banks' external auditors. Arrangements were agreed with all banks; they will be fully implemented during each bank's next financial year. Each bank will ask its external auditor to report on the observance of prudential standards and other requirements set by the Reserve Bank; the effectiveness of, and observance of, its management systems to monitor and control risks; the reliability of statistical data provided to the Reserve Bank; and compliance with relevant regulatory and operating requirements. External auditors will also be asked to bring to the attention of the Reserve Bank, through and after discussion with the bank itself, any matters which, in the auditor's opinion, might have potential to prejudice materially the interests of depositors of the bank.

These arrangements are not intended to interfere with customary relationships between a bank and its external auditor; communications between the Reserve Bank and the auditors will pass through the bank concerned."

The Reserve Bank's Prudential Statement PS H1, published in April 1986, contained a more detailed explanation:

"Relationship Between Banks, Their External Auditors and the Reserve Bank

1. The Reserve Bank has responsibilities for the protection of depositors of banks subject to the Banking Act. It also has an interest in the stability of the financial system generally.

2. Against that background, the Reserve Bank has developed a system of prudential supervision of banks. This is directed towards the Bank satisfying itself by enquiry and report that individual banks are following management practices which limit risks to prudent levels and which are kept under review and adapted to changing circumstances.

3. The information on which bank supervision in Australia operates includes:

(a) statutory returns submitted by banks;

(b) other data provided to the Reserve Bank by banks;

(c) published financial statements of banks together with reports by their external auditors;

(d) information provided by banks about their management systems to control exposures and limit risks;

(e) requirements for prudential operation of banks, as set out in various statements sent to them by the Reserve Bank.

4. At present, the Reserve Bank cannot say from its own enquiries or independent enquiries on its behalf that the data in 3(b) are reliable, that the systems in 3(d) are being followed or that the requirements in 3(e) are being observed.

5. Rather than add an extra layer of external examination in order to cover these matters, the Bank considers that it would be more efficient, and less intrusive, to build on existing arrangements and seek independent review by each bank's external auditor.

6. In proposing this there is no intention on the part of the Reserve Bank to vary or interfere with customary relationships between a bank and its external auditor. The Bank envisages that banks would commission their auditors to provide the necessary reports; that all communications between the Reserve Bank and auditors would pass through the bank concerned; and that any discussion would involve the management of the banks, the auditor and the Reserve Bank.

The arrangements

7. In furtherance of its responsibilities for the protection of depositors, the Reserve Bank will seek the external auditor's opinion whether a bank's internal management systems and controls are generally adequate and specifically:

(a) whether the prudential standards which the Reserve Bank has set for banks are being observed. Currently these standards relate to the prime assets ratio, minimum capital ratio and open foreign exchange position;

(b) whether the management systems to control exposures and limit risks outlined to the Reserve Bank by the bank are effective, and are being observed. Controls of relevance here are those which serve, inter alia, to satisfy prudential principles and requirements outlined in various statements issued to banks. Policies in relation to provisions and the valuation of assets would be of particular importance;

(c) whether statistical data (both statutory and voluntary) provided to the Reserve Bank by the bank are reliable;

(d) whether any statutory or regulatory banking requirements and conditions on the banking authority have been complied with.

8. Each bank will be asked to inform its external auditor of the Reserve Bank's requirements as outlined in various prudential statements and to request the auditor to have regard for them in forming his opinions.

9. The Reserve Bank will consult with each bank and its external auditor about the form of the reporting. Banks might find it convenient to have the reporting to the Reserve Bank based on the auditor's normal report to management, supplemented as necessary to cover specific needs of the Reserve Bank.

10. The auditor will be asked to bring to the attention of the Reserve Bank, through and after discussion with the bank's management, any matters which, in the auditor's opinion, may have potential to prejudice materially the interests of depositors.

11. Three-way discussion is envisaged, ie between the bank, its external auditor and the Reserve Bank. Normally, there will be an annual meeting following completion of the statutory audit. Any party may propose a discussion at any other time.

12. The above paragraphs outline the intended arrangements as the Reserve Bank currently sees them. The Bank recognises that, to the extent that its request runs beyond the scope of the current investigations of external auditors, there could be additional costs for banks. The Bank is, therefore, seeking to meet its needs with minimal extra costs to banks."

15.4.3.1 External Auditor's Report to the Reserve Bank - Chronology of Key Events

Against the background outlined above, I now turn to look at what occurred in the relevant period.

(1) The Reserve Bank diary note of its first annual prudential consultation with State Bank, on 23 October 1985, records:

"...

9. Contact with external auditors

Mr Brady outlined proposals to open channels of communication between supervisors and banks' external auditors as a means of ensuring that the management and control systems which banks purported to use were observed in practice.

Mr Marcus Clark said that he understood the suggestion, but did not embrace it fully. They had already told the Bank of England they were reluctant to agree to meetings between supervisors and external auditors without management being present. He said that they would want a letter from the Reserve Bank which could be the basis on which the Board, through management, would advise the external auditors of the prudential standards and data requirements sought by the Reserve Bank. Mr Brady responded that we would be happy to provide the Board with the sort of information we seek. Mr Marcus Clark noted that our requirements could be included in the audit program and the auditors could provide the Bank with a certificate. He felt, however, that it was not appropriate, at this stage of their bank's development, for direct contact to occur between the external auditors and the Reserve Bank. He explained that last year had been the first occasion on which their bank's external auditors (currently Touche Ross and Peat, Marwick Mitchell) had spoken to the Board. It would be rushing excessively to now include contact between the Auditors and the Reserve Bank."

(2) Minutes of the State Bank's Board meeting of 24 October 1985, relating to the prudential consultation with the Reserve Bank, record, in part:

"Reserve Bank

The Reserve Bank expressed a desire to hold regular meetings with the Bank's external Auditors. Although the major banks had agreed to the request, it was not considered appropriate for this Bank at its current stage of development to comply. It was suggested to the Reserve Bank that the Board of Directors may be prepared to forward any requests from them to the Bank's Auditors to consider when carrying out the audit of the Bank."

The Board explained to the Investigation that its October 1985 Board Minute should not be understood to indicate that the Board knew what it was the Reserve Bank wanted but, nevertheless, refused to agree to the Reserve Bank request. Rather, the Board simply received a report from Mr Clark of Mr Clark's prior discussion with the Reserve Bank, in which Mr Clark told the Board that the Reserve Bank had accepted a State Bank proposal that, if the Reserve Bank wanted any information, then the Bank (subject to the Board's approval) would be happy to forward that information to the Reserve Bank through the Bank's external auditors. In short, the Board says it simply accepted management's assurances that the Reserve Bank was happy to accept the State Bank's offer to supply information through the Board's external auditors, and, therefore, it did not appreciate that the Reserve Bank's objectives were designed to ensure the observance of State Bank's management and control systems.

(3) By letter of 20 March 1986, the Reserve Bank wrote to the State Bank's Managing Director advising as follows:

"The (Reserve) Bank has decided, as part of the process of prudential supervision, to establish a relationship between each bank, its external auditor, and the Reserve Bank."

The letter enclosed the Reserve Bank's April 1986 Prudential Statement PS H1, referred to above, and continued:

"... we are asking each bank subject to the Banking Act to adopt (the memorandum). We should be pleased if your bank would also agree to these arrangements."

(4) The State Bank's response, by letter of 8 April 1986, said their external auditors had asked for "a few weeks" to "absorb the content of (the) proposal" and suggested a meeting between the State Bank, its auditors and the Reserve Bank in "early May or afterwards".

(5) The Reserve Bank diary note of 1 May 1986, records that meeting was held on 30 April 1986. The State Bank was represented by Mr Ottaway, Mr Metcalf, Mr Barnes and Mr Newman. A Reserve Bank diary note of that meeting suggests that State Bank officers at the meeting, and State Bank's auditors, assumed that the auditors would be reporting as had been requested.

(6) By letter of 6 May 1986, the Reserve Bank wrote to the State Bank's Managing Director following up on matters raised at the meeting (of 30 April) and, in particular, to explain paragraph 7 of Prudential Statement PS H1. It is useful to quote, in full, the relevant parts of that Reserve Bank letter of 6 May:

"Paragraph 7 of that memorandum indicated the scope of the report which the Bank would like to receive from your external auditors. It was thought that you would find it helpful in commissioning your auditors to provide the report if we were to offer some guidance on aspects of the matters raised in that paragraph.

Internal Controls

The introduction to paragraph 7 seeks opinion whether a bank's internal management systems and controls are generally adequate.

We are not seeking a thorough-going review of each of your bank's systems and controls. We would, however, like to have an expression of opinion, based on professional observation and experience, of their general adequacy. We appreciate that, in general, an auditor's review of internal controls may be limited to obtaining audit evidence and might therefore be insufficient to enable him to determine the adequacy of the internal controls for management purposes. In seeking their opinion, however, we assume that your external auditors would already be generally familiar with those management systems and controls that are directed to the security of the bank's assets and operations.

Prudential Standards (Paragraph 7(a))

As indicated in the paper, prudential standards have been set by the Reserve Bank in three areas. These are detailed below. We would look for an opinion from your external auditors to the effect that the bank had met its commitment in respect of each standard, as follows:

(i) Prime Assets Ratio (PAR)

The State Bank of South Australia has agreed that it will move towards conforming with and then hold at all times a tranche of prime assets equivalent to 12 per cent of total liabilities (other than shareholders' funds) which are invested in Australian dollar assets within Australia.

For purposes of your bank, prime assets comprise notes and coin, balances with the Reserve Bank, Treasury notes and other Commonwealth Government securities, and loans to authorised money market dealers secured against Commonwealth Government securities. For convenience of measurement, the Prime Assets Ratio is calculated on the basis of banks' total Australian dollar assets within Australia, less shareholders' funds (as reported in your case on Forms D and I and attachments).

(ii) Capital Ratios

Through an exchange of correspondence in November 1985 understandings were reached between our respective institutions on your bank's capital position. In terms of those arrangements, your bank will endeavour to maintain a ratio of capital to total assets of at least 5.0 per cent; this ratio is to apply in respect of the bank itself and the bank and its associated companies on a consolidated basis.

For the purposes of calculating capital ratios for banks generally, the capital base is defined to include:

. paid-up ordinary shares;

. irredeemable preference shares on which dividends are non-cumulative;

. mandatorily convertible notes;

. general reserves;

. retained earnings; and

. minority interests in subsidiaries.

Management Systems to Control Exposures and Limit Risks (paragraph 7(b))

Here we look for a positive review of, and opinion about, particular systems which your bank employs to control exposures and limit risks.

For the time being, this request relates to systems in respect of credit (on and off-balance sheet), liquidity and foreign currency operations. We have written separately to you seeking written descriptions of each of these systems. Subject to our review of them, we see such descriptions as providing the basis upon which the auditors would report.

As well as seeking confirmation that the systems described to us are being observed, we would look for the auditor's opinion that they are adequately providing a means to control exposures and limit risks to the prudent levels set by management.

Statistical Data (paragraph 7(c))

We are not seeking a complete check of the statistical data provided to us but we need to have your auditors' opinion as to their reliability.

We have not yet asked banks to provide data in respect of items (iii) and (viii).

Statutory Requirements (paragraph 7(d))

As the State Bank of South Australia is not subject to the Banking Act we are not looking for an expression of opinion from your auditors under this item."

The Reserve Bank concluded its letter by noting its understanding that the State Bank would implement the external auditor reporting arrangements from the commencement of State Bank's next financial year (ie from 1 July 1986).

(7) By letter of 20 May 1986, the State Bank's Managing Director responded (to the Reserve Bank letter of 6 May) as follows:

"The State Bank of South Australia acknowledges the role of the Reserve Bank of Australia as a prudential supervisor, but we are concerned that your requirements now and in the future do not prejudice our role and responsibilities as a State Bank. In this regard we remind you that the Bank does not come within the formal jurisdiction of the Reserve Bank in other than selected issues, and we reserve that position where circumstances are in our view prudent and appropriate."

The letter then outlined the definitions of `Capital' and `Prime Assets' adopted by the State Bank so as to illustrate the difference between them and the Reserve Bank definitions, and continued:

"In summary, the Bank is committed to respond to the Reserve Bank in its role as a prudential supervisor so far as we are able, but we must make firm our independence from formal jurisdiction where our role and status as a State Bank may be prejudiced."

(8) The Reserve Bank's response, by letter of 2 July 1986, explained that the Reserve Bank's proposed arrangements concerning external auditors reflected "existing undertakings" between the State Bank and the Reserve Bank, which undertakings acknowledged that State Bank would co-operate only to the extent that its own statute permitted, and that the arrangements relating to the auditors "in no way extend the undertakings about "Capital Ratio and Prime Assets Ratio". The letter concludes:

"... we, therefore, look forward to receiving, in due course, the relevant opinions from your external auditors."

(9) The second annual prudential consultation was held on 12 September 1986. The Reserve Bank diary note records as follows:

"...

2. Introduction

Mr Kelleher opened by outlining the aims of prudential supervision and acknowledging the co-operation of state banks with the Reserve Bank.

Mr Marcus Clark confirmed that SBSA will try to co-operate with the Reserve Bank's prudential guidelines; but he would not want the Bank to assume that it could give the same instructions to state banks as it does to Banking Act banks. Mr Kelleher accepted the point, but explained that there were times (eg with SBSA's current plan to establish a representative office in Hong Kong) when overseas supervisory authorities sought from the Bank a statement that it was satisfied with the systems and management of a particular bank. In order to give such statement we needed to know that a bank's systems were adequate and were being observed."

"Mr Marcus Clark then pointed out that he had strong reservations about certain aspects of the proposal in regard to external auditors. He said that he was not concerned about the Reserve Bank's having access to the auditors in SBSA's presence. However, he said that this would lead to a lot of extra expense, which SBSA would not pay, and which the Reserve Bank would therefore have to pay. He added that SBSA was trying to minimise its costs and that profitability was a major issue at present. SBSA uses two external auditors (not a government auditor). In their end-year discussions with these auditors it had emerged that the Reserve bank's requirements would involve a fee of $25,000 for each auditor. Mr Kelleher responded that the external audit proposal was an integral part of the Reserve Bank's prudential framework; however, SBSA should feel free to write to us on this issue. He noted that the Bank had tried to limit the additional demands on banks and sought only an extension of information which would already be provided to management. He suggested that the main identifiable cost related to spot checks of statutory forms by external auditors. He indicated that the nationally operating banks had also suggested that they might not carry the additional audit fees but we had not accepted their arguments. Mr Marcus Clark said that Mr Matthews would follow this up with us by letter."

(10) On 31 October 1986, the State Bank (Mr Matthews) wrote to the Reserve Bank to advise:

"Our view is that if the Reserve Bank requires any additional work or certification, any costs incurred in carrying out such work should be the responsibility of the Reserve Bank."

(11) By letter of 5 December 1986, the Reserve Bank replied to Mr Matthews as follows:

"The arrangements being established for a link between banks, their external auditors and the Reserve Bank recognise that the prime responsibility of a bank's auditor is to the Board of Directors of the bank. Without prejudicing that responsibility, the arrangements are intended to provide to the Reserve Bank independent assurance that the data provided by banks are reliable and that the prudential standards and management systems agreed between it and banks are being observed."

"We see the link with auditors through banks as an integral part of our prudential supervision and therefore as essential to continuation of the close relationship established between us on prudential matters, in which I believe we both see much benefit.

We hope you will be able to join the arrangements."

(12) By letter of 6 March 1987, the State Bank (Mr Matthews) agreed to the Reserve Bank request. This letter provides:

"State Bank of South Australia places great value on the necessity to maintain high prudential standards. We also value greatly the very close relationship that exists between the Reserve Bank and this Bank.

In establishing our prudential standards we have put in place the control mechanisms and management review processes that we believe enables Executive Management and the Board of Directors to adequately monitor that the Bank is maintaining a position that meets with the standards established for the banking industry. From discussions the Reserve Bank is aware of our position in this regard."

"Therefore, State Bank of South Australia is prepared to join the arrangements to involve external auditors in the process of prudential supervision. This undertaking is on the basis that -

. Contact between the Reserve Bank and our external auditors is channelled through State Bank; and

. Any requests for additional information on the business of State Bank will be a matter for discussion and agreement with State Bank."

When questioned on this letter during formal interview on 12 December 1991, Mr Matthews told the Investigation he was:

"... sure that I would have written that letter only after discussing it with Tim Clark". ⁽⁾

and further that his [Mr Matthews] recollection was that he:

"... got Tim to the view ... that we had to do this, all the other banks are going to do it, we will be seen as being different, we should do it." ⁽⁾

During formal interview on 28 January 1992, Mr Clark told the Investigation that, although he could not recall seeing, or discussing the contents of, Mr Matthews' letter before it was sent to the Reserve Bank:

"... that sort of letter it would have been agreed, but he wouldn't have necessarily shown me the letter."

Mr Clark proffered the view that, although the State Bank's letter, from Mr Matthews, may have agreed, in principle, to comply with the Reserve Bank request, the letter did not raise, or resolve, the matter of the cost of the auditors reports, possibly because Mr Matthews forgot to mention that aspect.

A written submission of 26 February 1992 from Mr Clark to the Investigation on this matter noted (at p. 9):

"In hindsight, I can appreciate that the Reserve Bank officers approached the October 1987 consultation from a different standpoint than did State Bank. Based on Mr Matthews' letter the Reserve Bank officers were not aware (and, I concede, had no reason to be aware) that we at State Bank were still concerned about the issue of costs. Again in hindsight, I can see that the attitude of State Bank and of myself in particular must have been surprising to the Reserve Bank team, who could reasonably have drawn the conclusion that we were `shifting the goal posts'.

Clearly, there was room for misunderstanding of each others' respective positions at the October 1987 consultation. It appears that the Reserve bank officers' impression of the October 1987 consultation generally and of my part in it particularly may have been coloured by this misunderstanding, involving (from their point of view) an apparent change of ground on our part."

During the interview referred to above, Mr Clark's submission stressed that his remarks at the October 1987 prudential consultation (see paragraph (15) of this Section, below) did not amount to him `refusing to comply' with the arrangements; rather he was saying that State Bank would comply, subject to resolution of the issues of direct contact and costs. Mr Clark stated that: "failure to monitor the reservation of State Bank on the question of costs in the letter (of Mr Matthews) of 6 March 1987, created a misunderstanding as to State Bank's position." ⁽⁾

The reasons for exploring this issue become apparent upon reading paragraphs (15) and (26) of this Section which follow. The matter is further analysed in the later part of this Chapter dealing with the 1987 consultation.

(13) The Reserve Bank replied by letter 17 March 1987 and acknowledged the State Bank's "... confirmation of the arrangements ...".

(14) By letter of 13 October 1987, the Reserve Bank sent the State Bank six copies of a reference manual "to assist your bank and its external auditors" in preparing the Reserve Bank report. The manual contained, amongst other things, information previously provided by the State Bank to the Reserve Bank explaining certain State Bank policies, and explaining management systems to control exposures and limit risks in certain operational areas to the levels, determined by management, as prudent.

(15) The next significant event was the prudential consultation held on 15 October, 1987. The Reserve Bank diary notes of the consultation record that the Reserve Bank officials explained to State Bank representatives that the State Bank had not yet complied fully with the Reserve Bank's prudential requirements in relation to capital adequacy and the Prime Asset Ratio. After apparently lengthy discussion about various matters, the Bank's external auditors then joined the meeting. The Reserve Bank diary note of that part of the meeting is as follows:

"Meeting with external auditors

At this point, Messrs Whimpress (Peat Marwick) and Burgess (Touche Ross) joined the meeting.

Mr Brady enquired of the current state of progress in respect of the external auditors' report for the year to June 1987. In response, the auditors indicated that they had not made any start to such report as they had yet to receive a letter of engagement from SBSA.

