For much of 2010/11, the Australian financial system was able to put the earlier acute strains of the global financial crisis further behind it. The operating environment seemed set fair. The global economy continued to recover, with robust growth in economies critical to Australian exports; global funding markets were readily accessible; and, after early investor hesitation, global (and domestic) equity markets resumed their lift from crisis lows. The Australian economy benefitted from record terms of trade, boosting income and employment. However, the pattern of growth was uneven: the structural adjustment to high commodity prices, working in significant part through the exchange rate, has proved painful for some sectors. Despite the supportive environment, any financial institution anticipating a return to the headier days of strong balance sheet growth before the crisis would have been disappointed. Households and businesses (outside the resources sector) in Australia have taken a cautious approach to their finances since the crisis began, evident most in a strong increase in household savings and the slowest pace in credit growth for two decades.
Around the middle of 2010/11, the financial shocks that had characterised the crisis gave way to physical shocks, in the form of a spate of natural disasters in Australia in rapid succession. These disasters had a disruptive effect on economic activity that has been slow to unwind. Compounded by the Christchurch earthquake, the disasters also had a large and immediate impact on the general insurance industry in Australia, which coped with it well.
Overall, the industries regulated by APRA were in good shape at year-end. In the case of authorised deposit-taking institutions (ADIs, including banks, building societies and credit unions), asset quality was sound, with non-performing loan ratios declining a little in business lending but drifting upwards in housing lending. Further reductions in bad debt expenses bolstered ADI profitability while profit retention and dividend reinvestment schemes pushed Tier1 capital ratios to record levels, leaving ADIs well placed to deal with future stresses and regulatory reforms.
Despite the adverse impact of the natural disasters, the general insurance industry remained profitable and well capitalised. A large amount of the claims arising from these disasters will be covered by reinsurance. The industry's resilience owes importantly to prudent risk management on the part of boards and management, particularly in maintaining and renewing comprehensive reinsurance programs to spread catastrophe risks; it also reflects the robust risk-based capital regime introduced some years previously by APRA.
The recovery in equity markets over much of 2010/11, though losing momentum in the final months, underpinned a further improvement in the profitability of the life insurance industry and enabled capital to stabilise around pre-crisis levels, reinforcing various initiatives by life companies to strengthen their capital management during the crisis. The recovery in equity markets and higher fixed-interest earnings ensured that most superannuation funds earned positive returns for the second year in a row, after two consecutive years in the red.
Unfortunately, the global financial
crisis is not over. Events since year-end have shown, on the contrary, that
its aftershocks remain powerful. Increasing concerns about public finances in
Europe and the United States – which had been weakened by earlier large-scale
intervention to support ailing banks – and the sovereign debt exposures of European
banks have been reflected in renewed bouts of turbulence in global equity markets,
greater risk aversion in global funding markets and increasing pessimism about
growth prospects, particularly for advanced but highly indebted countries. The
implications of these developments for the Australian economy are not yet clear
but what is obvious is that the operating environment for the Australian financial
system is, yet again, clouded with uncertainties.
The sharp decline in global and domestic equity markets since year-end has had an immediate impact on the life insurance industry, which APRA is monitoring closely, and has eroded returns for superannuation funds. The deteriorating environment also poses two particular challenges for the ADI industry. The first is the danger of a widespread dislocation in global funding markets, in a rerun of October 2008. Risk aversion has intensified in bank funding markets in the euro area, where credit spreads have widened considerably, and it appeared to be broadening. The larger ADIs in Australia that tap global funding markets have very little direct exposure to the European banks and sovereigns under pressure but they would not be immune if, as in October 2008, risk aversion tarred all internationally active banks whatever their underlying quality. That said, the larger ADIs are now much better positioned to cope with a loss of access to global funding for a period.
The second and more general challenge is coming to terms with 'life in the slow lane'. The cautious attitude of households and businesses in Australia, which will be reinforced by recent global developments, will very likely deny ADIs the strong volume growth that supported a sustained period of profit increases before the crisis. Unless shareholder expectations adjust to the prospect of lower returns on equity, boards and management may be tempted to chase unrealistic expectations by assuming more risk – through lowering credit standards or seeking new and unfamiliar markets where they may have little comparative advantage – or by aggressive cost-cutting that may weaken risk management capacities. Those temptations must be resisted in favour of more measured strategic ambitions.
In its 2010 Report, APRA
said it was not ready to reduce the intensity of its supervision from crisis
levels because of the uncertainties then prevailing. That stance may have seemed
unduly cautious as 2010/11 unfolded, but APRA's continued close oversight of
the strategies, risk management systems and capital positions of institutions
has been vindicated by recent developments. The crisis is entering what the
International Monetary Fund has described as a 'dangerous new phase' and APRA
will need to maintain the intensity of its supervisory and policy activities
in the current year, and possibly beyond the current year.
