In its bi-annual Financial Stability Review, released this morning the Reserve Bank said that the recent difficulties in global markets “have been compounded by a straining of the bond of trust between many banks and investors.”

As the Governor, Glenn Stevens, and the the bank has said in recent commentaries, Australia isn’t immune to these pressures, as we are seeing now by the way banks are hoarding cash. But it has done better than many other financial systems. The RBA said:

In this difficult environment, Australia has benefited from having strong and profitable financial institutions with few problem assets on their balance sheets, and a sound regulatory regime. While the Australian financial system has not been completely insulated from developments abroad, it is weathering the current difficulties much better than many other financial systems.

Given the difficulties with valuing structured credit products, many investors remain wary about the valuations being used by some banks. While standards of disclosure have improved over the past year, further improvements are required to rebuild the trust that is a cornerstone of a well‑functioning financial system.

Concerns about the capital position of some banks are also weighing on investor confidence, with bank share prices down considerably and the spreads that banks pay when raising funds up significantly on the levels of just over a year ago.

Reflecting these developments, the smooth functioning of the credit supply process has been disrupted in some countries.

This has increased the risk of a damaging feedback loop running from the financial sector to the economy and back to the financial sector. How powerful this loop ultimately turns out to be will depend to a significant extent on what happens to property prices in the United States over the period ahead, as well as on the ability of banks to retain the confidence of investors.

From this perspective, recent support efforts by the authorities in the United States are to be welcomed.

Overall, the past year has been a very challenging one for many financial systems. A return to more settled conditions will require a rebuilding of confidence in many overseas financial institutions and further steps to strengthen their balance sheets.

And, in an interesting development, The Council of Financial Regulators, consisting of the RBA, APRA ( the prudential authority), ASIC and the Federal treasury have all signed and released today a special memorandum of understanding (MOU) of what they will do and their responsibilities in a financial crisis.

In an effort to further strengthen these relationships and to improve public understanding of the responsibilities of each of the agencies, the Council members have recently agreed on a joint Memorandum of Understanding (MOU) dealing specifically with crisis management arrangements. This MOU is being publicly released on 25 September 2008 and can be found on the websites of all four agencies.

The MOU reflects the strong commitment of Australia’s regulatory agencies to the open exchange of information and to a co-ordinated response to potential threats to the stability of Australia’s financial system. The release of this document should help public understanding of the responsibilities of each of the agencies in the areas of financial stability and the objectives and principles that would guide their response to potential threats to financial stability.

Peter Fray

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