Mr Marcus Clark then commented that when the Bank had first raised the question of tripartite arrangements involving external auditors, he had had some very severe reservations. Paramount was his belief that there should be no direct contact between the Reserve Bank and the auditors. Mr Marcus Clark indicated that, in addition to these concerns, the bank had no intention of meeting the additional costs (which he estimated would be around $40,000 a year) that would be involved in the auditors "doing tasks set down by the Reserve Bank"; rather, he believed that these costs would have to be for the Reserve Bank's account.

Mr Brady replied that the Reserve Bank had already made it very clear that, under the arrangements agreed to in our (sic) letter of 6 March 1987, there would be no direct association between the external auditors and the Reserve Bank. As regards the question of additional costs, our understanding from correspondence received from SBSA in March this year was that SBSA had already indicated it would meet these costs, as indeed had every other bank. Mr Brady also indicated that in the light of SBSA's position on the matter, the Reserve Bank may need to reconsider the liquidity support commitments it had given to SBSA in an exchange of letters in 1984. Additionally, what the Bank had said in the past to overseas prudential supervisors about SBSA being adequately supervised and meeting our prudential requirements might need to be reviewed.

Mr Marcus Clark reiterated that he was not prepared to accept the audit arrangements, especially the additional costs involved, without reference to both his Board and the SA Government. At this point, Mr Marcus Clark left the meeting.

Mr Ottaway asked if some background to the external audit arrangements could be given. Mr Pearson explained the arrangements at some length, covering also the likelihood of the Auditing Standards Board issuing some guidance on a standard form of reporting. Mr Ottaway asked the date which the Bank had expected the arrangements had been put in place with SBSA. Mr Pearson indicated we had regarded our letter of 6 May 1986 as having established the arrangements, and that we had expected to receive a report for the year to end June 1987.

Mr Ottaway indicated that in the light of the Managing Director's comments, he felt he could add little further comment to the present discussion. However, he would endeavour to have the subject raised at Executive level within the bank and hoped that the difficulty could be overcome in due course.

Mr Ottaway asked whether, if the bank was able to see its way clear on the audit arrangements, the Bank would require a retrospective report for the past year. Mr Brady indicated that he did not feel a retrospective report would be necessary. However, nor did he wish to wait until September 1988 for the first report and hence would ask that SBSA look to provide some sort of interim report before then. Mr Ottaway acknowledged the point and reiterated his earlier comment that he would do his best to sort out the bank's difficulty with the issue."

(16) Except to the extent that Minutes of Executive Committee meetings were available to a subsequent Board meeting, no report of this 1987 prudential consultation was given to the State Bank Board, even though a reasonably detailed diary note was made, apparently written by Mr Ottaway. The Reserve Bank consultation was raised at an Executive Committee meeting the day following the consultation. Minutes of that Executive Committee meeting of 16 October 1987 deal with the prudential consultation in two paragraphs:

"General Discussion

The Reserve Bank of Australia

The General Manager, Corporate and International Banking advised that the meeting with the Reserve Bank on 15 October 1987, confirmed this Bank's relationship with the Reserve Bank. The Reserve Bank noted the Bank's move towards prudential controls in line with the Reserve Bank policy.

There were some outstanding matters to be resolved, particularly in the area of special audit requirements of the Reserve Bank (GSO)."

As I indicated above, that Executive Committee Minute suggests that the Executive Committee, and the Board, received an inadequate (and, therefore, misleading) message. This matter is further considered in the following part of this Chapter dealing with the 1987 prudential consultation.

(17) On 28 October 1987, the State Bank's Mr Ottaway "called on" Mr Brady, at the Reserve Bank Sydney office. Amongst other things, Mr Ottaway discussed some of the matters raised at the prudential consultation of 15 October 1987. A Reserve Bank `general diary note' of the 28 October meeting notes that:

"With regard to the Bank's PAR and capital requirements, draft letters had been prepared which indicated SBSA's intention to observe the guidelines. The Bank's request regarding arrangements with SBSA's external auditor was to be presented to SBSA's board and they would also be seeking the endorsement of South Australia's Treasurer to the arrangements."

Mr Brady's (Reserve Bank) diary note dated 28 October in respect of that meeting is more expansive:

"With regard to the arrangements with external auditors, which was the major bone of contention, Mr Ottaway believed that a satisfactory solution to the problem had been found. He said that Mr Marcus Clark was now prepared to accept the need for (inevitability of) such arrangements. However, Mr Clark felt that entry into these arrangements with the external auditor and the Reserve Bank was getting close to intrusion into the bank's role as a state bank and for that reason he wished to consult his Board and also to seek the endorsement of the Treasurer of South Australia. Mr Ottaway was confident that no difficulties would be raised."

(18) As noted in the previous chronology relating to the Reserve Bank liquidity management guideline, on 27 November 1987, the State Bank (Mr Ottaway) rang the Reserve Bank to advise that the State Bank Board had agreed management should investigate opening a New York branch. The Reserve Bank's diary note, dated 27 November 1987, records:

"The impression I gained from our conversation was that SBSA (as distinct from Mr Ottaway who was being quite co-operative) was still being very difficult about the question of supervision by the Reserve Bank. I reminded Mr Ottaway that SBSA was the only bank in Australia which had not acceded to our proposal to involve external auditors in the process of supervision (even though we believed that they had so agreed on an earlier occasion). I also reminded him that an unwillingness on the part of SBSA to observe our prudential requirements could have a bearing on the ability of SBSA to establish an operation in New York."

(19) By letter of 27 November 1987, the State Bank (Mr Ottaway) gave qualified undertakings in respect of the Reserve Bank's liquidity management guideline and capital adequacy guideline. In relation to the Reserve Bank's requirements concerning external auditors, the letter says:

"Audit Arrangements

The Bank's Board of Directors will consider this matter at a future meeting. You will be further advised."

(20) The State Bank Board meeting of 17 December 1987 considered a paper prepared by Mr Ottaway. It is worth setting out the body of that paper in full.

"TOPIC: The Reserve Bank of Australia - Request for External Audit Report

RECOMMENDATION:

That the Board of Directors note and confirm the Bank's decision to voluntarily accede to the request of the Reserve Bank of Australia for an audit overview and report on matters pertaining to prudential supervision, provided always that the Reserve Bank acknowledges the prior obligations of the Bank to pay due regard to its responsibilities under the State Bank Act, 1983.

BACKGROUND

The Reserve Bank has responsibilities for the protection of depositors of banks subject to the Banking Act. It also has an interest in the stability of the financial system generally.

To meet these responsibilities the Reserve Bank has developed a system of prudential supervision of banks. This is directed towards the Bank satisfying itself by enquiry and report that individual Banks are following management practices which limit risks to prudent levels and which are kept under review and adapted to changing circumstances.

State Bank of South Australia has acknowledged the importance of the Reserve Bank overview to the long term stability of the Australian banking system, and while it is not formally subject to the Banking Act, it has maintained a general agreement of compliance with all the Reserve Bank prudential guidelines. In providing this commitment the Bank has consistently reminded the Reserve Bank that any undertakings given are subject always to any overriding responsibilities to which it may be subject under the terms of the State Bank Act, 1983.

RECENT DEVELOPMENTS

Deregulation of financial markets has introduced a number of new elements into the reporting requirements of the Reserve Bank, many of which are complex and dependent upon the availability and accuracy of detailed bank records.

This complexity, and the need for accuracy, has led the Reserve Bank to now seek external audit assurance that:

(a) a bank's internal management systems and controls are generally adequate, and

(b) the prudential standards set by the Reserve Bank are observed, and

(c) systems to control exposures and limit risks outlined to the Reserve Bank by individual banks are in the auditors opinion effective, and are in fact being observed, and

(d) statistical data provided to the Reserve Bank is reliable.

THE AUDIT ARRANGEMENT

The Reserve Bank has sought an audit arrangement with banks which will be the least intrusive possible consistent with their needs. They do not wish to vary or interfere with customary relationships between banks and their external auditors.

The Reserve Bank has proposed that "banks might find it convenient to have the reporting to the Reserve Bank based on the auditor's normal report to management, supplemented as necessary to cover specific needs of the Reserve Bank".

The auditor will be asked to bring to the attention of the Reserve Bank, through and after discussion with the bank's management, any matters which in the auditor's opinion may have potential to "prejudice materially" the interests of depositors.

In practice, the requirements of the Reserve Bank are quite specific, and generally outside the ambit of a "true and fair view" audit required of our external auditors.

A condition of the Reserve Bank arrangement is that the audit for their purposes will be without cost to the Reserve Bank. We are informed by our joint auditors that the estimated cost of the additional work involved is between $25,000 and $35,000 annually.

Note: By our own estimate the cost in the first year will be about $25,000, with some potential for a reduced charge in future years. However, the overall cost can be expected to escalate in subsequent years in line with general cost increases and an anticipated progressive increase in requirements of the Reserve Bank.

THE BANK'S OBLIGATIONS

The Bank has no statutory obligation to accede to the audit request of the Reserve Bank. We have been asked to co-operate on the basis of consistency with the Banking Act banks, and as a contribution of conscience towards effective supervisory control.

In the event that the Bank refused outright, the Reserve Bank could be expected to use its influence to appeal the desirability of its proposals directly to the Treasurer of South Australia.

A suggested withdrawal from its commitment to provide last resort facilities is most likely to emphasise and put a Reserve Bank perspective on the importance of the issue.

THE EFFECT OF COMPLIANCE

1. The Bank will bear a direct cost for the audit and considerable potential for future cost escalation.

2. The Bank's agreement will act to formalise an obligation compliance with the full ambit of the Reserve Bank prudential requirements.

3. The function of the State (the Treasurer) as the final arbiter in the operations of the Bank will be substantially abrogated in favour of the Reserve Bank.

PRACTICAL OUTCOME

The Bank is bound to acknowledge the responsibility assumed by the Reserve Bank for the financial health of the banking system in its totality. Given this responsibility we are bound also to accept any reasonable request to which the Banking Act banks are subject.

The question for the Bank is whether or not the request for audit assurance at the cost of the Bank is an undue imposition, and whether our perception of the dilution of the role of the State has any substance.

Upon review we may conclude that despite some concerns the arguments against our agreement to co-operate are outweighed by our obligations as a major participant in the Australian banking system. In reaching this position we should continue to regularly remind the Reserve Bank of our special status as a State Bank and that such compliance is voluntary and without prejudice to our obligations under the State Bank Act, 1983 and any subsequent amendments which may apply.

Note: The addendum attached outlines the general scope of the audit which is over and above the true and fair view requirements of the Bank itself, together with an estimate of additional time and cost involved.

Prepared by:
G S OTTAWAY
10th December, 1987.	Noted & Confirmed
	(Signed)
	L Barrett
	CHAIRMAN"

(21) The Board (at 17 December 1987) was not informed that the Reserve Bank had asked for State Bank's co-operation in March 1986, nor that Mr Matthews (by letter of 6 March 1987) had agreed to comply with Reserve Bank's requirement. As a result, the Board was not made aware of any of the tension in the relationship between the Reserve Bank and the State Bank over this issue.

Mr Ottaway told the Investigation that it would be unrealistic and unfair to expect that his report to the Board would include information which was embarrassing for the Managing Director, Mr Clark. Mr Ottaway's view at the time was that it was preferable to get the matter resolved in the most expeditious way, namely, to report in a way which avoided any implied criticism of Mr Clark.

The relevant Board Minute (87/406) records that:

"The Bank has no statutory obligations to accede to the audit request ... but had co-operated on the basis of consistency with the Banking Act banks and as a contribution towards effective supervisory control of the industry by the Reserve Bank."

"Confirmation was given to the decision of the Bank to accede to these Reserve bank requirements."

It is to be observed that the Board confirmation, recorded above, is expressed in absolute terms.

(22) On 22 December 1987, the Reserve Bank (Mr Brady) received a telephone call from the State Bank (Mr Matthews). The Reserve Bank diary note (dated 22 December) records that the State Bank's Board was considering the opening of a New York office and, in relation to external auditors:

"... Mr Matthews said that the Board had last week accepted the principle that, within the constraints of its own legislation, the bank would endeavour to comply with the Reserve Bank standards. The State Bank would be meeting with its external auditors within the next couple of weeks in an effort to come to an arrangement about the extra work that would be involved. He wanted to reassure me that SBSA was trying to reach a position where both the Reserve Bank and SBSA would feel satisfied. He would be writing to us about this matter." (Emphasis Added)

When the Board was made aware of this diary note (during the course of the Investigation) it advised that the absolute nature of the confirmation was a fact consistent with the Board's commitment to Reserve Bank supervision; that the reservation that emerged was management's reservation; and that any conditions were not developed by the Board but by management of its own volition and without the Board's knowledge or approval.

For his part, Mr Matthews explained that his comments to the Reserve Bank simply reflected the language used by State Bank officers when dealing with the Reserve Bank and that the Reserve Bank, was aware that the State Bank would comply once the details had been finalised with the external auditors.

(23) A Reserve Bank diary note of 13 January 1988 records certain views of the then head of the Reserve Bank's Supervision Unit (Mr Brady). For present purposes, the relevant parts of the diary note are:

"The major outstanding matter between us relates to arrangements with external auditors. We were told informally on 22 December that the board of SBSA had decided that, within the constraints of its legislation, it would endeavour to comply with our requirements; the bank would meet its external auditors in an effort to come to an agreement about the extra work that would be involved. The bank would write to us. It has not yet done so.

Recent history shows that SBSA (or at least its Managing Director) has been grudging in accepting our prudential requirements. I think we should make it clear that our support of applications by SBSA to establish operations overseas is not given lightly ..."

(24) On 20 January 1988, the State Bank (Mr Matthews) telephoned the Reserve Bank to discuss the possible opening of offices in the Cayman Islands and in New York. The Reserve Bank reminded Mr Matthews of the outstanding matter of the external auditors' report.

The Reserve Bank diary note of the telephone conversation records:

"Mr Matthews said that SBSA was well along the path towards resolving that matter. The SBSA board had agreed in principle that the bank would supply whatever reporting was necessary. It was now necessary to agree with the auditors on the amount of work to be done. I reminded Mr Matthews that we had sent to the SBSA a copy of a guidance release issued by the Auditing Standards Board setting out views on how external auditors might provide their opinions to the Reserve Bank. Mr Matthews said that he hoped that work by the external auditors would commence later this financial year and that by 1 July the full arrangements would be in place." (Emphasis Added)

(25) On 10 March 1988, Mr Matthews called at the Reserve Bank's Sydney offices. The Reserve Bank diary note of that meeting, after dealing with State Bank's desire to establish offices in New York and Cayman Islands, records:

"As had been foreshadowed earlier to Mr Matthews, the Bank would find some awkwardness in providing such statement, in the absence of a satisfactory resolution of the external audit arrangements. Mr Brady said he would be interested to learn of the current state of play on this matter.

Mr Matthews indicated that this matter was now very close to being resolved. The bank's board had agreed in principle to the arrangements. Discussions had taken place with the auditors. The auditors have been through the Auditing Guidance Release and had indicated they could meet the standard report. The only remaining hassle with the auditors was the question of costs. Mr Matthews said he hoped this issue would be sorted out at a further meeting with the auditors early next week. He would write confirming the position following next week's meeting.

Mr Pearson enquired when the bank envisaged providing the first report from its auditors. Mr Matthews indicated that the intention was that the auditors will commence to cover the full gambit of the Bank's requirements from 1 April, with a view to providing their first report for April-June around September next."

(26) By letter of 28 March 1988, the State Bank (Mr Matthews) again advised the Reserve Bank:

"Following lengthy discussions between this Bank and its External Auditors it has been agreed that the External Auditors will provide reports to the Reserve Bank to assist in the process of prudential supervision.

This will occur on the basis that:

1. It is recognised that State Bank of S.A. does not come within the formal jurisdiction of the Reserve Bank and that State Bank is agreeing to provide this information in a spirit of co-operation.

2. The requirements of the Reserve Bank, now and in the future do not prejudice our role and responsibilities as a State Bank.

3. Contact between the Reserve Bank and our External Auditors is to be channelled through State Bank.

4. Any requests for additional information on the business of State Bank will be a matter for discussion and agreement with State Bank."

The Investigation is not aware of the Reserve Bank ever seeking an explanation for the inconsistency between State Bank's agreement to comply (in Mr Matthews' letter of 6 March 1987), and Mr Clark's statement to the October 1987 prudential consultation.

Mr Matthews told the Investigation that it had been "personally embarrassing" to repeat, in March 1988, what the State Bank had agreed to in March 1987, especially in the absence of any explanation. Mr Matthews also told the Investigation that he did not specifically discuss these personal views with Mr Clark.

(27) By letter of 21 March 1988 to the State Bank (Mr Matthews), the external auditors (Messrs Touche Ross & Co and Peat Marwick Hungerfords) set out, in general terms, the auditors understanding of the scope of the work to be performed in connection with the Reserve Bank reporting requirements.

(28) The external auditors' first report for the Reserve Bank purposes was in respect of a limited period only, namely 1 April 1988 to 30 June 1988. An important part of the reports provided by external auditors to the Reserve Bank was their certification as to certain key management systems. That part of the State Bank's external auditors' first report is in the following terms:

"Key Systems to Control Exposure and Limit Risks

We have been advised by the Bank that the management systems to control exposures and limit risks on the Bank's credit, liquidity and foreign exchange operations have been documented by the Bank and are currently awaiting acceptance by the Reserve Bank for inclusion in the Reference Manual.

Accordingly, we are unable to express an opinion on the credit, liquidity and foreign exchange management systems and whether the systems adequately provide means to control exposures and limit risks to the levels set by management."

(29) The Reserve Bank diary note of the 15 November 1988 prudential consultation records that, apart from certain omissions, the Reserve Bank believed the external auditors' report met the Reserve Bank requirements. The omissions, in the first audit report, had previously been discussed by the Reserve Bank and the State Bank, on 1 November 1988, when Mr Matthews and Mr K L Copley called on the Reserve Bank. The relevant part of the Reserve Bank diary note of that meeting records as follows:

"Mr Matthews then asked if we had received the copy of the bank's external auditors' report, which he had faxed to us a day or so ago. Mr Pearson acknowledged receipt. He said that while we would comment more fully on the report at the forthcoming meeting with the bank and its auditors, he would have to say that we were somewhat surprised to see that the auditors had indicated they were unable to report on the adequacy of the bank's management systems because they were currently awaiting acceptance by the RBA for inclusion in the Auditors' Manual. Mr Pearson said it was our understanding that the bank's systems had been accepted by way of our letter of December 1987. Also, in SBSA's letter to us of March 1988, which informed us that SBSA's external auditors would be able to provide reports as from 1 April, we noted that the view had been expressed that the auditors would be able to report on all areas covered by the Auditing Guidance Release that were pertinent to SBSA.

In response, Mr Copley said he understood the auditors had refrained from expressing the opinion sought on systems simply because the descriptions had not yet been included in the Manual. Mr Pearson stated that such a view was both unreasonable and irrelevant - that the Manual was not designed to replace source documents but to bring relevant material together into one binder to help auditors. He added that while it was probably too late for anything to be done for the current report, it was something which the bank needed to sort out with its auditors for next year's report. Mr Matthews acknowledged the points Mr Pearson had made and undertook to take the matter up with the auditors on his return to Adelaide. Mr Pearson added that his quick reading of the rest of the report suggested that it was an excellent start to the reporting arrangements."

(30) Following the prudential consultation of November 1988, no further material comment is made by the Reserve Bank as to the State Bank's compliance with the Reserve Bank's requirement in respect of the external auditors report. Further reports were submitted by the State Bank's external auditors for years ending 30 June 1989, and 30 June 1990. In general terms, those reports did not raise any matters of concern (or at least none which are relevant for present purposes).

15.4.3.2 Conclusions - External Auditors Report to the Reserve Bank

The above chronology is significant in two respects in that:

(a) It reveals significant matters relative to Mr Clark's influence in the Bank, and the means available to him to use that influence.