The new phase of the crisis repeats the lessons of history that weaknesses in banking systems can have deep and enduring impacts on economic activity. Since the crisis first erupted in 2007, global policymakers have been pursuing an ambitious reform agenda aimed at promoting a more resilient global banking system. Recent developments will add impetus to global reform efforts, even if the implementation task may become harder in some countries.
The core elements of the global reform
agenda were finalised by the G-20 Leaders at their Seoul Summit in November
2010. The reform agenda rests on four pillars – a strong regulatory framework,
effective supervision, reducing the risks posed by systemically important financial
institutions, and transparent international assessment and peer review. Each
of these pillars is shaping, fundamentally in some cases, the prudential framework
in Australia and APRA's supervisory approach.
Global reform measures to strengthen the regulatory framework (the first pillar) are centred on raising the quality, quantity and international consistency of bank capital and liquidity. A new global capital and liquidity framework ('Basel III') has been developed by the Basel Committee on Banking Supervision, the global standard-setting body for banking regulation, and was largely finalised in December 2010. This point was reached only after extensive deliberations within the Basel Committee (of which APRA and the Reserve Bank of Australia are members), industry consultation and a series of quantitative impact studies, in which a number of ADIs in Australia participated.
The rubber is now hitting the road on these particular reforms. Although the Australian banking system has to date weathered the global financial crisis much better than most peers, APRA sees no case to distance Australia from the reforms. The larger ADIs in particular trade actively in global financial markets, are reliant on global funding markets and raise equity from global investors. These ADIs are global citizens, and investors and market analysts judge them accordingly. It is entirely appropriate, in APRA's view, that they at least meet minimum global standards. To strengthen the resilience of the Australian banking system, APRA proposes to apply the new global capital and liquidity framework to all ADIs in Australia, with some exceptions for ADIs with simple, retail-based business models.
The new global framework will be implemented
in Australia in three broad phrases. The first phase, involving enhancements
to the three Pillars of the Basel II Framework, will come into effect from 1
January 2012. The enhancements, inter alia, improve the risk coverage
of the Framework by ensuring that appropriate capital is held to support the
risks arising in trading activities, securitisations and exposures to off-balance
sheet vehicles. The new capital requirements will have only a limited impact
on ADIs in Australia.
The second phase, involving a comprehensive package of capital reforms, will come into effect in stages from 1 January 2013. This package includes measures to raise the quality and minimum required levels of capital, promote the build-up of capital buffers and establish a back-up leverage ratio. It formalises two capital buffers – a conservation buffer above the regulatory minimum capital requirement that is intended to be drawn down in periods of stress, subject to restrictions on capital distribution, and a countercyclical buffer that will come into effect when excessive credit growth and other indicators point to a build-up in systemic risk.
APRA's proposals for implementing the Basel III capital reforms in Australia have now been released. APRA proposes to broadly adopt the minimum Basel III requirements for the definition and measurement of capital, which will require some 'give and take' on current policies in a number of areas. In other areas, however, APRA proposes to continue with its conservative policies and not apply the concessional treatment available. In sum, APRA's proposed approach, accompanied by clear disclosure of the points of departure from Basel III, will go a considerable way to improving the comparability of 'headline' capital measures for ADIs in Australia with overseas peers. International comparability, however, is not an end in itself. APRA's fundamental objective must be to ensure that capital held by ADIs in Australia is genuinely available to absorb losses. Two longstanding points of principle underpin APRA's conservatism: assets that rely on the future profitability of the ADI to be realised or that are highly uncertain in value cannot be included in the calculation of capital, and capital cannot be used more than once in the financial system to absorb losses. There is no evidence from the global financial crisis that APRA's conservatism, which produces lower 'headline' capital ratios compared to other jurisdictions, penalised ADIs in Australia in raising equity capital, accessing wholesale funds at competitive rates or maintaining their credit ratings. The opposite was more likely the case.
Furthermore, APRA's proposal to accelerate aspects of the Basel Committee's timetable has, quite rightly, been interpreted as a vote of confidence in the strength of the Australian banking system.
The third phase of global banking reforms, involving stronger liquidity regulation, will begin to come into effect from 1 January 2015. These reforms seek to promote stronger liquidity buffers and more stable sources of funding through two new global liquidity standards – a 30-day liquidity coverage ratio to address an acute stress scenario and a structural funding ratio to encourage longer-term resilience. Australia could not meet the liquidity coverage ratio as originally proposed because the volume of high-quality liquid assets (particularly government securities) is, for the best of reasons, in short supply in Australia. These circumstances have been recognised by the Basel Committee, and APRA and the Reserve Bank of Australia worked closely with fellow Committee members to agree an alternative treatment that meets the intent of the global reforms. APRA's proposals for implementing the Basel III liquidity reforms will be released shortly.