(b) It provides a further, and important example, of how the State Bank's senior executives failed to keep their Board adequately informed.

The Reserve Bank first asked the State Bank to have its external auditors provide a report as part of the prudential supervision arrangement in late 1985. In March 1986, the Reserve Bank repeated its request. Following its initial resistance, the State Bank agreed, in March 1987, to comply. At the October 1987 prudential consultation, the Reserve Bank asked how the first external auditors report was progressing. The external auditors told the Reserve Bank they had not received instructions to begin. Mr Clark said he was concerned about the question of direct contact, and about who should bear the cost of the exercise which he estimated at approximately $40,000 per year.

In late November 1987, the Reserve Bank told the State Bank that State Bank's plans to establish a New York operation may be frustrated by the Reserve Bank's inability to confirm to the United States bank authorities that the State Bank observed Reserve bank prudential guidelines.

In December 1987, without being informed of the background to the matter, the Board was asked to note and confirm the Bank's decision to comply with the Reserve Bank request. The Board quite properly did so, without reservation. The first full year in which a report was done was financial year 1988-89 (although a report, limited in scope, was done for the Reserve Bank for the period April to June inclusive 1988).

Even if it is to be accepted that there had simply been poor communication between Mr Clark and Mr Matthews, and that Mr Clark was genuinely concerned about the matters of direct contact and cost, nevertheless the chronology gives rise to matters of concern.

On the material before me, I am of the opinion that the failure to provide any report to the Board of what had been discussed in this regard at the September 1986 and October 1987 prudential consultations is, at best, seriously inept. I find it a matter for concern that, the day after the Reserve Bank threatened to reconsider its undertaking to provide State Bank with emergency liquidity support, and to review what it had said in the past to overseas prudential supervisors, Mr Ottaway should feel able to report to the Executive Committee that the consultation had "confirmed" State Bank's relationship with the Reserve Bank, and that "The Reserve Bank noted the (State) Bank's move towards prudential controls in line with the Reserve Bank policy" (see paragraph (16) of Section 15.4.3.1, above).

In my opinion, the responsibility for that inadequate and misleading report must lie primarily with Mr Clark. For reasons best known to himself, Mr Clark had, at least tacitly, endorsed a report likely to mislead the Executive Committee and, therefore, the Board. That action was a clear breach of his duty to the Board, and is a further measure of his influence in the affairs of the State Bank.

A further illustration of the extent of Mr Clark's influence is that the effect of his involvement delayed the introduction of this Reserve Bank request for more than two years. Even if it were to be accepted that he was motivated to do so on reasonable grounds, he nevertheless, in my opinion, had a duty to promptly advise his Board of the Reserve Bank's request, to advise of his concerns and, in the light of all of that, to seek Board approval for his proposed actions. Mr Clark's conduct needs to be seen in the light of what this Investigation has revealed, namely, that certain of those management information systems which were to be reviewed by State Bank's external auditors on behalf of the Reserve Bank were, during 1986 and 1987, defective. Had those information system deficiencies been detected at that time (and corrected) I believe the extent of State Bank's financial difficulties, as reported in February 1991,would have been mitigated.

In general terms, the chronology indicates:

(a) State Bank was a reluctant and slow starter, but eventually complied with the Reserve Bank requirement concerning external auditors reports.

(b) That compliance was achieved more as a result of the commercial necessity for the State Bank to have the Reserve Bank's endorsement in order that the State Bank could operate in overseas jurisdictions, rather than of any desire by the State Bank to co-operate fully with the Reserve Bank prudential guidelines because those guidelines were a prudent and appropriate policy.

Although the Reserve Bank had to press the State Bank to comply fully with the Reserve Bank requirement, the extent of the State Bank's lack of compliance was not sufficient to prompt the Reserve Bank to raise the matter directly with the State Bank's Board or State Bank's owner. Although these things appear simple with the benefit of hindsight, in my opinion, the Reserve Bank was extraordinarily patient with State Bank. The Reserve Bank approach, of course, needs to be viewed in light of assertions made by Mr Clark and by Mr Ottaway to the effect that the Reserve Bank request regarding arrangements with the State Bank external auditors would need the prior endorsement of the South Australian Treasurer. The Treasurer's endorsement was not required. In any event, it was not sought. By referring to the need for this endorsement, however, Mr Clark created the impression that his resistance was known to, and perhaps supported by, the South Australian Government.

On the material before me, I am of the opinion that this aspect of the State Bank's operations and affairs was not adequately or properly supervised and controlled by Mr Clark, as Chief Executive Officer, nor by Mr Matthews, nor by Mr Ottaway.

It is appropriate that I enlarge on that view. As noted above, Mr Clark, in my opinion, bears the primary responsibility for this failure. His responsibilities as Managing Director and Chief Executive Officer, however, do not, in my opinion, entirely exclude the responsibilities of other senior State Bank managers to ensure that their Board was kept properly informed. On the material before me, it seems to me that those senior State Bank managers, who were then closely involved in the relationship with the Reserve Bank, found themselves facing a question about where their loyalty lay: with their Chief Executive Officer, or with their Board. It also seems to me that, in almost every respect, that question was answered in favour of their Chief Executive officer.

It is appropriate that I comment on the Board's involvement with this aspect of State Bank affairs. Even though the deficiencies referred to above clearly made it more difficult for the Board to adequately discharge its functions, there were, nevertheless, at least two occasions when the Board was given an opportunity to take the appropriate action, but failed, in my opinion, to adopt an appropriate course.

At its meeting on 24 October 1985, the Board accepted Mr Clark's assertion that, even though the major banks in Australia had agreed to the involvement of their external auditors, it was not appropriate for State Bank to comply at that stage of its development.

In their response (dated 30 November 1992) to my provisional conclusions, the Directors submitted that the Board was entitled to accept management's recommendation, and to accept the then view of management:

"... as to the desirability and capacity of the Bank to comply with an obligation which all Australian banks, at that stage, considered onerous, particularly in the light of the start-up position of the State Bank."

I do not agree. The fact that the Bank was then in the early stages of its development was, in my opinion, a sound justification for the Bank to be seeking more, not less, guidance and oversight from the Reserve Bank. The Board, based on its collective experience, should have recognised the value to it of involving the Bank's external auditors in the prudential supervision arrangements, and should have, in my opinion, rejected management's recommendation.

At its December 1987 meeting, the Board received the paper (described at paragraph (20) of Section 15.4.3.1, above). The paper contained the following statements:

"A suggested withdrawal from its commitment to provide last resort facilities is most likely to emphasise and put a Reserve Bank perspective on the importance of the issue",

and

"The function of the State (the Treasurer) as the final arbiter in the operations of the Bank will be substantially abrogated in favour of the Reserve Bank".

In response to my provisional conclusions, the directors submitted that I am not entitled to draw any conclusion adverse to them from the fact that the minutes of the Board meeting record no discussion of those statements, and that neither of those statements were such as to require a Board member to seek further information from management.

I disagree with that submission. The plain implication of the first statement referred to above is that the Reserve Bank had suggested that it might withdraw its so called lender of last resort facilities. The mere suggestion should have attracted the directors attention and comment, but, apparently, did not do so.

The plain assertion in the second statement was that the final arbiter of the Bank's operations was the Treasurer. Once again, I am surprised that the minutes of the meeting do not record that some explanation was sought by, and given to, the directors.

The appropriate questioning from the directors may have revealed to them the fact that the State Bank had delayed complying with this important Reserve Bank prudential requirement for more than two years.

15.4.3.3 The External Auditor's Reserve Bank Reports

The preceding chronology began by setting out the Reserve Bank's Prudential Statement PS H1, published in April 1986. That, and other Reserve Bank statements, explained the reasons for introducing a bank's external auditors into the Reserve Bank's prudential supervision process.

One of the Reserve Bank's key objectives was that it sought to be better equipped to assess the effectiveness of, and observance of, a bank's management systems to monitor and control risk. Prudential Statement PS H1 explained that the Reserve bank was seeking two opinions in this regard, namely:

"In furtherance of its responsibilities for the protection of depositors, the Reserve Bank will seek the external auditor's opinion whether a bank's internal management systems and controls are generally adequate, and, specifically:

...

(b) whether the management systems to control exposures and limit risks outlined to the Reserve bank by the bank are effective, and are being observed. ..."

In May 1986, the Reserve Bank wrote to the State Bank to expand on the second aspect of the above paragraph of PS H1. That letter said:

"Management Systems to Control Exposures and Limit Risks (paragraph 7(b))

Here we look for a positive review of, and opinion about, particular systems which your bank employs to control exposures and limit risks.

For the time being, this request relates to systems in respect of credit (on and off-balance sheet), liquidity and foreign currency operations. We have written separately to you seeking written descriptions of each of these systems. Subject to our review of them, we see such descriptions as providing the basis upon which the auditors would report.

As well as seeking confirmation that the systems described to us are being observed, we would look for the auditor's opinion that they are adequately providing a means to control exposures and limit risks to the prudent levels set by management." (Emphasis Added)

The reader will recall, however, that Chapter 5 - "The Management of the Bank Group's Diversifiable Credit Risk", and Chapter 8 - "Credit and its Management: Guidelines, Policies, Processes, procedures and Organisational Delivery Mechanisms" identify what, in my view, were serious inadequacies in the State Bank's credit management systems during the period 1985-1990. In particular, the Bank did not, until 1990, have credit management systems which enabled it to accurately measure the Bank's, or the Group's, credit exposure to a particular industry, to a particular customer, or group of related customers, or to a particular region.

In view of my opinion as to that matter, it has been necessary to inquire into the circumstances which led to the external auditors expressing their opinion on that matter to the Reserve Bank.

Those circumstances have been the subject of inquiry. My provisional conclusions have been released to all affected parties. One of those parties sought, and has been granted, additional time in which to respond. For those reasons, it has not been possible to form any final conclusions on this aspect of the State Bank's relationship with the Reserve Bank. Accordingly, this matter will be further considered in my subsequent report.

It is nevertheless important, in my opinion, for this Chapter to record the basic facts; in particular, the Reserve Bank's prudential supervision objectives, and the opinions that were, eventually, provided by the Bank's external auditors concerning the Bank's management systems to monitor and control risk. The Reserve Bank objectives are described above, and in the preceding chronology. The opinions from the Bank's external auditors are set out below:

(a) As at December 1990, the external auditors had received instructions to produce only two complete reports. Those reports were for financial years ending June 1989 and June 1990. As noted in the chronology at paragraph (28) of Section 15.4.3.1, the report of 28 October 1988 ("the First Report") was for the limited period 1 April 1988 to 30 June 1988, and did not address the State Bank's:

"... management systems to control exposure and limit risk on the Bank's credit, liquidity and foreign exchange operations ..." because "... we have been advised by the (State) Bank that the management systems to control exposures and limit risks on the Bank's credit, liquidity and foreign exchange operations have been documented by the Bank and are currently awaiting acceptance by the Reserve Bank for inclusion in the Reference Manual."

As noted in the chronology at paragraph (29) of Section 15.4.3.1, the Reserve Bank was:

"... somewhat surprised to see that the auditors had indicated they were unable to report on the adequacy of the bank's management systems because they were currently awaiting acceptance by the RBA for inclusion in the Auditor's Manual.

...

In response, Mr Copley said he understood the auditors had refrained from expressing the opinion sought on systems simply because the descriptions had not yet been included in the Manual. Mr Pearson stated that such a view was both unreasonable and irrelevant - that the Manual was not designed to replace source documents but to bring relevant material together into one binder to help auditors ..."

The material before me confirms that the Reserve Bank's assessment was accurate. On the material before the Investigation, I am suspicious about the failure of the State Bank to instruct their external auditors to review this aspect of the State Bank's credit management system. It is impossible to divorce that failure from the information provided to the August 1988 Executive Committee notifying of important credit management system inadequacies. (See below).

In the First Report, the auditors did comment, at a general level, on the State Bank's internal control systems, in the following terms:

"We have examined the financial statements of State Bank of South Australia ("the Bank") for the year ended 30 June 1988 and have issued to the Bank our report thereon dated 25 August 1988. The performance of our statutory audit included a review of the Bank's systems of internal control for the purpose of determining the appropriate audit procedures to enable an opinion to be expressed on the financial statements. This review is not a comprehensive review of all those systems or of the system taken as a whole and is not designed to uncover all weaknesses in those systems. We have formed the following opinion, based on our audit procedures, supplemented by our familiarity with the Bank's systems of internal control.

In our opinion, subject to the limitations expressed in the preceding paragraph, those major management systems and controls which are directed to the security of the Bank's assets and operations, are generally adequate and our examination has not disclosed any condition which we believe to be a material weakness."

The First Report also comments favourably upon the State Bank's observance and compliance with its undertakings with respect to prudential standards, that the statistical data provided to the Reserve Bank by the State Bank was capable of being relied upon with reasonable assurance, and that the State Bank was complying with its statutory and regulatory requirements, that is to say, with the terms of the State bank of South Australia Act.

It should be noted that, in their Reserve Bank reports, the external auditors basically adopted the wording of a draft report set out in an Australian Accounting Research Foundation "Auditing Guidance Release", issued in December 1987. There was, however, one notable departure by the Bank from the process envisaged in the Auditing Guidance Release. The Auditing Guidance Release envisages that the external auditors will transmit their reports to the Reserve Bank via the chairman of a bank's board of directors. The State Bank's reports were sent via management, and do not appear ever to have been disclosed to (or sought by) the Board.

(b) The external auditor's second report was sent to Mr Matthews, and to the Reserve Bank, on 13 November 1989 ("the Second Report"). The Second Report expressed favourable opinions on all matters required to be dealt with. In relation to the State Bank's specific management systems to control exposures and limit risks it says:

"We have examined the management systems to control exposures and limit risks on the bank's credit, liquidity and foreign exchange operations as outlined by the Bank to the Reserve Bank by correspondence dated 5 May, 1988. During the year under review we carried out such tests and reviewed such procedures as we considered necessary to determine whether those systems generally were being observed and adequately provide a means to control exposures and limit risks to the prudent levels set by management. Inherent limitations in any management system and systems of internal control may mean that errors or irregularities might occur and not be detected.

Subject to these limitations, in our opinion the credit, liquidity and foreign exchange management systems were generally being observed during the year under review and adequately provide a means to control exposures and limit risks to the prudent levels set by management."

In relation to the general statement of opinion as to the State Bank's internal management systems and controls, the Second Report states:

"Internal Control Systems

We have examined the financial statements of State Bank of South Australia ("the Bank") for the year ended 30th June, 1989 and have issued to the Bank our report thereon dated 24th August 1989. The performance of our statutory audit included a review of the Bank's system of internal control for the purpose of determining the appropriate audit procedures to enable an opinion to be expressed on the financial statements. This review is not a comprehensive review of all those systems or of the system taken as a whole and is not designed to uncover all weaknesses in those systems. We have formed the following opinion, based on our audit procedures, supplemented by our familiarity with the Bank's systems of internal control.

In our opinion, subject to the limitations expressed in the preceding paragraph, those major management systems and controls which are directed to the security of the Bank's assets and operations, are generally adequate and our examination has not disclosed any condition which we believe to be a material weakness."

(c) The external auditor's third report was submitted to Mr Copley in his capacity as General Manager-Group Accounting on 28 November 1990, and forwarded to the Reserve Bank on 7 December 1990, ("the Third Report"). The Third Report reports favourably in all relevant areas. As to the specific management systems to control exposure and limit risks, it says:-

"We have examined the management systems to control exposures and limit risks on the bank's credit, liquidity and foreign exchange operations as outlined by the Bank to the Reserve Bank by correspondence dated 5 May, 1988. During the year under review we carried out such tests and reviewed such procedures as we considered necessary to determine whether those systems generally were being observed and adequately provide a means to control exposures and limit risks to the prudent levels set by management. Inherent limitations in any management systems and system of internal control may mean that errors or irregularities might occur and not be detected.

Subject to these limitations, in our opinion the credit, liquidity and foreign exchange management systems were generally being observed during the year under review and adequately provide a means to control exposures and limit risks to the prudent levels set by management."

The external auditor's general opinion concerning the State Bank's internal management systems and controls was in exactly the same terms as for the previous two reports, and concluded:

"In our opinion, subject to the limitations expressed in the preceding paragraph, those major management systems and controls which are directed to the security of the Bank's assets and operations, are generally adequate and our examination has not disclosed any condition which we believe to be a material weakness."

It is important to record the further observation that none of the above should be taken to infer that senior Bank executives were unaware of the inadequacies in the Bank's key credit management systems. This aspect is considered in detail at Section 5.5.1 - The Evolution of Group Risk Management" of Chapter 5 - "The Management of the Bank Group's Diversifiable Credit Risk". For present purposes I note that, in his paper (Executive Committee Paper 88/213) to the Executive Committee of 19 August 1988, the then Chief General Manager Mr Matthews, after identifying that credit risk was the first of the "main areas of risk", went on to say:

"At this time we do not have any mechanism to accurately assess our total exposure as a Bank or as a Group to any one individual, business entity, industry, region or country."

The Executive Committee Minutes do not mention this paper.

In a further paper presented to the Executive Committee of February 1989 (Executive Committee Paper 89/21), Mr Matthews explained that much of the information available from various parts of the Bank and Group was either not in sufficient detail or was not in a form that was readily available by computer process. That paper also highlighted the need to implement common classification standards in the Group in order to produce timely and accurate reports, particularly for industry exposures.

If the State Bank's senior managers knew of the significant limitations in their credit management systems, the question arises - what did the State Bank advise the Reserve Bank? With that in mind, the Investigation contrasted the message to Executive Committee with what the State Bank was telling the Reserve Bank at about the same time.

Only three months after the August 1988 Executive Committee, Mr Matthews was the most senior Bank officer at the prudential consultation with the Reserve Bank, on 15 November 1988. As is noted in this Chapter, there was a discussion about the State Bank Group's "increased involvement in property development financing."

"(Mr Matthews) He said the bank was conscious of the need to keep the growth of the bank's operations under tight control. SBSA believed their systems and management resources were adequate for this task. Representatives of the bank are on the Boards of all subsidiaries and the bank feels that this presence ensures operations are conducted prudently.

Mr Kelleher reminded Mr Matthews of the lessons of the Bank of Adelaide/FCA episode, including how management and directors of the bank believed there was a good handle on the subsidiary's activities.

Mr Matthews said he considered the group's corporate lending to be quite strongly controlled; he saw the lack of write-offs as evidence of this. The group's involvement in property development is kept under especially close review. In this area lending is predominantly for construction purposes, typically with a firm take-out on completion and where the borrower has a strong cash flow. He said he shared out views that banks should not be growing merely for growth's sake but was confident that the bank could continue to expand strongly without bringing high risk business onto its books. Their aim is for a good spread of business geographically and this underscored the bank's strategy in establishing operations in Sydney and Brisbane; SBSA is also conscious of the need to avoid concentration of lending to particular industry sectors."

On 28 February 1989, the Reserve Bank again recorded that it counselled Mr Matthews "on the need to watch the commercial property exposures very carefully", to which Mr Matthews is recorded as:

"... acknowledging the Bank was carefully monitoring the group's exposures in this regard ..."

In my opinion, it is clear that the general thrust of what Mr Matthews was saying to the Reserve Bank was inconsistent with the papers he was, at about the same time, presenting to the Executive Committee. I set out my findings concerning Mr Matthews' role in this aspect of the State Bank's relationship with the Reserve Bank in my general conclusions, at Section 15.6.

15.4.4 LARGE CREDIT EXPOSURES - THE RESERVE BANK'S OBJECTIVES

(a) As noted above, the Reserve Bank encourages banks to have, and maintain, loan portfolios which are appropriately diversified, and not unduly large in proportion to the capital of a bank. The Reserve Bank is concerned with the adequacy of a bank's systems used to control, monitor, and limit, such risk.

The Reserve Bank formalised its requests in relation to large exposures in early 1986. The following excerpt from the Reserve Bank letter to the State Bank of 6 May 1986 is self-explanatory:

"LARGE EXPOSURES

We attach considerable importance to a bank's policy on large exposures and to its management systems for assessing and controlling credit risks generally. In discussions with banks on this subject we have focussed on the concentration of credit risks in respect of individual clients or groups of related clients and have indicated that we would expect such an exposure to be limited normally to a maximum of 25 to 30 per cent of shareholders' funds.

We should now like to put our position on a more formal basis as follows:

1. We would like to receive from you a statement of your Board's policy in respect of large exposures to individual clients or groups of related clients.

2. You are asked to continue to report quarterly, within one month of the end of each quarter, all exposures to individual clients, or groups of related clients, above 10 per cent of shareholders' funds of the banking group.

3. We would expect these exposures to be kept under close review and that no exposure to a non-bank, non-government client, or group of related clients, would exceed 30 per cent of shareholders' funds on a banking group basis, other than in the most exceptional circumstances. Exposures to banks and to governments will be reviewed regularly with you.

4. A bank which has a large number of exposures of more than 10 per cent of shareholders' funds of the banking group (and any exposures above 30 per cent) will be asked to show that excessive risks have not been undertaken. (If a bank wishes to maintain a high volume of large exposures, this could indicate a need for it to maintain a higher capital ratio.)

We would also like to have a description of your management systems for assessing and controlling credit risks."

(b) The State Bank's letter of 21 May 1986 enclosed a report describing certain of State Bank's policies. That report included the following statement:

"Although State Bank does not come under the control of the Reserve Bank we agree to continue to provide a quarterly report of large exposures."

(c) Those arrangements were amended in January 1987. The Reserve Bank, by letter of 28 January 1987, advised:

"... we should like to extend the arrangements to include prior notification of a bank's intention to enter into an exposure to a non-bank non-government client (or group of related clients) which exceeds 30 per cent of the banking group's capital base. Notification should be early enough to allow comment by the Reserve Bank before the bank is committed to the exposure. We would respond without unreasonable delay. A bank would be expected to show that the prospective exposure would not result in it undertaking excessive risks. This change is consistent with banking supervisory requirements in other countries which do not put a mandatory limit on exposures to a single client (or group of related clients).

We would appreciate your continuing co-operation in this area of prudential supervision."

(d) The State Bank's response to that request was a qualified undertaking to comply. The State Bank's letter of 6 March, 1987 (from Mr Matthews) to the Reserve Bank's Head of Supervision (Mr Brady), is set out in full below. It is, in my view, a useful illustration of the relationship between the Reserve Bank and State Bank:

"I refer to your letter of 28th January 1987 and subsequent discussions between yourself and Mr. Clark.

The regular monitoring of large exposures is one of several important aspects of prudential management in State Bank. Further, while State Bank is not subject to the Banking Act we have been, and still are, prepared to provide the Reserve Bank with details of large exposures as set out in your letter of 6th May 1986. This is done in the spirit of co-operation with the Reserve Bank's prudential guidelines.

We have considered carefully the extension of the arrangements as set out in your letter of 28th January 1987. Whilst we understand the Reserve Bank's reasons for seeking prior notification of large exposures, we have some concerns with practical workings of the proposal put forward.

Since merger, State Bank has been structured to respond very quickly to requests for funding arrangements. (Where necessary, we are able to process an application, including consideration by the Board of Directors, within 24 hours.) As a result of this level of service, the Bank has been able to gain a competitive advantage on several occasions. This has been achieved without any breakdown of sound analysis and credit assessment. We would not want to see this particular competitive advantage eroded.

We note your assurances that there would not be unreasonable delays in the Reserve Bank responding to prior notification. At the same time, we can envisage limited situations where any delay could be costly in terms of gaining a valuable client relationship that would maintain a good spread in our lending portfolio. Generally, State Bank is prepared to give the Reserve Bank prior notification for most potential large exposures."

(e) The Reserve Bank replied by letter of 13 March 1987:

"We would be able to respond ... within the timeframe indicated for your processing of an application."

"We trust that your bank will be able to co-operate and give us prior notification for all potential large exposures."

Against that background, I now deal with the key events in relation to this area of prudential concern during the relevant period.

15.4.4.1 Chronology of Key Events - Reserve Bank Prudential Guideline - Large Credit Exposures

(1) The matter of large credit exposures was raised at the first prudential consultation, in October 1985. Mr Clark is noted in the Reserve Bank diary note as indicating:

"... in considering the maximum size of a loan, they considered the bank's total exposure to any group of companies. As examples, he cited their exposure to the Brierley group and to the Adsteam group. He also said he would not feel comfortable with an exposure over $40 million unless there were hard specific assets over which the bank had first charge. If they provided a facility over $40 million they would generally look to sell off the surplus risk.

Mr Brady referred to our large commitments return. (Mr Marcus Clark and Mr Byrnes had not seen it and the former stressed to his colleagues that all returns should go to the two General Managers and/or himself before being submitted to the Reserve Bank). Mr Clark indicated that, when they submitted this return in future, they would use their own definition of shareholders' funds but specify the amount of subordinated debt included."

(2) At the second prudential consultation (12 September 1986) the Reserve Bank diary note (17 September) records that Mr Kelleher:

"... outlined our general approach to large exposures by banks. He indicated that we had no particular comment on SBSA's large exposures as reported at end June, and indicated that its total large exposures (as a multiple of shareholders' funds) were below the average for all state banks."

(3) In mid-June 1987, there was a series of events in connection with State Bank's funding of a transaction contemplated by Equiticorp Tasman Ltd (hereafter called "Equiticorp"). It is worth looking in detail at these events as they provide a useful illustration of the relationship between the Reserve Bank and State Bank. Although set out in detail here, and briefly considered in the conclusions at the end of this chronology, the implications of State Bank's dealings with Equiticorp are examined at length in Chapter 26 - "Dealings between the State Bank and Equiticorp".

(3.1) A Reserve Bank diary note of 1 June 1987, by Mr Brady as Head of the Supervision Unit, records that Mr Matthews called on Mr Brady that morning to "discuss a proposed large exposure". Mr Matthews outlined a proposed funding of a takeover bid for Monier Ltd by Equiticorp. The effect of the commitment by State Bank was to lift its total exposure to Equiticorp from $50.0M to $250.0M. The Reserve Bank estimates put that exposure at 60 per cent of State Bank's capital. The Reserve Bank diary note (of 1 June 1987) records:

"SBSA was confident that if necessary it could quickly sell down the facility; it would look to do this prior to July/August when the facility would likely be utilised."

and:

"The proposal had so far been put to six of the nine SBSA board members, separately by telephone. All had supported the proposal."

Mr Brady is recorded as indicating that the Reserve Bank would not normally expect a bank to undertake such a large exposure, he was not convinced that the State Bank's confidence that it could achieve a quick "sell down" was well placed, and furthermore, he would consult within the Reserve Bank before providing the Reserve Bank's view.

(3.2) A further Reserve Bank diary note of the same date (1 June 1987) states:

"After discussion with the Governor about SBSA's proposed commitment to Equiticorp (see attached diary note), I rang Mr Matthews and told him that the Bank would counsel strongly against SBSA committing itself to the transaction. This view reflected four main reasons:

. the exposure was too large in relation to the size of the bank;

. SBSA already had several commitments in excess of 30 per cent of capital;

. reduction of the exposure was not assured by arrangements for selling down the commitment or other means, eg sale of assets;

. it was not possible to ignore the association of the Managing Director of SBSA with the client; we fully accepted SBSA's assurance that he had stood apart completely from the dealing; nevertheless, he had executive responsibility for the bank and there was also the question of public perception of the dealing.

Mr Matthews said that he noted my comments. He could not accept them and the bank would proceed with the transaction. SBSA felt very comfortable with the transaction and was confident of its ability to sell down the exposure. He had spoken to his corporate people in Adelaide; they had told him that Equiticorp unsecured debt had been sold down overseas at a rate of 0.75 per cent; they were very confident of their ability to sell secured debt of Equiticorp at three times that rate."

"Mr Matthews noted the comment about the association of the Managing Director of SBSA with the borrowing client but made no other comment on that matter.

Mr Matthews concluded by saying that SBSA would proceed to make an offer to Equiticorp and would keep us informed of developments."

(3.3) That Reserve Bank verbal advice was confirmed by letter from Mr Brady to the State Bank (Mr Matthews) of the same date (1 June 1987). The letter is set out in full:

"LARGE EXPOSURES

I refer to our discussion today about a proposal by your bank to enter into a commitment for an amount of $250 million which represents more than 50 per cent of its capital.

I confirm our subsequent telephone conversation in which I said the Reserve Bank counselled strongly against your bank entering into this transaction on the basis outlined by you, for the following reasons:

. the exposure is very large in relation to the size of your bank;

. your bank already has several commitments in excess of 30 per cent of its capital;

. there is no assured programme to reduce the exposure within a very short period, e.g. by sell-down, sale of assets etc;

. there is some awkwardness in a situation where a senior executive of a bank is also associated at Board level with the borrowing company. This in no way reflects on the person involved but rather it is a matter of possible public perception."

(3.4) The State Bank's Chief Manager, International Banking, Mr Mallett, wrote to Equiticorp that day, namely 1 June 1987, to offer a $200.0M facility to assist in the proposed acquisition of Monier Ltd.

By telex dated 2 June 1987 from Equiticorp to State Bank (Mr Mallett), Equiticorp accepted the Bank offer "on the terms and conditions outlined in your letter of June 1st 1987." Equiticorp publicly announced its takeover offer for Monier Ltd on the same day, 2 June 1987.

It is appropriate to record here that, between the time of his Monday morning (10:30) meeting with Mr Brady, and his subsequent (12:10pm) telephone conversation with Mr Brady later that day, Mr Matthews had rung the State Bank's Adelaide Head Office. Mr Matthew's advised the Investigation that he probably spoke with Mr T L Mallett as the head of that division of the Bank which had the primary conduct of the transaction. Mr Matthew's told the Investigation that he told (Mr Mallett) of the discussions with Mr Brady, asked Mr Mallett to reconfirm with the other members of the Lending Credit Committee that they wished to proceed, and asked Mr Mallett to ring at least the Chairman of the Board of Directors.

Mr Matthew's advised that, before he received Mr Brady's telephone call, he had received telephone confirmation, probably from Mr Mallett, that the transaction had been considered and that the Bank was prepared to proceed with it. Mr Matthew's also now assumes that, after his telephone conversation with Mr Brady, he rang someone in Adelaide to inform them of the position and that, as a result, the letter of offer was sent.

(3.5) The extent of the Reserve Bank's concern is further evidenced by the content of a letter, dated 5 June 1987, sent by the Reserve Bank Governor to the State Bank's Chairman of Directors (Mr Barrett):

"I am writing to express my disappointment that your bank decided not to adopt the counsel which we offered in response to your officer's enquiry in relation to a very large lending proposal.

I would like to make clear that our views in such matters are not affected or influenced by the type of bank or other parties involved or the purpose of the underlying transaction but solely by the potential impact on the bank concerned in the event of the transaction going awry. As I am sure you will recognise many things can go wrong through no fault of the parties even with transactions that look completely watertight at the outset.

I appreciate that in the case of your bank, notwithstanding the understandings established through our exchange of letters in 1984 and our communications with banking supervisors abroad about relations between us, that in the last resort, you are not obliged to accept our advice on prudential matters. I should say, however, that had a bank that is subject to the Banking Act put to us a proposal of a similar nature and scale, we would have used such powers as we have to oppose it very strongly."

(3.6) The State Bank Board responded, by letter from Mr Barrett dated 19 June to the Reserve Bank's Governor, in the following terms:

"Recently an officer of this Bank had discussions with officers of the Reserve Bank concerning a large underwriting proposal which this Bank negotiated. The Reserve Bank's position on the proposal was set out in a letter dated 1st June, 1987 and you made further comment in your letter to me dated 5th June.

I now advise that the Bank has syndicated the major proportion of this underwriting so that any contingent exposure would be less than 30% of the Bank's capital base. This is in accord with the Bank's philosophy that exposure to groups of this nature will not exceed 30% of our capital base.

I too felt that we should make quite clear our consideration in this matter. We were fully aware from previous correspondence received from your officers that when the Bank wished to take on an exposure in excess of 30% of its shareholders' funds, that we would be expected to show that this prospective exposure would not involve us undertaking excessive risks. Both Management and the Board of the Bank believed that the potential underwriting for an amount of $250 million did not involve an excessive risk in this particular case.

At the time the Bank entered into negotiation, it was clearly understood that this was an underwriting proposal and the Bank was not committed to a funding proposal until certain conditions precedent had been met. It was also always the Bank's intent that there would be a syndication of the facility. Due to the timing required, it was not possible for the Bank to make formal approaches to other financial intermediaries to sell-down an appropriate amount of the underwriting; however, we had made informal approaches to some intermediaries which indicated that the proposal was feasible. Subsequent negotiations have resulted in the sell-down as indicated.

I note that what was originally described to the Reserve Bank as a funding commitment is described in Mr Barrett's letter as an "underwriting proposal". There was, and has been, a disposition, on the part of some senior management, to regard this transaction as not amounting to a true exposure, because the offer from the Bank contained conditions to be met by Equiticorp; they prefer to call it "an underwriting". This, to my mind, does not stand close scrutiny. The offer conveyed by the letter of 1 June 1987 was not a conditional offer; it comprised a set of terms which were to be fulfilled if the offer was accepted; those terms were accepted as whole and unconditionally. The test is this: if Equiticorp had duly purchased the necessary shares, but before that purchase the Bank had unilaterally gone back on its word, would the Bank have been still bound to provide the facility? In my opinion, it would. The correct analysis of the deal is that once Equiticorp performed its part, the Bank was bound to perform its part and this was an exposure, in plain banking terms, to a limit of $200.0M. In my opinion, the State Bank's undertaking was at the outset, and remained, a funding commitment.

In their written submissions responding to my tentative conclusions, the Board reject that opinion and reiterate that, based on management's representations, the Board understood that this facility might not require the Bank to fund the full $200.0M because of the possibility that other banks may agree to be involved in the financing.

Although the Bank's exposure was not, in my opinion, an "underwriting", it is appropriate to record here that I have not been concerned, for the purposes of this Chapter, to form a final view on all aspects of the transaction. What is important, for present purposes, is what the transaction reveals about the Board's supervision, direction, and control, of the relationship between the State Bank and the Reserve Bank. It is also an example of how management obstructed communications between the Reserve Bank and the Board. These matters are further explored in the general comments set out at the end of this chronology.

(3.7) The Board considered the matter again at its meeting on 25 June. Mr Matthews was present at the meeting. The Board received a paper from Mr Matthews, dated 23 June, which included relevant correspondence and diary notes up to that time. (It is likely that that paper was only able to be considered by the Board on the night before, or on the morning of, the Board meeting).

The relevant part of the Board Minutes is set out below:

"Large Exposure-
Discussions with the Reserve Bank of Australia

The Chief General Manager advised Directors that he had been involved in discussions with the Reserve Bank of Australia concerning a proposal by State Bank to enter into a $200m underwriting commitment to the Equiticorp Group which, in the event of take-up by Equiticorp, would result in the Bank committing in excess of 30% of its Group capital base.

The Reserve Bank counselled strongly against the Bank entering into the transaction for the following reasons -

. The exposure was deemed too large for the Bank's present capital base.

. State Bank already has several commitments in excess of 30% of its capital.

. There was no assured programme to reduce the exposure within a very short period.

. It was not possible to divorce the interests of the Managing Director of the bank from his position as Director of Equiticorp.

Directors were advised that the Reserve bank of Australia and Bank Management differed in their interpretation of the transaction in that Management saw the transaction as purely an underwriting facility, whereas the Reserve Bank regarded it as an actual commitment. It was always the intention of the Bank to sell-down the $200m in the event of take-up by Equiticorp, but due to the timing problem, Management did not have the opportunity to test the market prior to notifying the Reserve Bank.

Subsequent negotiations have resulted in the Bank's exposure to the Equiticorp Group being reduced through sell-down to below 30% of the Group's capital base. The Reserve Bank have been notified of this fact.

The Bank's other large exposures referred to in the letter involved South Australian Financing Authority, Beneficial Finance Corporation Limited and Morgan Guaranty. Directors considered these exposures as appropriate and were at ease with the transactions.

IT WAS RESOLVED that the Chairman again write to the Reserve bank of Australia to answer to all the relevant points raised in their letter of 1st June 1987."

In relation to the actual loan proposal, the Board Minutes record:

"87/186
Loan Proposal - Equiticorp Tasman Limited (ETL)

The Managing Director declared an interest in the proposal as a Director of Equiticorp Group and adjourned from the meeting during discussion on the topic.

IT WAS RESOLVED to confirm the round robin decision made over the period 30th May to 1st June 1987, to approve a $200m Commercial Bill Facility to assist with the funding of a proposed acquisition of Monier Limited shares."

In the oral submission to the Investigation on 2 and 3 December 1992, the Board, through Mr Simmons, advised that, when it considered the matter on 25 June, it did so on the basis that:

(a) it was still open to the Board to refuse the indicative approval it had given on the weekend of 30 May;

(b) the Board had not been told of the apparently binding contract between the Bank and Equiticorp that had come into existence on the 1st and 2nd of June; and

(c) $110.0M of the $200.0M exposure had been "sold down" to other financiers.

Mr Simmons also explained that the Board resolution, that "the Chairman" "again" write to the Reserve Bank was seen by the Board as constituting a rebuke to management. Mr Simmon's noted also that the previous letter (of 19 June) had not addressed the Reserve Bank's counselling, but had simply sought to defend the State Bank's position.

In their further submission (dated 29 January 1993), the directors explained that, in placing reliance upon management's explanations about the nature of the transaction, the directors failed to appreciate the serious nature of the Reserve Bank concerns. That may well be so. My concern, however, is that it should have been obvious to the Board, on 25 June, that management were aware of significant Reserve Bank concerns before the letter of offer was sent, but had not referred those concerns to the Board, even though management were dealing with a potential $200.0M transaction which had been approved by the Board, over a weekend, using the "round-robin" process.

(3.8) A further letter from the State Bank to Mr Brady of the Reserve Bank's Supervision department of 7 July 1987, is also set out in full:

"Over recent weeks there have been conversations and exchanges of letters between our two organisations concerning a large underwriting exposure entered into by this Bank.

Details of these communications were discussed at some length by the Board of Directors of State Bank at their meeting at the end of June and they have asked me to outline again the Bank's position in this transaction with regard to the four points raised in your letter of 1st June.

Your first point was that the exposure is very large in relation to the size of State Bank. As indicated in a letter dated 19th June from the Chairman of the Bank to the Governor of the Reserve Bank, it was clearly understood within State Bank that this was an underwriting proposal. The Bank was not committed to a funding proposal until certain conditions precedent had been met. In considering this transaction, it was always the intent that any exposure would be syndicated. Due to the timing required, it was not possible for the Bank to make formal approaches to other financial intermediaries to sell-down an appropriate amount of the underwriting before indicating to our customer that we were prepared to make an offer. The Bank has had significant experience in "selling-down" and our assessment was that the credit and the fee structure was such that the transaction was readily saleable. In the time available, we had made informal approaches to some intermediaries and their response was such that indicated that the proposal was feasible. Subsequent negotiations have resulted in the sell-down of the major proportion of the transaction so that any contingent exposure would be less than 30% of the Bank's capital base.

The second reason advanced by you was that the Bank already has several commitments in excess of 30% of its capital. We find this hard to accept as a valid reason, as only one of these exposures is outside "the ownership" of the Bank. One of the other exposures is Government risk and includes some securities which are saleable on the open market. In addition, as I discussed with you in our telephone conversation, this is a position that had been known to the Reserve Bank for some time and one which the Reserve Bank had not raised with us before. My understanding of the Reserve Bank's comments at that time is that the Reserve Bank had noted the matter internally for discussion with us on some future occasion. On this basis, we find it hard to accept the validity of this as a reason.

In regard to the third point raised in your letter that there is no assured programme to reduce the exposure within a very short period, I believe that I have covered this in responding to your first point. There may be a difference of view of timing of the "sell-down". State Bank had carefully assessed the proposal and were firmly of the view that, in terms of actual exposure, we would not in fact exceed the prudential guidelines. I might add that State Bank's general philosophy is that exposure to groups of the nature involved in this transaction would not exceed 30% of our capital base. As already indicated, we have achieved a sell-down to meet this objective.

t The fourth point raised by you was that of some awkwardness in a situation where a senior executive of a bank is also associated at Board level with the borrowing entity. The Board of the bank have asked me to strongly re-emphasize the fact that the decision was taken by the Board of Directors on their assessment of the transaction and that the person concerned took no part in any of the discussions or the decision concerning this matter. The relationship between the borrowing entity and State Bank has been well established for some considerable time and there is a strong customer/banker relationship.

In summary, this was a proposal that had been considered on its merits by the Management and approved by the Board of Directors as an appropriate, viable commercial transaction. As we have indicated to you on previous occasions, one of the marketing advantages that we believe we have is our ability to respond very quickly to requests for funding arrangements. We have been able to achieve this without any break-down in sound analysis and credit assessment. This transaction is an example of this, where we have been able to act in a competitive way without compromising sound prudential management. In this regard, I would like to thank you and your colleagues for giving such prompt attention and providing your response so quickly to this transaction."

(3.9) By letter to Mr Matthews of 12 August 1987, the Reserve Bank (Mr Brady) replied in the following terms:

"We appreciate receiving the further background you have provided in your letter. We are also pleased to know that you have achieved a sell-down of the transaction so that your bank's exposure is now less than 30 per cent of its capital base. Nevertheless, there remain several aspects of the exchange between us which might best be clarified in discussion and I suggest that we take the opportunity of doing so in our next formal consultation. We will be in touch with your officers shortly to set a time for that meeting.

I do feel, however, that I should respond at this time to one point which was made both in your letter and in your Chairman's letter of 19 June to the Governor. I refer to the comment that the transaction was an underwriting proposal and that your bank was not committed to a funding proposal until certain conditions precedent had been met. Neither my colleagues nor I can recall that point having been put to us in our initial discussion. Without knowing what those conditions were, I cannot say whether they would have had a bearing on our attitude to the transaction. Perhaps we could also discuss that at our forthcoming consultation."

(3.10) The Reserve Bank diary note of the third prudential consultation (October 1987) indicates that, although the matter of the Equiticorp funding was discussed, the issue of the nature of the facility was not pursued. The Reserve Bank diary note is in the following terms:

"Against the background of the recent exchange of correspondence with SBSA on a possible large exposure to Equiticorp, Mr Brady carefully drew out the salient features of the Bank's prior notification requirements. Mr Clark commented that his bank was able to understand the Bank's thinking in this area of its prudential requirements; he hoped, however, that for its part the Bank could also understand that in many instances where a large transaction was involved, time was of the essence. Mr Brady said we recognised this and that he believed we had proved to banks our ability to deal quickly with notifications.

Mr Ottaway indicated that the Equiticorp matter had been a good experience all around. Mr Clark suggested that the problem with that particular dealing was that it had not been fully and completely explained to the Bank at the time. He believed that had this been done, the Bank might well have not needed to express concern. Mr Brady said he could assure SBSA that what the Bank had said to it on that matter, it had equally said to other banks."

This correspondence, together with subsequent advances to the Equiticorp Group are considered at the end of this Chronology, and at Chapter 26 - "Dealings between State Bank and Equiticorp", which summarises the dealings between State Bank and Equiticorp.

(4) Following the October consultation, State Bank (Mr Ottaway) contacted the Reserve Bank on 27 November 1987, in relation to the State Bank's desire to establish a branch in New York. He was told that the State Bank's unwillingness to observe the Reserve Bank prudential requirements could have a bearing on the Reserve Bank's preparedness to confirm, to the New York central banking authority, that the State Bank was supervised by the Reserve Bank.

The State Bank's (Mr Ottaway) letter of 27 November 1987 to the Reserve Bank dealt with a range of prudential issues. In relation to Large Exposures, it said:

"The Bank acknowledges the concerns of the Reserve Bank in respect of large exposures undertaken by banks generally. We have noted your request to limit exposure to one entity or group to an amount not exceeding 30% of the Bank's capital resources."

Up to that date, the State Bank's undertakings in respect of the Large Credit Exposure guideline had been two-fold:

(a) from May 1986 - The State Bank had simply noted the Reserve Bank's request to limit exposure to less than 30 per cent of capital resources (except in the "most exceptional circumstances");

(b) from March 1987, the note was "... (generally) ... to give the Reserve Bank prior notification for most potential large exposures".

(5) The Reserve Bank was clearly conscious of the qualified undertakings by State Bank in respect of this, and the other areas of prudential concern, but was apparently unsure how best to resolve the matter. It opted to wait until the State Bank's external auditors had become involved in providing reports to the Reserve Bank as part of its supervisory arrangements with the State Bank. An excerpt from an undated handwritten Reserve Bank diary note illustrates the point:

"To question further at this stage what the State Bank have spelt out quite specifically could be counter-productive when we are so close to settling agreement on what have been testy and testing matters."

(6) From that point on, the Reserve Bank diary notes in respect of Large Credit Exposures reflect a different emphasis. There was also a change at about that time in the conduct of the relationship. Beginning in March 1988, it had become Mr Matthews' practice to visit the Reserve Bank on approximately a quarterly basis. Those visits typically included discussions on a range of issues within the Reserve Bank's prudential framework.

(7) The Reserve Bank's diary note of the fourth prudential consultation, held on 15 November 1988, records a discussion about State Bank Group's "increased involvement in property development financing":

"Mr Matthews responded that the bank's strategy continues to be to take the initiative in investigating opportunities to further expand its operations both in Australia and overseas. The bank has a five year strategic plan which is reviewed annually before being approved by the board. Largely as a by-product of deregulation the bank had been able to reach its targets after three years. He said the bank was conscious of the need to keep the growth of the bank's operations under tight control. SBSA believed their systems and management resources were adequate for this task. Representatives of the bank are on the boards of all subsidiaries and the bank feels that this presence ensures operations are conducted prudently.

Mr Kelleher reminded Mr Matthews of the lessons of the Bank of Adelaide/FCA episode, including how management and directors of the bank believed there was a good handle on the subsidiary's activities.

Mr Matthews said he considered the group's corporate lending to be quite strongly controlled; he saw the lack of write-offs as evidence of this. The group's involvement in property development is kept under especially close review. In this area lending is predominantly for construction purposes, typically with a firm take-out on completion and where the borrower has a strong cash flow. He said he shared our views that banks should not be growing merely for growth's sake but was confident that the bank could continue to expand strongly without bringing high risk business onto its books. Their aim is for a good spread of business geographically and this underscored the bank's strategy in establishing operations in Sydney and Brisbane; SBSA is also conscious of the need to avoid concentration of lending to particular industry sectors."

I interpose the following comment on Mr Matthews' assertion that he saw a lack of write-offs as evidence that corporate lending was quite strongly controlled. The Investigation has revealed that lending controls in the corporate area in 1988 were anything but strong. (See Chapter 8 - "Credit and its management: Guidelines, Policies, Processes, Procedures and Organisational Delivery Mechanisms" and Chapter 22 - "Executive Information Management at the State Bank".) In my opinion, the low level of write-offs is symptomatic of the control deficiencies, not the reverse. Mr Matthews was the second most senior officer in the Bank, but did not, in my opinion, have an adequate knowledge and understanding of the State Bank's internal control systems or of the capacity of those systems to produce relevant data.

It is also appropriate that I refer to the findings set out in Chapter 5 - "The Management of the Bank Group's Diversifiable Credit Risk". That Chapter reports that there were significant inadequacies in the Bank's credit management systems, and that, until 1990, the Bank did not have management systems which enabled the Bank to accurately measure its credit exposures.

Mr Matthews was aware of at least those inadequacies. At the Executive committee meeting of 19 August 1988 (only three months before the November 1988 prudential consultation) Mr Matthews presented a paper (88/213) which stated that the Bank did not, at that time:

"... have any mechanism to accurately assess our total exposure as a Bank or as a Group to any one individual, business entity, industry, region or country."

(8) The Reserve Bank diary note (of 2 March 1989) records a meeting in Sydney between State Bank's Mr Matthews and Mr Copley, and the Reserve Bank (Mr Kelleher) on 28 February 1989. That note records that Mr Kelleher counselled:

"... on the need to watch the commercial property exposures very carefully"

Mr Matthews is recorded as:

"... acknowledge(ing) the bank was carefully monitoring the group's exposures in this regard"

(9) The question of the State Bank's exposure to the property market was again raised at a meeting on 26 June 1989, when Mr Matthews called on the Reserve Bank's Supervision department (Mr Austin and Mr Prees). Mr Austin asked if Mr Matthews "saw any problems in the present environment". The Reserve Bank diary note of 29 June 1989 records that Mr Matthews' reply was:

"... the property market was tight but the South Australian property market was still quite strong. SBSA has some exposure to two or three projects within the Adelaide CBD but believed that they did not constitute a risk.

Mr Austin asked about SBSA's high level of lending in construction reported in the Commercial Finance return. Mr Matthews was not aware of the data shown on the return but indicated that SBSA had been looking to boost commercial business. He would look at the run of figures and come back to us with his comments."

I interpose the comment that the discussions referred to above, and in following paragraphs, need to be seen in the light of the State Bank's credit exposure policy. This matter is considered in detail in Chapter 5 - "The Management of the Bank Group's Diversifiable Credit Risk". For present purposes, it is sufficient to note that the State Bank advised the Reserve Bank of its industry exposure policy in May 1986. In broad terms, the Bank's policy was that its total exposure to any one industry was limited to 20 per cent of its "risk assets". Chapter 5 reports that the State Bank did not comply with that policy, and that the Bank's imprudent exposure to commercial property was a contributing factor to its financial losses.

(10) The Reserve Bank diary note of the fifth prudential consultation, held on 16 November 1989, records that Mr Kelleher discussed State Bank's asset quality, and received an update on State Bank's problem loan exposures. Mr Matthews is noted as saying that:

"... in summary, SBSA believes it has identified, as best it can, the full extent of its problem loans."

In response to a comment that the Reserve Bank had noted, from data received on the State Bank's commitments, a relatively large proportion of approvals for construction, Mr Matthews is recorded as saying:

"... the (State) Bank was comfortable with these exposures; it lends only to strong developers and only on a cash flow pre-leasing or takeout basis."

After recording that:

"... compliance with the Bank's prudential guidelines do not, of themselves, raise concerns", (and)

"there are no exceptionally large exposures"

The Reserve Bank diary note continues:

"That said, Mr Kelleher remarked that we remain concerned that the bank could be vulnerable in current and prospective economic conditions. The pace of the group's expansion remained abnormally rapid in 1988-89 and was concentrated on the corporate sector. The recent slowing in balance sheet growth is a welcome event. The bank's name has already been associated with a number of corporates experiencing financial difficulties; this causes us to wonder whether provisions are adequate. We noted that the loan portfolio has an above average exposure to property, which is widely regarded as a potential problem area. Moreover, there have been market reports concerning SBSA's aggressive lending policies resulting in its taking on corporate business that other banks have turned down.

Mr Kelleher said that from our perspective, it is essential that the board and management of the bank closely monitors and controls the lending activities of subsidiaries. Beneficial Finance grew by 40 per cent in 1988-89 and is looking to expand at the same rate in 1989-90; we do not believe that such growth is sustainable indefinitely.

In responding to these comments, Mr Matthews said that the bank would carefully note what Mr Kelleher had had to say, and as in the past, would report the Bank's comments in a note to the board."

The question of what information was, in fact, received by the Board is considered in the more detailed analysis of the 1989 prudential consultation set out later in this Chapter, at Section 15.5.7.

(11) On 30 January 1990, the Reserve Bank (Mr Austin) rang the State Bank (Mr Matthews) about "property exposures". The Reserve Bank diary note of 30 January 1990 records:

"I drew to Mr Matthews' attention the figures for his bank's approvals for construction and property and business services, extracted from the Australian Bureau of Statistics Commercial Finance Return (CF1). I pointed out the high proportion (72 per cent) that these categories represented of total commercial finance approvals by SBSA in 1989. I compared the figures with those for 1988 which we had previously discussed with Mr Matthews.

Mr Matthews thanked me for drawing these figures to his attention. He said he would investigate and call back within a few days. He said that there was a possibility that classification errors were involved.

In response to my question about the property sector generally, Mr Matthews said that SBSA viewed Adelaide as not as difficult as the eastern States. Activity over recent years would mean more property becoming available in the CBD over the next 18 months but little new activity was being undertaken at present. In contrast, SBSA viewed the Melbourne property market as very difficult, followed by Perth and Sydney."

"Mr Matthews mentioned that SBSA's system for measuring exposures by industry group, including property, was not yet completed but could be ready by mid-year."

(12) Mr Matthews subsequently explained to the Reserve Bank that the apparently high level of concentration was a misleading figure, in that the State Bank had classified the category of the borrower by reference to the security provided by the borrower. Because that security had nearly always been `property', the Bureau of Statistics return was inaccurate because of that wrong classification.

Mr Matthews added that, once properly categorised, the State Bank exposure to property dropped to a level consistent with other banks. In the light of what the Investigation has discovered about the deficiencies in the State Bank's management information systems, and how those deficiencies meant State Bank was not able to effectively monitor its credit exposures, it is difficult to see how Mr Matthews could have expressed that view to the Reserve Bank. Mr Matthews advised the Investigation in this respect that he believes he was provided with this information from the relevant State Bank officers and that there was, at that time, no reason to suspect that the information was inaccurate.

The implications of the deficiencies in State Bank's management information systems are considered at Chapter 22 - "Executive Information Management at the State Bank" and Chapter 5 - "The Management of the Bank Group's Diversifiable Credit Risk".

15.4.4.2 Further Dealings Between the State Bank and Equiticorp

Before expressing conclusions that arise out of above chronology, it is appropriate that I set out the following history of two further transactions between State Bank and Equiticorp in December 1987 and January 1988. The December 1987 transaction is particularly relevant as it represents the culmination of the June 1987 transaction, referred to in the above chronology at paragraph (3) of Section 15.4.4.1.

The December 1987 Facility

On Friday 11 December 1987, Equiticorp again approached the State Bank seeking urgent funding of $200.0M.

On the basis of material before me, it is reasonable to infer that this transaction was introduced to the State Bank by Mr Clark who, that day, asked the Bank's General Manager Corporate and International Banking, Mr Ottaway, to deal with the matter, with assistance from Mr Masters. I am not to be taken as suggesting that Mr Clark's role was, of itself, inappropriate. His involvement does, however, give rise to the need for the Investigation to give particular attention to how State Bank officers thereafter assessed the adequacy of Equiticorp's application, especially in terms of the length of time available for that consideration, and the basis upon which it came to be approved.

During an informal interview with the Investigation on 21 August 1992, Mr Masters, who had a clear recollection of this transaction and of the urgency involved, recounted how Mr Ottaway had come into his office with the question:

"How would you like to earn fees of two million dollars over the weekend?"

Mr Masters accepted the challenge. On Monday 14 December, the Board was approached, by telephone, and asked to approve a facility, the effect of which was to loan Equiticorp the sum of $200.0M to assist Equiticorp purchase a 50 per cent shareholding in Monier Ltd, and thereby achieve control of 98 per cent of Monier's shares. At its meeting on 17 December 1987, the Board confirmed its so-called round robin approval of 14 December (which round robin process was, in my opinion, and for the reasons set out in Chapter 8 - "Credit and its Management: Guidelines, Policies, Processes, Procedures and Organisational Delivery Mechanisms", irregular).

Mr Masters presented the Board with two papers which were to be "read in conjunction" (Board Papers 87/401 and 87/402). In my opinion, the clear intent, and effect, of the proposal described in those papers was that the State Bank was to advance $200.0M to the Equiticorp Group for a period of thirty days from 21 December 1987. Board Paper 87/401 explained that the previous (ie the June 1987) facility for $200.0M (but sold down to $65.0M) had not been required after 23 November 1987, the date of expiry of Equiticorp's on market offer for Monier shares, but that Equiticorp had subsequently extended its offer until 21 December 1987 and "has requested the Bank to reinstate $50.0M to the previous $65.0M exposure."

Neither of the Board Papers make any reference to the Reserve Bank large exposure requirements. It seems that the facility was structured by management, and, in particular, Mr Ottaway and Mr Masters, in an attempt to limit State Bank's exposure to Equiticorp (on this transaction) to $50.0M. In other words, the $200.0M was arranged as follows:

(a) $50.0M was lent to Equiticorp for thirty days (from 21 December) on the terms set out in Board Paper 87/401. The loan, secured by a guarantee from Equiticorp Holdings Ltd and a charge over the Monier shares, was to be repaid by Equiticorp using funds from the sale of certain of Monier's assets, which asset sale was to take place contemporaneously with the share purchase (see below). The Board Papers note that Mr Clark had declared an interest in the matter and had abstained from voting during the round robin process, and that Mr Clark declared his interest and left the room during subsequent Board discussions on the proposals.

(b) The balance of $150.0M was not described as a loan. It was characterised as a purchase of a portfolio of loan receivables from Equiticorp for $150.0M, for a "term of thirty days from 21 December," on the following basis:

(i) As part of the share purchase arrangements, Equiticorp would sell back certain Monier assets and receive $315.0M. That amount would then be used to fund the repurchase of the loan receivables from State Bank "in terms of a put option between Equiticorp and the Bank".

(ii) The Board was told that State Bank's security was to include "Letters of Comfort (from Equiticorp) in relation to the position assumed by the Bank and acknowledging the purpose of the transaction." (these "Letters of Comfort" can not now be located by the Bank).

(iii) The Board was also told that "repayment of the facility will come from the $315.0M proceeds" of the asset sale.

(iv) The Board Paper (87/402) disclosed a Fee Structure as follows:

"Establishment Fee - 0.5% flat (AUD 750,000)

Asset Purchase Fee - 1.50% pa for the term of the facility".

It is important to recall some of the surrounding circumstances. The proposal was submitted to the Board two months after the sharemarket `crash' of October 1987, and only six months after the Board had received strongly worded written advice direct from the Governor of the Reserve Bank concerning the June 1987 $200.0M funding commitment. It must also be borne in mind that the December facility was for the same client, for the same amount, and to be used for essentially the same purpose as the June facility, and that the Board had once again been asked to consider, via the telephone, an urgent, highly unusual, complex, and large exposure, to a company associated with State Bank's Managing Director. The Board advised the Investigation that, whilst there is no written record of any concern or enquiry from the Board, Mr Barrett, the Chairman of the time, has a very clear recollection that he questioned Mr Ottaway at length about the structure of the transaction, and was told by Mr Ottaway that it was being arranged in a manner which would not involve a breach of Reserve Bank prudential limits and that, further, legal advice from a leading firm of Sydney solicitors was being obtained in order to protect the integrity of the structure of the transaction.

Based on the material considered by the Investigation, I have no doubt that, notwithstanding its structure, the arrangement was, in substance, a loan to Equiticorp of $200.0M. The Investigation has not, however, been concerned to assess the commercial viability of the proposal - my point is to demonstrate how, even after the exchange of correspondence with the Reserve Bank in June 1987, the State Bank, through Mr Ottaway and Mr Masters, structured the transaction in a way which avoided the Reserve Bank's prudential recommendations.

Why would State Bank structure the facility that way? On the material before me, I am satisfied that State Bank had been requested by Equiticorp, to provide the facility as a matter of urgency. Apart from any other complications that might have arisen if State Bank had complied with the Reserve Bank prudential guideline, it is reasonable to infer that State Bank preferred not to consult with the Reserve Bank because there was a significant chance that the predictable Reserve Bank reaction would delay the urgently required funding.

There can be no doubt that the exposure of $200.0M would have significantly exceeded the Reserve Bank's (30 per cent of capital) large exposure limit. My understanding is that, as at end December 1987, the State Bank's exposure to the Equiticorp Group represented approximately 50 per cent of State Bank's capital.

There is one further application from the Equiticorp Group which occurred in January 1988 which I should say something about in the present context because of what this further transaction reveals about State Bank's operations and affairs in the period December 1987 - January 1988. Before describing the January transaction, I need to expand the following aspects of the December transaction.

The December facility of $200.0M referred to above (which I will now describe as "the December Facility") was drawn down on Monday 21 December and was partly repaid on 15 January 1988 when Equiticorp repurchased the receivables for $150.0M (plus the agreed profit margin).

In the course of arranging the December Facility, Mr Ottaway had instructed New South Wales solicitors to assist in preparing documents and arranging settlement. A letter sent by facsimile to Mr Masters and Mr Ottoway on 21 December 1987 expressed the solicitors' "general concern as to the Bank's overall position in relation to this transaction taking into account the number of usual requirements in relation to taking this type of security which are being waived".

The solicitor's letter expressed the view that "normal prudential requirements" would involve the Bank taking a number of steps that the Bank had instructed the solicitors not to take: there had been no legal transfer of each component of the portfolio; no notice of assignment had been executed by the assignors and served on the borrower; documents of title to the assets being purchased were not to be handed over at or prior to settlement; there was virtually no investigation of the securities to verify things such as the correct disclosure of parties, the payment of stamp duty, the adequacy of insurance etc; lastly, the solicitors were instructed not to undertake company searches of each of the vendor or guarantor companies. The letter says that the full investigation of the titles to the securities will not be carried out in view of time and other constraints.

The solicitors' letter then outlines what risks were inherent in not taking proper legal assignments, and not receiving the title documents. In summary, the solicitors explained that it was their view that State Bank was at substantial risk in its ability to enforce its rights over the securities being assigned to it. The solicitors' letter also noted other matters.

(a) Even though there had been insufficient time to complete company searches of all companies involved, the solicitors had been able to obtain a search of one of the Equiticorp Group that was originally to provide receivables as security, namely Equiticorp Financial Services Ltd. The solicitors' searches revealed that that company had a debenture trust deed registered against it, which debenture trust deed meant that certain meetings would need to take place. The solicitors' letter continues -

"We note that in view of this difficulty the transaction is not proceeding with Equiticorp Financial Service Ltd but Equiticorp Finance Ltd (formerly associated with Midland Corporation Ltd) will be taking its place with a portfolio of alternative securities."

(b) It was noted that certain assets contained in the mortgage portfolio may not be able to be transferred without re-arrangements of those transactions.

(c) It was noted that, as the transaction may involve a sale of a substantial part of the assets of each vendor company, the Memorandum and Articles of Association of each company or the general company law may require the directors of each vendor company to obtain approval of shareholders to such sale.

(d) The default interest rate of 5 per cent was possibly a penalty, and, if so, unenforceable.

(e) There was possible breach of Stock Exchange Listing Requirement Rule 3(J)(3).

(f) Of particular significance was the solicitor's advice that they had been unable to come to a final opinion on whether the transaction would attract stamp duty.

Perhaps most significantly, for present purposes, is the warning from the solicitors in the context of Reserve Bank prudential requirements that:

"... although the transaction is structured as a sale with Put Option, it is possible the transaction may be regarded by the Courts and the Reserve Bank as a loan, notwithstanding the structure, if there is an understanding or arrangement that the Put Option will be exercised."

The letter concluded as follows:

"We understand that notwithstanding the above risks and problems involved in the transaction, the Bank wishes to proceed. Accordingly could you please provide to us by facsimile written acknowledgment of receipt of this letter as confirmation that the Bank will be proceeding notwithstanding our comments."

By letter of the same date (21 December 1987), Mr Ottaway replied to the solicitors. His letter included the following:

"The legal issues raised by you are acknowledged by the Bank, and we have taken a Commercial [sic] approach to the transaction in assessing these issues."

"Specific comment is made with regards to the following:

...

3. Precedent exists for our position with the Reserve Bank of Australia and the Bank is satisfied that this transaction is not in breach of prudential requirements."

...

"5. This letter confirms your bringing the issue to our attention and that the Bank will proceed with the transaction as advised."

It is clear, in my opinion, that various basic procedures that would ordinarily be adopted in order to protect the Bank's position were not adopted. That is not to say that Bank officers were unaware of their position. On the material before me, I accept that their commercial judgement rested on two primary grounds:

(a) State Bank officers, in particular Mr Ottaway and Mr Masters, held the view that the Bank had thirty days from drawdown of funds in which to deal with the more significant of the normal prudential requirements described above.

(b) State Bank's officers also accepted that the Bank was to be repaid on the twenty first day of the term of the loan. If, for some reason, Equiticorp did not comply with its agreement to repurchase the receivables on the twenty first day, then the remaining nine days was, in their view, sufficient time to make good the defects in the State Bank's security position.

The Investigation has not sought to assess the validity of that judgement. Rather, I have, for the purposes of this Chapter, concentrated on the implications of this transaction on the State Bank's relationship with the Reserve Bank. In that context, the Investigation has considered the comments in Mr Ottaway's letter of 21 December 1987.

Bearing in mind my opinion that the December Facility was a loan which created a $200.0M exposure to Equiticorp, Mr Ottaway's assertion as to compliance with Reserve Bank requirements is, in my opinion, incorrect. Mr Ottaway must have been aware that the clear intention of the parties was for Equiticorp to repurchase the receivables. Indeed, as has just been explained above, it was their confidence that the repurchase would occur on the twenty first day of the term which Bank officers point to justify their decision not to follow normal prudential requirements.

Mr Ottaway can not have it both ways. If the usual prudential measures to protect the Bank were not taken because the receivables were to be repurchased by Equiticorp within twenty-one days, then it must follow that the so-called `asset purchase' by the State Bank was, in truth, a loan. As a loan, the Reserve Bank's prudential guideline on large exposures was, quite clearly, applicable.

Mr Ottaway had also been present at the annual prudential consultation with the Reserve bank only two months previously when the Reserve bank had once again explained its large exposure guideline specifically in relation to the June 1987 Equiticorp exposure. The Reserve Bank diary note (of 26 October 1987) of this consultation records that:

"Mr Ottaway indicated that the Equiticorp matter had been a good experience all around."

The January 1988 Facility

On 28 January 1988, a further submission (88/11) was presented by Mr Masters to the Board recommending that the Board approve "a standby facility whereby the Bank would purchase a $100.0M asset portfolio from Equiticorp Australia Ltd". (which I will now call "the January Facility").

Whilst it is likely that the proposal was discussed generally, the proposal was approved by the Board, even though the submission does not explain what the facility is to be used for, other than to say that:

"Short term liquidity of the Equiticorp Group is currently being effected by the withdrawal of funding lines to New Zealand Steel due to change of ownership."

and that

"Although negotiations with Mitsubishi and BNZ are well advanced in relation to replacement facilities, the Equiticorp Group requires the additional comfort of knowing that it can sell a portion of its receivable portfolio at short notice to reliquefy."

The Board was once again told, and apparently had no difficulty in accepting, that the proposed arrangement to purchase the asset portfolio did not permit any recourse to Equiticorp Australia Ltd and, "there is therefore no exposure to the Equiticorp Group". In view of other elements of the proposal, it was, in my opinion, plainly evident that the Bank would have an exposure to Equiticorp. As with the December Facility, it was clearly the understanding or arrangement of the parties that the proposed put options would, in fact, be exercised. In addition, other elements were:

(a) A put option in favour of the Bank to secure repurchase of the assets by Equiticorp.

(b) A letter of comfort from Equiticorp "in relation to the position assumed by the Bank and acknowledging the purpose of the transaction."

The term of the January Facility was until 29 June 1988 on what is described as a "standby basis" and that "the facility would be available at any time up until 29/6/88 for individual periods of no longer than thirty days and would only be available provided an assured take out was in place." The Board Paper noted that the "Fee Structure" for the facility comprised an "Establishment Fee", a "Standby Fee", a "Drawdown Fee" and an "Asset Purchase Fee".

The January Facility, although approved by the Board, was never offered to Equiticorp because of the following unusual events:

(a) On 1 February 1988, an officer of the Corporate Banking branch (Mr Pyper) referred a draft letter of offer to the State Bank's internal legal branch.

(b) An internal memo from the legal branch (dated 1 February) pointed out that the documents used for the December Facility "were prepared on a one off basis and may not be suitable for the proposed arrangement." The legal memorandum enclosed a copy of the letter of 21 December 1987 from the Bank's external solicitors referred to above, together with the advice that the external solicitor's comments applied equally to the proposed transaction (namely the January Facility). In particular, the internal legal memo contained the following comment:

"The proposal looks more like a loan than the [December Facility] and when looked at together with the [December Facility] a loan is the most likely result. Hence the Reserve Bank requirements may be of concern. That is, the Bank's exposure to EAL may be too great and there may be PAR [Prime Asset Ratio] requirements."

(c) In his paper dated 5 February 1988 for the Lending Credit Committee, Mr Pyper explained that:

"... detailed investigation into the practical and legal aspects has made it apparent that the facility cannot be successfully established without recording the exposure against the Equiticorp Group. Due to current exposure levels to the Group, proceeding further in the transaction, or for that matter transactions of a similar nature, is not possible."

(d) That paper of 5 February for the Lending Credit Committee followed a report prepared by Mr Pyper on 2 February for the Chief Manager, Corporate Banking, Mr Masters. In his report of 2 February 1988, Mr Pyper basically restated the same concerns that had been set out in the 21 December letter from the Bank's external solicitors.

The concluding paragraph in the report of 2 February to Mr Masters is in the following terms:

"It is felt that because of the Bank's significant exposure to the Equiticorp Group, the fact that if the facility was deemed a loan, we would be in excess of our prudential limits, and the relationship of the Bank's Managing Director as a director of Equiticorp and a number of its subsidiaries, participation further in this transaction places the Bank in a precarious position."

It is clear from Mr Masters' handwritten comments, endorsed on the note of 2 February, that Mr Masters did not concur with the proposed course of action, that is of cancelling the approval. Mr Masters' note is to the effect that the Bank was not agreeing to do anything except enter into an arrangement whereby Equiticorp could sell a portfolio of loans to the Bank for a specified amount.

(e) Mr Pyper's report, dated 5 February, was considered by the Lending Credit Committee on 9 February, 1988. The Lending Credit Committee including Mr Matthews (Chairman), Mr Ottaway, and Mr Masters, simply noted that a decision had been taken not to proceed with the facility.

"Members were informed that the facility cannot be successfully established without recording exposure against the Equiticorp Group.

However, because of the view taken by the Reserve Bank in regard to the exposure and because of our current exposure levels to the Group, it has been decided not to proceed with the facility."

(f) The Lending Credit Committee did not appear to have any choice in the matter, given that on 4 February 1988, Mr Ottaway had written to Equiticorp to advise that the Bank was unable to proceed further in the asset purchase facility "because of legal implications and because of advice received from the Reserve Bank of Australia on 2 February 1987".

So far as I can tell, the "advice from the Reserve Bank" that Mr Ottaway referred to was a discussion paper received from the Reserve Bank on that date, but dealing with certain proposed changes to the manner of determining capital adequacy ratios. No specific advice on the January Facility was sought from the Reserve Bank.

(g) The Lending Credit Committee minutes of 9 February 1988 were tabled at the Board meeting of 24 March 1988, but the history described above (at (a) to (f)) was not disclosed to the Board. Even in the absence of those details, however, I would have expected that the directors would want to record management's explanation of why there now would be an exposure to Equiticorp even though the Board had been told (in submission 88/11 referred to above) that there would be no exposure to Equiticorp. There is no record of any such discussion between the Board and management.

Although I have not pursued the matter any further in this Chapter, it is important to note that, following the decision by the Bank not to proceed in respect of the January Facility, Beneficial Finance, using subsidiary companies of off balance sheet companies, purchased receivables from Equiticorp to the value of approximately $200.0M during the period January to March (inclusive) 1988.

The circumstances surrounding Beneficial's purchase are to be examined in a later report.

There is, however, one further matter that I should report on in this context.

Having gone to the trouble of designing the structure for the December Facility (described above) in an attempt (in my view) to avoid the Reserve Bank prudential recommendation, the architects of the arrangements seem to have forgotten that the State Bank lodged a quarterly return with the Reserve Bank which disclosed large exposures. Whatever the explanation, the State Bank's December large exposure return disclosed an exposure to a non-bank client of greater than 30 per cent of its capital.

The Reserve Bank analysis of the State Bank's December return noted that the:

"... large exposure return for end December raises cause for prudential concern. The (State) Bank reports an exposure to a non-bank client of ... 37.9 per cent of capital); we have not received a prior notification of this exposure."

A Reserve Bank diary note of 25 January 1988 records that a Supervision Unit officer (Mr Milford) rang the State Bank's Finance department (Mr B Newman) on 22 January 1988, and was told:

"Exposure is to Equiticorp. The exposure is, to the best of his knowledge, not related to the June transaction. It is a new exposure over the quarter."

Based on that, a further Reserve Bank diary note of 25 January records the following observations:

"SBSA's large exposure return ... raises cause for concern ..."

"We received no prior notification of the exposure. The size of the facilities extended to the Equiticorp group raises concern, especially in view of comments made at the prudential consultation [of October 1987], where SBSA indicated that they fully understood our requirements on large exposures."

"Once we have clarified all matters in relation to the large exposure to Equiticorp we should follow this breach of our guidelines up with the bank."

The situation changed on 27 January 1988 when Mr Newman telephoned the Reserve Bank (Mr Milford). Mr Milford's diary note records the new advice from the State Bank that the exposure to Equiticorp:

"... represents utilisation allowance of the commitment line of June 1987."

That Reserve Bank diary note then records:

"Given the sensitivities with SBSA, suggest further clarification be sought at a higher level."

The matter was pursued when the Reserve Bank (Mr Coventry) rang the State Bank (Mr Matthews) on 9 February, which, it should be noted, was the same day that Mr Matthews chaired the Lending Credit Committee meeting which noted that the January Facility (described above) could not successfully be established without recording exposure against the Equiticorp Group. Mr Coventry's diary note (of 9 February) records, in part, the following:

"Mr Matthews confirmed that the exposure reported in the December return reflected the drawing down of the Equiticorp facility (as reported to Supervision Unit in June/July last year). He explained that the reason why it showed up as an exposure of > 30% of capital for SBSA was simply one of timing - between funding by SBSA and the sell-down arrangements coming into place."

Mr Coventry's diary note records that, following their conversation, Mr Coventry thought the matter could perhaps be explored further at a meeting Mr Matthews had previously arranged for 10 March 1988. The Reserve Bank diary note of Mr Matthews' meeting on 10 March with Mr Brady, Mr Pearson, and Mr Coventry, records the following discussion on this topic:

"... large exposures. Mr Brady referred to the data we had received from SBSA on the bank's large exposures as at end December, which had reported an exposure to a non-bank, non-government client in excess of 30 per cent of capital. His understanding was that we had subsequently established with SBSA that the exposure reflected drawdown of the Equiticorp facility which SBSA had reported to the Bank in June last year and which had been the subject of a lengthy exchange of correspondence. Mr Brady said that at that time he had understood that the SBSA had sold down the major portion of that exposure and that, as a result, it had been left with an exposure which did not breach our 30 per cent requirement. Mr Brady said he would be interested to learn how SBSA could now indicate an exposure greater than 30 per cent on the latest return.

Mr Matthews indicated that although the facility had been put together in mid 1987 with the selldown arrangements also formally in place at that time, the matter had subsequently gone very quiet until just before Christmas when the deal had been resurrected. SBSA had contacted each of the selldown banks concerned and had received confirmation that all were still happy to proceed on the basis agreed to previously. Because of a need by Equiticorp to drawdown the facility quickly, SBSA had agreed to fully fund the drawdown, content in the knowledge that reimbursement from the selldown banks would be effected during the following week or so. Mr Matthews said he believed that his bank's reliance on verbal confirmation by the selldown banks (of their continued involvement) was "a common market practice". Indeed, the selldown arrangements had since come into effect and SBSA's exposure to Equiticorp was now well below the 30 per cent requirement.

Mr Brady said he had some difficulty in understanding whether the selldown arrangements with this particular transaction applied to risk selldown or funding selldown. Mr Matthews agreed that the difference between the two was not all that clear; nor, did he feel sufficiently competent on the technical aspects to offer a satisfactory explanation."

The Reserve Bank officers accepted Mr Matthews' explanation without further comment, even though that explanation was incorrect in several respects. The December Facility was new. The exposure disclosed in the December return was, therefore, not a reflection of a drawdown of the June facility. Of more significance is that the December Facility did not involve any selldown of risk to any other financial institution. No other banks had any involvement in the December Facility.

In some other respects, Mr Matthews' explanation was not far from being correct; the December Facility was for the same amount and the same purpose as the June exposure; that June exposure to Equiticorp had, so far as the Investigation can tell, been sold down to the point that State Bank had only a $65.0M exposure; that $65.0M was cancelled (in November 1987) and the December Facility included $50.0M which, in one sense, reinstated the $65.0M.

The Investigation discussed the issue with Mr Matthews during a formal interview on 19 August 1992. Mr Matthews explained that, while he accepts the honesty and credibility of the Reserve Bank, he is not prepared to adopt the Reserve Bank's notes of the meeting as accurate and correct as he is unable to recall the conversation. Mr Matthews stressed that he did not intend to mislead the Reserve Bank, and had not been aware that the topic was to be discussed at that meeting:

"... the only explanation I can say is that I have misunderstood the transaction and gave the information in all good faith, that I believed was correct." ⁽⁾

When asked how he came to have his understanding, Mr Matthews explained⁽⁾:

"... I cannot recall the details of the conversation, ... the only thing I can suggest that that I was still talking about the first transaction."

"... the information I gave to the Reserve Bank was given in good faith on my understanding of what had occurred."

As to his assertions concerning the alleged selldown arrangements, Mr Matthews confirmed that that was his understanding, and that:

"I can only assume that I gained the information from a general comment from our corporate banking people or whoever was involved ... I cannot be more specific than that." ⁽⁾

The Investigation discussed this matter with appropriate State Bank officers. All such officers were aware that the December Facility did not involve any other banks, and, accordingly, did not involve any form of selldown. All assured the Investigation that Mr Matthews' understanding did not reflect their advice to him.

On the material before me, I accept that Mr Matthews did not intend to deliberately mislead the Reserve Bank. Even so, the Reserve Bank was mislead. That result reflects very poorly on the State Bank and on Mr Matthews in his handling of the matter.

In the absence of a soundly based understanding of the details of the December Facility, Mr Matthews' response should have made it clear that it was really no more than a guess on his part.

When asked whether he had made an enquiry upon his return to State bank to reassure himself that he had given the correct facts to the Reserve Bank, Mr Matthews replied, that:

"I cannot recall whether I did or did not." ⁽⁾

In my opinion, Mr Matthews' conduct on 10 March 1988 was careless in that he did not ensure that the Reserve Bank received accurate information on a matter which Mr Matthews well knew was of significant interest to the Reserve Bank. One can only now wonder what the Reserve Bank reaction would have been had it discovered the true nature of the December Facility. Based on what had happened the previous June, it is not unreasonable to suggest that the Reserve Bank would have been gravely concerned, not only about the exposure to Equiticorp, but also about how the structure of the December Facility had the effect of avoiding its large exposure guideline, and what that meant in terms of its supervision arrangements with the State Bank and of the Bank's good faith.

15.4.4.3 General Observations - Large Credit Exposure Guideline

The above chronology further demonstrates that the Reserve Bank could seek, but could not compel, the State Bank's total compliance with its prudential recommendation. Although the State Bank provided relevant statistical information to the Reserve Bank throughout the period, State Bank never gave more than a qualified undertaking to abide by this Reserve Bank prudential recommendation.

The chronology demonstrates, in my opinion, that the Board did not fully appreciate the implications of Mr Clark holding directorships of companies that were customers of State Bank. In my opinion, it was not consistent with sound banking practice for the Board to allow the Bank to enter into a complex transaction for a relatively large amount with a company affiliated with the Bank's Managing Director, particularly where there was an element of urgency involved, without the opportunity for a detailed assessment of all relevant banking issues.

The above chronology, and, in particular, that part of it dealing with State Bank's dealings with Equiticorp, demonstrates that the State Bank, consistent with its qualified undertaking, treated the Reserve Bank in a casual, almost a derisive, way.

In my opinion, Mr Matthews purported consultation with the Reserve Bank on 1 June 1987 is of concern. Having been told, on 1 June 1987, of significant Reserve Bank concerns, Mr Matthews and Mr Mallett, without adequate reference to their Board, dispatched the State Bank letter of offer that same day.

At its meeting on 25 June 1987, the Board was given an explanation of Mr Matthews meeting with the Reserve Bank on 1 June 1987, and shown the subsequent correspondence. The Board's failure to take decisive action in the face of management's behaviour is difficult to understand, having regard to the importance of the position of the Reserve Bank in the area of prudential supervision.

Even when presented with clear evidence that management had not consulted properly with the Reserve Bank, and with clear evidence that the Board had not been adequately informed of the Reserve Bank's serious concerns before the letter of offer was sent (on 1 June 1987), the Board resolved only that the Chairman should write again to the Reserve Bank. That letter (sent by Mr Matthews, not the Chairman) again purported to justify the State Bank's conduct primarily by asserting that the facility was some sort of underwriting, and that the Bank was not committed until certain conditions had been satisfied. In my opinion, the facility was a funding commitment, albeit one which State Bank would attempt to reduce in amount by selling some of its exposure to other banks. Mr Barrett's prior letter of 19 June 1987 to the Reserve Bank Governor demonstrates, in my opinion, that Mr Barrett did not properly assess the true nature of the facility.

In December 1987 the Board had another opportunity to insist that management treat the Reserve Bank prudential guidelines more seriously. Instead of insisting on appropriate conduct, however, the Board again failed to recognise that management had engaged in inappropriate conduct, namely, by structuring the $200.0M exposure to Equiticorp in an artificial way, designed, in my opinion, to avoid having to discuss that new Equiticorp funding with the Reserve Bank. I am not to be taken as suggesting that the Board was itself a party to structuring the loan in a way outlined in the chronology or for the purposes suggested.

On the evidence available to me, and for the reasons indicated in the above chronology, my opinion is that this aspect of the State Bank's operations, affairs, and transactions, was not adequately or properly supervised, directed, and controlled, by the Board of Directors, by the Chief Executive Officer, or by the following officers of the Bank; ie Mr Matthews, Mr Ottaway, and Mr Masters.There is cause for concern regarding Mr Matthews's involvement with the Equiticorp funding which began in June 1987 and culminated at Mr Matthews's meeting with the Reserve Bank on 10 March 1988. Mr Matthews was closely involved with the events of June 1987, and with subsequent correspondence passing between the Reserve Bank and the State Bank. Mr Matthews is recorded as being present at the Board meeting on 17 December 1987, when the further $200.0M exposure to Equiticorp was discussed and confirmed by the Board. Mr Matthews was also present at Lending Credit Committee meetings (325 and 326) which considered, and eventually recommended, that the Board approve variations to one component of the December $200.0M exposure to Equiticorp, namely, to increase the $50.0M loan to the Equiticorp Tasman vehicle (Uruz Pty Ltd) from $50.0M to $65.0M, and from thirty days to six months.

I have accepted that Mr Matthews did not intend deliberately to mislead the Reserve Bank at his meeting on 10 March 1988. Nevertheless, Mr Matthews did mislead the Reserve Bank on a matter of fundamental significance.

In the same vein, one has to seriously question whether Mr Ottaway could reasonably have been unaware of the Reserve Bank's large exposure guidelines in relation to the December exposure of $200.0M to Equiticorp. In particular, Mr Ottaway had been present at the prudential consultation with the Reserve Bank in October 1987, and was also the author of a letter to the Reserve Bank of 27 November 1987, in which the State Bank acknowledged the concerns of the Reserve Bank in respect of large exposures undertaken by banks.

Although the matter is considered in detail at subsequent parts of this Chapter dealing with the prudential consultations, it is appropriate that I set out here my conclusion with respect to the adequacy of information going to the Board in connection with this area of prudential concern. On the basis of the material before me, and for the reasons set out in the chronology, I am of the opinion that the information and reports given by the Chief Executive Officer and other bank officers to the Bank Board were, under all the circumstances not timely, reliable, or adequate, and were not sufficient to enable the Board to discharge adequately its functions under the Act.

It is also appropriate that I say something, in this context, about the Reserve Bank. It is not clear to me why the Reserve Bank did not pursue the State Bank more vigorously to secure the State Bank's unqualified undertakings in respect of its large credit exposure guideline. Four factors, however, may explain the Reserve Bank approach:

(a) The State Bank's attitude in choosing not to follow the Reserve Bank's strong recommendation concerning the June funding to the Equiticorp Group;

(b) The State Bank throughout the relevant period submitted appropriate statistical data: that data did not, so far as the Investigation is aware, reveal any matters of significant concern;

(c) The matter of the State Bank's loan concentration to various industry sectors, including commercial properties, was discussed at various meetings and at prudential consultations. The State Bank's management, whenever the matter arose, advised the Reserve Bank that the State Bank had appropriate policies and systems, in place,and that those policies and systems were adhered to;

(d) The external auditors' reported (eventually) to the Reserve Bank that State Bank policies were being properly adhered to, and that State Bank management systems to control credit risks were being observed, and adequately provided a means to control exposures and limit risk to the prudent levels set by management.

In relation to the State Bank's June $200.0M commitment to Equiticorp, Mr Clark submitted (during formal interview with the Investigation on 28 January 1992) that the Reserve Bank Governor's letter to the State Bank Chairman demonstrated that the Reserve Bank could, when it was so minded, take vigorous action, and could "fire a cannon when it wanted to".

I accept that. The difficulty is that the State Bank, to continue the analogy, was able to ignore the `shot across its bows' because it had a special immunity: it was, ultimately, free to decline the Reserve Bank's counsel.

I have already noted that the Reserve Bank did not require the State Bank to submit two particular statistical returns lodged by nationally operated banks. These returns (broadly) measured loan exposure to any given industry. As a more general observation, I note that, with the benefit of hindsight, it is possible to identify limitations in the systems used by the Reserve Bank to monitor industry exposures. No one, however, should think it an easy matter for bank supervisors to know, in advance, the appropriate concentration of credit risk in any given sector of the economy. Further, and despite its considerable importance to the supervision of individual banks, credit risk concentration is not easily capable of objective measurement.

I understand that the Reserve Bank is reviewing its present system in this regard and, as part of that review, is addressing the conceptual and definitional problems.

There are two further State Bank transactions which have been reviewed by the Investigation and which are relevant for the purposes of this Chapter. They are the State Bank advances to the REMM Group of Companies ("REMM") and to the Adsteam Group of Companies ("Adsteam").

The Bank's dealings with REMM are considered in detail in Chapter 14 - "Case Study in Credit Management: The REMM Group". For present purposes, it is sufficient to note that, for the reasons set out at Section 14.2.7 - "The Bank's Prudential Guidelines", the State Bank's exposure to REMM was, by the very nature of the State Bank's financing obligations, without limit. It necessarily follows that the State Bank was plainly in breach not only of its own internal prudential exposure limits, but also in breach of the Reserve Bank large exposure guideline.

The State Bank's dealings with Adsteam are considered in detail at Chapter 9 - "Case Study in Credit Management: The Adsteam Group", (Section 9.4.6 - "Management of Facilities"). Having regard to the time available, the Investigation has not been able to give detailed consideration to the Bank's dealings with Adsteam for the purposes of this Chapter. Suffice it to say that, by the first quarter of 1990, the Reserve Bank was aware of State Bank's large exposure to Adsteam and, so far as the Investigation is aware, the Reserve Bank has never raised the State Bank's exposure to Adsteam as a matter of particular prudential concern, although at the prudential consultation held on 29 August 1990, the State Bank's exposure to Adsteam was on the list of large exposures discussed.

For the reasons set out in Chapter 9 - "Case Study in Credit Management: The Adsteam Group", however, my opinion is (and notwithstanding the Board does not accept it) that the State Bank Board approved exposures to Adsteam which exceeded the State Bank's internal prudential limits, in terms of the percentage of shareholders funds (ie the 20 per cent limit) and the absolute dollar limit set for any one group of companies. Having regard to its expressed concern in other matters concerning large exposures to a particular entity, I have no doubt that the Reserve Bank would have been seriously concerned about the level of State Bank's exposure to Adsteam (from 30 June 1988 to 30 June 1990) had it known the actual position.

15.4.5 CAPITAL ADEQUACY - RESERVE BANK OBJECTIVES

The Reserve Bank prudential guidelines on minimum capital adequacy recognise that capital serves a number of purposes for a financial institution. The Reserve Bank's primary objective is to ensure that there will be sufficient capital to provide a cushion against losses, and to provide re-assurance to depositors.

The Reserve Bank requirement to maintain adequate amounts of capital can be traced back to the exchange of correspondence between the Reserve Bank and State Bank on 24 and 26 July 1984, referred to above at Section 15.3.

During 1984, and the early part of 1985, the Reserve Bank was developing its framework for supervising banks' capital adequacy. On 1 February 1985, the Reserve Bank sent to the State Bank copies of a Reserve Bank's paper (dated 25 January 1985) "The Reserve Bank's Approach to Prudential Supervision of Banks and on our Framework for the Supervision of Capital Adequacy of Banks".

On 4 November 1985, the Reserve Bank wrote to the State Bank's Managing Director in the following terms:

"In the course of our discussion on 23 October, you indicated that you would be agreeable to an approach to the prudential supervision of the capital position of State Bank of South Australia which would involve:

. your bank agreeing to maintain a level of capital - as defined in the Reserve Bank's note No. 2 "Supervision of Capital Adequacy of Banks" of 25 January 1985 - of at least 5.0 per cent of its total assets. This ratio would apply to the bank itself and the bank and its associated companies on a consolidated basis.

. Your bank initiating discussions with the Reserve Bank if there were a significant adverse development in its capital ratio which was likely to result in a breach of the 5.0 per cent minimum; this would be with a view to developing an early program to correct the decline;

. discussions, at least annually, on capital adequacy and other prudential matters.

"We would be pleased to receive your written confirmation if the above arrangements are acceptable to your bank."

By letter of 18 November 1985, the State Bank replied in the following terms:

"State Bank of South Australia is prepared to co-operate with the Reserve Bank in its approach to the supervision of capital adequacy. In particular, we will:

. endeavour to maintain a level of capital of at least 5.0 per cent of total assets of the Bank and the Bank and its associated companies. At the meeting with the Reserve Bank on 23 October 1985, we explained the procedures for converting the Bank's subordinated loan to capital;

. inform the Reserve Bank if developments are likely to result in the Bank's capital ratio being less than the 5 per cent minimum;

. hold discussions, at least annually, with the Reserve Bank on capital adequacy and other prudential matters.

We mention that the above undertakings are subject to any considerations relevant to our responsibilities from time to time in terms of the State Bank of South Australia Act, 1983."

Against the background of those objectives, and the nature and terms of the consultative arrangements, I now set out a chronology of key events in the period 1984-1990.

15.4.5.1 Chronology of Key Events - Reserve Bank Prudential Guideline - Minimum Capital Adequacy

(1) The early thinking of Mr Clark in this area of prudential concern is set out in an (unsigned) memo, dated 18 May 1984, from Mr Clark to Mr Matthews, Mr Macky, and Mr S Davis:

"Capital Adequacy

The Reserve Bank has indicated that it is looking for a 5% capital ratio for Australian Banks. In this regard it is basing its thinking on overseas practices for large multi-national banks and basically is referring to the Australian operating banks which themselves are large multi-product, multi-national financial groups.

The percentage of capital required for the nationally operating banks in Australia bears little relationship to the appropriate capital requirement of the State Bank of South Australia. If 5% is needed for the nationally operating banks, our requirement is probably in the range of 2-3%."

"Free Capital

The Reserve Bank places emphasis on the amount of free Capital available to support depositors' balances. State Bank of South Australia has adequate free capital, but it is really not an important factor because our deposits are guaranteed by the government.

Security for Depositors

The purpose of the Reserve Bank's thrust on capital adequacy is to ensure that there is adequate support for the depositors of the Bank. The Reserve Bank is mainly interested in ensuring depositors of the Bank can always be repaid. With State Bank of South Australia the State Government guarantees all deposits in the Bank.

Confidence

The most important of all factors is confidence by the public in the Bank. This confidence is inspired by good management, prudential cash management and a low risk asset and liability mix. State Bank has all these factors, plus government guarantee.

Conclusion

Considering the above key factors, State Bank of South Australia does not intend to be grouped with the nationally operating banks and be required, or even have it considered, that it should have the same percentage for capital adequacy or for free capital.

It will always be happy to discuss its operations with the Reserve Bank and discuss any trends in its asset mix, liability mix or capital percentages which could reduce confidence in the Bank's soundness. However, it will conduct its operations with lower capital ratios than currently being employed by the nationally operating banks."

During formal interview, on 28 January 1992, Mr Clark explained that the document may have been a document prepared by him as a basis for discussion. In any event, Mr Clark agreed that the document "was definitely my thinking in 1984"⁽⁾. Mr Clark's thinking gradually changed after merger of the former State Bank and the Savings Bank:

"Now, as we merged very successfully, acquired Beneficial, started to get into corporate lending, started to go overseas, two things changed. The first one was that our asset profile, as I mention here, was changing very dramatically. Therefore the thinking there would change. Secondly, to go overseas you have to have the approval of your home based Reserve Bank, and they would require you to go to whatever their prudential was before they would give you a clean bill of health for London or New York. So they were the two factors that would have changed quite quickly."⁽⁾

State Bank's early position is set out in a July 1984 Board Minute (84/31) concerning "Prudential Exposure Limits" which provides:

"Background

As part of the development of reporting and control systems within the Bank, a preliminary investigation has been carried out to determine appropriate Prudential Exposure Limits for the Bank.

While the adoption of Prudential Exposure Limits is common practice in Banks throughout the world, there is no "standard practice". Therefore in preparing our proposed limits we have consulted the other State Banks. Over the next few months Planning Department will carry out further work in this area, as part of an examination of the capital position of the Bank. Should any changes be required to the limits recommended these will be brought to the Board.

Capital Ratio

The required Capital Ratio is currently the subject of discussion between the Bank and the State Government, the Reserve Bank and the State Banks Association.

The Reserve Bank has indicated they see a Capital: Assets Ratio of 5% as a suitable guideline. It is considered that, for a number of reasons, this Bank can and should trade with a ratio of less than that. This matter will be covered further when five year forecasts are presented to the Board for consideration later this financial year.

Future Activities

As mentioned, discussions in relation to the overall capital position of the Bank are underway. The outcome of these will be reported to the Board".

(2) Following the correspondence of 24 and 26 July 1984 between the Reserve Bank and the State Bank previously referred to, the State Bank's Mr Macky and Mr S G Paddison called on the Reserve Bank on 3 October 1984. The Reserve Bank diary note of 8 October 1984, records:

"They explained that the bank was preparing its first five year strategic plan and wondered what might be expected of SBSA, in terms of prudential supervision by the RBA, in the period ahead.

Mr Brady noted that the RBA had no formal powers in relation to State Bank but appreciated the co-operation received from them. He noted that an increase in the number of banks in the industry may require a somewhat more formal system of supervision with more specific powers being written into the legislation.

Mr Brady outlined our approach to assessing capital adequacy, noting that we believed no bank (possibly excluding government banks) should be allowed to let its capital ratio fall below 5%. He said we hoped to finalise our discussion paper on this topic shortly; it would be published but no particular ratio would be mentioned."

(3) A Reserve Bank diary note of 10 October 1984 analyses a State Bank Profit Plan for 1984-85, and an unspecified monthly operating review. The Reserve Bank had no "comment of substance" in relation to capital adequacy and noted that:

"Their ratio of capital to total assets was 6.9% at end June 1984 (the ratio drops to 5.5% including the funds for concessional housing channelled through the Bank by the state government). The SBSA intends to keep the ratio above 5.5% (excluding concessional borrowing)."

(4) On 25 October 1984, the Reserve Bank wrote to the State Bank's Managing Director in the following terms:

"We have studied with interest the material provided .. and note the efforts that your bank is putting into its planning and control processes. We appreciate your willingness to share this information with us and would be pleased to receive the Annual Profit Plan and 5 Year Strategic Plan as they are produced; an Operating Review each quarter, rather than every month, will be sufficient for our needs.

We have noted the views expressed in the documents on an appropriate minimum capital ratio for State Bank; we will make an opportunity to explore this matter further after we have finalised our paper on capital adequacy ...."

(5) By diary note of 14 June 1985, the Reserve Bank records a further analysis of the State Bank. This Reserve Bank analysis was prepared for a forthcoming meeting with the State Bank's General Manager, Corporate and International Banking (Mr P Byrnes). In relation to capital, the note records:

"Capital

As part of the SBSA's aggressive 5 Year Plan to double profits the bank is to increase its capital from $44 million to $200 million on 30 June. The injection of funds will be initially through subordinated debt which will be converted into capital, at the bank's option as the balance sheet expands.

The bank anticipates this injection of capital resources will make it the most capitalised bank in Australia".

(6) At its meeting in June 1985, the Board was advised that certain arrangements had been completed with State Treasury for the proposed injection of additional capital by way of converting $156.39M of existing Concessional Housing funding. The effect on the Bank's balance sheet of the conversion of concessional housing funds into capital was said to be that the balance sheet would show an addition to the capital resources of $156.39M by way of "Loan Capital", and a reduction of $156.39M in the concessional housing funding contributed from "Government and other sources".

Board Minute (85/175) records:

"It was reported that arrangements have been completed with State Treasury to provide additional capital by the conversion of $156.39M of existing Concessional Housing capital [sic] funding.

Under the terms of the agreement the Bank will have a fixed quarterly liability of 7.4% per annum of the full amount of converted loans, whether held as subscribed capital or as subordinated loan capital. Debt conversion will be confined to the extent necessary to ensure that gearing does not fall below 20:1."

(This Board Minute should be compared with the Reserve Bank's note of the prudential consultation held in October 1985, see paragraph (8) of this Section, below).

This minute is consistent with the supporting Board Paper, prepared by Mr Ottaway, Chief Manager Finance, which notes:

"The agreed weighted average interest rate on the converted loans is 7.4% pa payable quarterly, while the average term is 25 years. Under the terms of our agreement the Bank will have a fixed liability of 7.4% pa payable quarterly on the full amount of converted loans, whether held as subscribed capital or as (subordinated) loan capital.

A conversion of subordinated loan to capital will reduce the Bank's interest expense and thus increase profit. Accordingly, it is desirable for both profit growth control and public/political image that debt conversion be confined to the extent necessary to ensure that gearing does not fall below 20:1."

The supporting Board Paper recorded that:

"... terms of agreement with the Treasurer have been negotiated and are contained in the attached working outline of indenture".

The outline Indenture provided:

"...

3. The Bank agrees to pay to the Treasurer:-

(a) In respect of the sum from time to time described by the Bank as subordinated debt, interest at the rate of 7.4% per annum, payable quarterly (31/3, 30/6, 30/9, 31/12).

(b) In respect of the sum from time to time described by the Bank as capital, dividend as provided in Section 22(1)(b) of the said State Bank Act at an equivalent rate of return of 7.4% payable quarterly.

(c) The rate of payment described in sub-clauses (a) and (b) of this clause shall continue for a term of 25 years from the date of execution hereof, whereupon such rate will be subject to review between the parties as may be mutually agreed."

(7) By diary note of 11 July 1985, the Reserve Bank records its analysis of the State Bank's first 5 Year Strategic Plan. In relation to capital, the diary note records as follows:

"Capital

Capital is expected to double over the projection period increasing from $155 million to $302 million. The bank proposes to boost its funding base through converting existing debt provided by the State Government into subordinated debt which would then be converted to equity capital at the bank's option. SBSA proposes to exercise this option as necessary from time to time to maintain the gearing ratio of the bank at 20:1. The timing and amounts involved in the implementation of this option are outlined in the projections.

The bank has agreed to inform us when this proposal is finalised."

(8) The Reserve Bank diary note of the first prudential consultation, held on 23 October 1985, records discussions about the State Bank's capital position. It is worth quoting from the Reserve Bank diary note at length, as follows:

"SBSA's capital position and subordinated debt

Mr Clark indicated that SBSA were aware that the Reserve Bank did not include subordinated debt in its definition of capital. SBSA took a different view because they could convert their subordinated debt to capital at any time they chose. They did not wish to convert it all to capital at once because of the effect this would have on the bank's profit and loss. SBSA propose to examine their end-of-year balance sheet each year to determine the amount of subordinated debt they need to convert to capital to meet the Reserve Bank's requirements.

Mr Brady noted that SBSA's strategic plan implied capital ratios of around 4.3 per cent out to 1990. Mr Clark responded that the plan had been formulated before they had reached the arrangement on subordinated debt with the Government.

Mr Brady asked what form the agreement with the Government took. Mr Ottaway tabled correspondence between SBSA and the Treasurer which stated that the bank needed only to inform the Treasurer that they had elected to convert a certain portion of the subordinated debt to capital. Mr Ottaway also noted that the Crown Solicitor was in the process of preparing a formal agreement between the bank and the Treasurer on this matter.

Mr Ottaway stated that the dividend to be paid on the capital which was converted from subordinated debt would be no greater than the weighted average rate of interest they paid on the old concessional housing loans (ie just as they now pay interest on the debt at 7.4 per cent, they would pay a maximum dividend also at a rate of 7.4 per cent on the capital which had been converted from that subordinated debt). Mr Brady queried whether this was a committed dividend and noted that capital is something to which no pre-emptive dividend is attached. Mr Ottaway said that this arrangement merely capped the rate of dividend. Mr Clark explained that, in terms of the State Bank Act, the SBSA Board of Directors makes a recommendation on dividend payment; the Treasurer may or may not accept this recommendation, but if he does not accept it he has to table the matter in Parliament. On further questioning, Mr Clark confirmed that the Board had the right to recommend against a dividend, based on their commercial judgment. He also stated that there is no cumulative element involved, ie if a dividend were passed one year, there would be no obligation on the bank to pay the passed dividend at a later date.

Mr Brady asked whether they were satisfied that SBSA was able to convert the subordinated debt into capital at any time of their choice. Messrs Clark, Ottaway and Matthews all answered in the affirmative. Mr Matthews said that the split into the two types of "capital" was purely the bank's internal accounting and that the Treasury regarded the full amount as the bank's capital. Mr Clark said that they would convert as much of the subordinated debt as was necessary to meet the Reserve Bank guidelines. Mr Matthews observed that their image in the banking community was important and that they want to be seen to be meeting the prudential guidelines. Mr Clark confirmed that, if their capital ratio fell below 5 per cent, they would rectify it.

Mr Brady explained that new banks were being asked to meet a capital ratio of 6.5 per cent in their formative years and noted that, while nothing had been published on established banks, they were being asked to aim at a capital ratio of at least 5 per cent. He also noted that supervisors around the world were looking to strengthen the capital position of banks and that established banks may in time be asked to meet an increased capital ratio. Mr Brady outlined our preferred approach on capital ratios:

. should capital ratios slip towards 5 per cent, banks would contact the Reserve Bank to discuss their plans to correct their position;

. there would be annual consultations to discuss capital and other prudential matters;

. either party could approach the other at any time to raise particular matters; and

. these arrangements could be confirmed by an exchange of letters.

Mr Clark responded that if the Reserve Bank recommended that they should increase their capital ratio, then they would comply. He also stated that, even if there were no the Reserve Bank guideline, they would not want their capital ratio to fall below 5 per cent."

There are several discrepancies between the position recorded in the State Bank Board Minute of June 1985 (85/175) (see paragraph (6) of this Section, above), and this Reserve Bank diary note. Those discrepancies are: the statement that there was no "committed dividend"; the statement that only a dividend (as opposed to interest) would be payable; the statement that such dividend was "capped" by the arrangement; and the statement that the Board had the right to recommend against payment of a dividend.

(9) Then follows the correspondence of 4 November and 18 November 1985, referred to above, in which the State Bank agreed to co-operate with the Reserve Bank's supervision of capital adequacy, but only to the extent that the State Bank would "endeavour" to maintain the suggested capital ratio.

(10) The State Bank January 1986 Board Minute (86/25), relating to "Bank Capital", provides:

"The significant increase in total assets in recent months has produced a marginal deficiency in Bank gearing as measured by the requirements of the Reserve Bank of Australia. To alleviate this position, it is proposed that the Bank convert the sum of $10 million from subordinated loan capital to subscribed capital, effective from 1st January, 1986. The Under Treasurer has been advised accordingly.

It was acknowledged that the Bank is not bound by statute to the requirements of the Reserve Bank, but it is proposed to continue long-standing policy of voluntary observance so far as it is appropriate and within the Bank's capacity. Accordingly, the Bank's gearing by the Reserve Bank definition will in future be monitored in the Monthly Operating Review.

IT WAS RESOLVED that approval be given for the conversion of subordinated loan capital to subscribed capital in multiples of $10 million on each occasion that the Bank's capital gearing, as measured by the Reserve Bank of Australia, declines to 5.05% or less. Management is to provide a recommendation to the Board on each occasion that a conversion is proposed."

(11) A Reserve Bank diary note of 29 April 1986 further analyses the State Bank's capital adequacy. The note discusses whether or not the Reserve Bank would regard the State Bank's subordinated debt as capital for the purposes of the Reserve Bank definition. The Reserve Bank conclusion was that, although it needed further documentation to properly understand the nature of the State Bank's subordinated debt, and whether that debt met the Reserve Bank criteria for capital, if the debt did meet the Reserve Bank definition, then "both the bank and the group are well above the agreed minimum capital ratio". This diary note illustrates the difficulty that even the Reserve Bank had in determining whether the various items that made up the State Bank's capital resources were within the Reserve Bank definition of capital.

(12) By letter of 20 May 1986, the State Bank's Managing Director, (responding to a Reserve Bank letter outlining the Reserve Bank's requirements for external auditors reports) advised the Reserve Bank:

"The State Bank of South Australia acknowledges the role of the Reserve Bank of Australia as a prudential supervisor, but we are concerned that your requirements now and in the future do not prejudice our role and responsibilities as a State Bank. In this regard, we remind you that the Bank does not come within the formal jurisdiction of the Reserve Bank in other than selected issues, and we reserve that position where circumstances are, in our view, prudent and appropriate."

"Capital Ratio

The Bank's capital resources include a component ($136M at this date) of subordinated government debt which is convertible to Bank Capital at the Bank's option. Conversion of the whole would have an unacceptable impact on profitability and, accordingly, the Bank is responding only to the extent necessary to maintain guideline gearing in published accounts.

For the Bank's own purposes, including the determination of a base for large exposures, the bank's capital includes subordinated government debt."

"In summary, the Bank is committed to respond to the Reserve Bank in its role as a prudential supervisor so far as we are able, but we must make firm our independence from formal jurisdiction where our role and status as a State Bank may be prejudiced".

(13) A Reserve Bank diary note of 22 July 1986 records that the Reserve Bank gave further thought to the question of whether subordinated loan funds should be included in the Reserve Bank definition of bank capital. The Reserve Bank's `decision', in relation to the State Bank, was that it could not finally determine the position until the Reserve Bank knew more information concerning:

"... the maturity structure of the debt instrument; whether the subordinated debt would be available to meet short-term losses; and whether payment of dividends is cumulative in the event of its being set below the maximum on some occasions."

(14) On 3 September 1986, the Reserve Bank wrote to the State Bank's Managing Director to advise of significant changes to the Reserve Bank requirements.

"Capital Adequacy of Banks

I am writing to let you know that the Reserve Bank has been reviewing required standards of capital adequacy for banks in the light of the rapidly changing financial environment.

We have concluded that there is scope to widen our definition of capital to give, among other things, greater consistency with bank supervision standards in other countries and also that minimum capital ratios of banks established before 1981 should be raised.

As to the first of these matters, we intend to widen for all banks, the definition of capital by including general provisions for doubtful debts and revaluations of banks' properties provided the revaluation is formally included in the banks' audited accounts or the published notes thereto. With considerable misgiving, we will also include, to a limited extent, subordinated perpetual debt provided it meets the criteria set out in the attachment to this letter.

In the case of banks established before 1981, these modifications to the definition of capital are contingent upon an overall ratio of capital (ie shareholders' funds plus perpetual debt) to total assets of 6 per cent being achieved within 2 years and a ratio of equity (shareholders' funds including general provisions and revaluation of premises as above) to total assets of 5.25 per cent being achieved forthwith.

We view these ratios as benchmarks requiring more than nominal observance but something less than necessarily rigid adherence at all times."

"We should be pleased to have your co-operation in implementing these arrangements."

"For banks established in 1981 and afterwards, it is not proposed to change the minimum capital ratio of 6.5 per cent which we require them to observe during their formative periods. However the revised definition of capital will apply to them also though the shareholders' funds component at 5.75% will be 0.5% higher than for the older banks."

(15) At the second Prudential Consultation, held on 12 September 1986, the matter of the capital adequacy guideline was discussed; the Reserve Bank diary note records:

"Capital

Mr Kelleher referred to the Bank's letter of 3 September on capital. He explained the reasons for the changes and for the Bank's reservations about PFRN's (Perpetual Floating Rate Notes) as a source of capital."

"Mr Kelleher indicated that the nationally operating banks were expected to have no difficulty in meeting the new capital ratio of 5.25 per cent forthwith (noting that their general provisions represented about 1 per cent of total assets), but that it could take some time for some of them to get to 6.0 per cent.

Mr Kelleher noted that we were including in the definition of shareholders' funds the recent/prospective issues by R&I, SBV and SBN. Mr Matthews asked why SBSA's subordinated debt was not also included in shareholders' funds, as it was a permanent commitment of funds by the government. Miss Butlin indicated that the documentation on this subordinated debt (the letter of 4 April 1985 from the SA Treasurer to SBSA) did not provide the necessary detail to demonstrate that this debt met our criteria for capital - ie that the debt is irredeemable and that any dividend on it is payable only out of current operating profit. Mr Matthews took this information on notice and may revert to us.

Mr Matthews indicated that SBSA had thought that the new arrangements for capital ratios had involved another change of policy - ie an extension of the coverage from the bank alone to the whole group. Mr Kelleher referred them to the exchange of letters in November 1985 between the Reserve bank and SBSA concerning SBSA's undertaking to meet a 5.0 per cent capital ratio for both the bank and the group on a consolidated basis.

Mr Matthews was unaware of this correspondence and acknowledged that there had been a misunderstanding on their part and noted that they had at no time sought to achieve a group capital ratio at the prescribed level.

Mr Hazel saw no difficulty for SBSA to achieve a bank capital ratio of 5.25 per cent. Mr Matthews said that they were already there if both provisions and the subordinated debt were included in the calculation. No indication was given about prospects for the group capital ratio.

Mr Kelleher noted that we would negotiate with banks individually on a transition period (of not more than two years) by the end of which they should have a capital ratio of 6.0 per cent for both the bank and the group. Mr Matthews responded that they would look at this carefully and discuss it with their owner".

(Mr Matthews' comment that he was unaware of the need for the Group to comply with the capital adequacy guideline should be contrasted with what the Board was told in November 1988, see paragraph (25) of this Section, below).

(16) On 10 October 1986, the State Bank's Mr Matthews rang Ms J Butlin of the Reserve Bank seeking clarification of various matters following the prudential consultation on 12

September, 1986. The Reserve Bank diary note of that conversation records as follows:-

"Mr Matthews raised again the question of why SBSA's subordinated debt was not included in our definition of capital. I went through the fact that we had been given no detailed documentation on the terms and conditions applying to the loan (eg on its irredeemability and the payment of dividends) and that we therefore had no firm documented basis on which to determine whether it did, or did not, meet our criteria for capital. Mr Matthews noted that a decision had been made that no formal agreement was needed to cover the loan and indicated that he would re-read the file and review the matter."

(17) By letter of 23 July 1987, the State Bank advised the Reserve Bank:

".... that subscribed capital of the Bank was increased by $150M effective from 30 June 1987 to $350M."

(18) The third Prudential Consultation was held on 15 October 1987. Mr Clark was not present at the beginning of the meeting when Mr Brady is recorded, in the Reserve Bank diary note, as raising:

"... the question of establishing better understandings regarding the bank's willingness to observe our prudential guidelines including PAR and capital ratios."

Mr Clark was present when the issue of capital ratio was discussed. The Reserve Bank diary note records as follows:

"Mr Brady then raised the question of the SBSA not having committed itself to observing a 6 per cent minimum capital ratio. Mr Clark replied that the bank was not prepared to give any such commitment. Indeed, while he did not believe the bank's capital ratio would fall below 6 per cent, he also considered it would be "imprudent and unwise" to commit the bank's shareholder to any such requirement. Mr Clark added that clearly it was in the State's interest, as well as the bank's, for the bank to be well capitalised. Nevertheless, he could see little point in committing his bank to a minimum capital requirement, without his bank getting anything in return.

Mr Brady noted that SBSA was the only bank in Australia, including state banks, which had not yet given a commitment on its capital position to the Bank. He said it was very important that SBSA could show to the world that it is adequately capitalised. Equally as important was the need for SBSA to not be seen as the only bank in Australia not prepared to give the prudential supervisor a commitment on capital.

Mr Pearson added that SBSA should be conscious that its failure to provide such a commitment left us with little option but to indicate to overseas supervisors that the bank was not meeting its prudential obligations. Mr Pearson said SBSA should not lose sight of the importance of the external point.

Mr Clark repeated that he could not see anything in giving such a commitment for his bank and that he was not prepared to commit his shareholder in this way. However, he was prepared to give the matter some further thought. Mr Brady then passed to Mr Clark a draft letter of commitment for the bank's consideration".

(19) By letter of 27 November 1987, the State Bank (per Mr Ottaway) advised the Reserve Bank in the following terms:

"In our discussions of 15 October, you asked us to advise/confirm the Bank's position on a range of prudential issues."

"Capital Adequacy

Reference Prudential Statement No P.S. 2 and your letter of 3 September 1986 (Item III/19,20).

In terms of our advice of 18 November, 1985, we confirm that the Bank is prepared to co-operate with the Reserve Bank in its approach to supervision of capital adequacy. In particular, we will:

. endeavour to maintain a level of capital consistent with the ratios described in your letter under reference;

. inform the Reserve Bank if developments are likely to result in the Bank's ratio being less than the requirement;

. hold discussions, at least annually, with the Reserve Bank on capital adequacy and other prudential matters.

In giving these undertakings, we reiterate that they remain subject to any considerations relevant to our responsibilities from time to time arising under the State Bank of South Australia Act, 1983".

On the same day the above letter was written (27 November 1987), Mr Ottaway had rung the Reserve Bank (Mr Brady) to let the Reserve Bank know the State Bank Board had agreed that management should investigate the feasibility of establishing a branch in New York. A Reserve Bank diary note of the conversation records that unwillingness on the part of the State Bank to observe prudential requirements could have a bearing on the ability of the State Bank to establish an operation in New York.

There is no record of a report of the 1987 prudential consultation being given to the Board. So far as the Investigation can now determine, the Board was not aware of the debate being conducted between State Bank officers and the Reserve Bank on the matter of the prudential guideline on capital adequacy. This issue is considered further at the later part of this Chapter dealing with the 1987 prudential consultation.

(20) During early 1988, the Reserve Bank sent various discussion papers to the State Bank outlining a proposed change in the Reserve Bank capital adequacy guidelines. In short, the Reserve Bank was suggesting a measure of assets which were to be `risk weighted'. State Bank participated in the discussions with the Reserve Bank.

(21) By letter of 19 July 1988, the State Bank advised the Reserve Bank:

".... the total capital resources of State Bank Group at 30 June 1988 will exceed $1 billion.

We believe that this action strongly positions our Group for future growth."

That letter did not explain how State Bank defined "capital resources".

(22) A Reserve Bank letter of 23 August 1988 signifies an important further development. That letter enclosed a paper entitled `Capital Adequacy of Banks'⁽⁾. The paper "... outlined arrangements for the foreshadowed risk-based approach to the supervision of capital adequacy of banks". The letter indicated the Reserve Bank's intention of ".... having the new system operative before the end of 1988".

The `risk-based measurement of capital adequacy' introduced certain refinements into the system which up to then had incorporated a ratio of capital to total assets. The new arrangements included:

(a) A new definition of capital which, for supervisory purposes, was to be divided into two tiers. Tier 1, or `core capital' was to be the highest quality capital. Tier 2, or `supplementary capital' was capital which does not have all the characteristics of Tier 1 capital, but which does contribute to the overall strength of a bank as a going concern. At least 50 per cent of a banks capital base was to be Tier 1 capital.

(b) A greater emphasis on differing degrees of credit risk. In short, the higher the perceived risk of the particular exposure, the greater the capital backing required.

(c) A requirement that a bank take account of its global operations and its subsidiaries, both on and off-balance sheet.

Each Australian bank and bank group is expected to maintain a minimum ratio of capital to risk-weighted assets. This (reviewable) ratio is 8 per cent (of which at least 4 per cent must be Tier 1 capital).

Tier 1 Capital, generally, means: paid-up ordinary shares; non-repayable share premium account; general reserves; retained earnings; non-cumulative irredeemable preference shares; and minority interests in subsidiaries.

Tier 2 Capital, generally, means: general provisions for doubtful debts; asset revaluation reserves; cumulative irredeemable preference shares; mandatory convertible notes and similar capital instruments; perpetual subordinated debt; and redeemable preference shares and term subordinated debt.

(23) The State Bank wrote to the Reserve Bank on 9 November 1988 to provide estimates of the State Bank's capital adequacy on a risk weighted basis. The figures indicated that the State Bank complied with the new risk weighted capital ratio.

(24) The Reserve Bank diary note of the prudential consultation on 15 November 1988 does not raise capital adequacy as a matter of concern. That note records:

"The possibility of recognition being given to the Government guarantee as part of the bank's capital base was raised by SBSA. Mr Kelleher pointed out that we had difficulty in accepting a guarantee as a substitute for an injection of capital funds. We recognised the problem that government banks faced in getting their owners to subscribe capital given budgetary constraints. It was pointed out that we were examining whether there was scope to give some weight to the guarantee in determining eligibility for core capital. A possibility mooted was to allow future issues of mandatorily convertible notes to be included in Tier 1 capital; it was stressed, however, that we would also insist on some form of cap to ensure that State Governments did not rely on this rather than other forms of core capital to fund the bank".

(25) The State Bank November 1988 Board Minute (88/454) resolves:

"... to approve that the Bank acquire additional capital of $200 million by way of