One aspect of the G-20's reform agenda has been finalised. That involves the implementation of 'tough' principles aligning remuneration in banking institutions with prudent risk management and the long-term financial soundness of these institutions. APRA implemented these principles in April 2010 through amendments to its governance standards and has since been assessing their practical impact.
APRA's substantial prudential policy workload in 2010/11 was not dictated entirely by global reform agendas and timetables, although some other initiatives have had their origins in lessons from the crisis. The severe contagion problems that required the public rescue of a major global insurance group highlighted the need for supervisors to be able to take a group-wide view of their regulated institutions and to understand the full range of risks that arise from group membership. Acknowledging this, APRA has been consulting on a proposed prudential framework for consolidated groups. APRA is also reviewing, and harmonising where it can, capital standards for the general and life insurance industries. This review has proven timely, given the recurring episodes of equity market volatility and, for general insurers, the recent natural disasters. APRA has also been preparing for the Government's Stronger Super reforms and it welcomes the Government's commitment to grant APRA the power to make prudential standards in superannuation. Prudential standards are more flexible than legislation, can recognise differences in the nature, size and complexity of institutions and can be kept up-to-date with industry developments. If approved by Parliament, a standards-making power in superannuation will be a major step in the harmonisation of the prudential framework in Australia, a key aspiration of APRA since its establishment.
The G-20's emphasis on effective supervision, as the second pillar of its reform agenda, is an important, albeit belated, recognition by global policymakers that a strong regulatory framework must be complemented with more intense and active prudential oversight and supervision. Differences in the ability and willingness of supervisors to act have come to be seen as a significant factor in the different performance of banking systems during the crisis, under the same broad set of global banking regulations. In support of this pillar, the International Monetary Fund (May 2010) and the Financial Stability Board (November 2010) have provided a series of recommendations for making the supervision of financial institutions more intense, effective and reliable. APRA has contributed to this work.
Some of the recommendations address broad governance issues, such as the mandate and independence of the supervisory agency, and some address supervisory powers. Australia's arrangements meet these recommendations. Importantly, APRA has been fully supported by successive governments in securing the broad range of powers needed to carry out its role. Other recommendations identify areas where improvements to supervisory techniques could be or are being made. These include the use of industry-wide ('thematic') reviews, analysis of business models and products, and stress-testing. The recommendations will be benchmarks for APRA as it seeks to enhance its supervisory approach in response to industry developments and its experience during the crisis.
One of these benchmarks relates to supervisory assessment of the role of boards, which have ultimate responsibility for the prudent management of a financial institution. APRA's engagement with boards is central to its supervisory approach. APRA has extensive formal requirements on boards that set out minimum foundations for good governance. APRA sees these requirements not as constraining but as empowering boards because they give a frame of reference for good practice and underpin the strong alignment of interests between the board and APRA. APRA has also increased its face-to-face contact with boards since the crisis began. Meetings with a board and its committees give APRA the opportunity to reinforce its expectations of board performance and to form first-hand impressions of whether these expectations are understood and accepted by directors. Discussions across the table enable directors to explore with APRA ways in which its prudential concerns could be addressed and how the institution is faring compared to its peers. The exchanges also enable APRA to take good soundings on the risk appetite of the board, its command of strategy, the transparency and candour with which the board approaches problems and, more generally, on how it sets the 'tone at the top' for the institution.
During 2010/11, APRA stepped up its engagement with boards in three particular areas. The first was risk appetite. A clearly articulated statement of the board's appetite for risk is at the heart of a good risk management framework and it needs to be actively and consistently applied in the business. APRA met with a number of boards to review practice in this area and found a wide range of approaches to risk appetite statements in terms of their length, their qualitative or quantitative nature, their scope and, indeed, their quality. APRA does not have a particular template in mind. Rather, as a principles-based supervisor, its interest is in how well the risk appetite statement fulfils its purpose, in conveying clearly and concisely the board's preferences and risk tolerances to the rest of the institution. Where needed, APRA will be seeking improvement in both the articulation of risk appetite and in its application.
The second area was executive remuneration. APRA met with the Board Remuneration Committees of the largest listed ADIs and insurers to assess the involvement of the board in establishing sound remuneration practices and to discuss any challenges facing boards in implementing APRA's remuneration requirements. Remuneration practices were generally sound but APRA saw scope to improve risk-adjusted performance measures, the differentiation of individual from organisation-wide performance, the use of scorecard approaches and oversight of the APRA-regulated subsidiaries in a group.
The third area was credit standards in ADI housing lending. Against the background of a continued upwards drift in loan arrears and intensifying competition in housing lending, APRA wrote to the boards of the largest ADI housing lenders reminding them of the need to be alert to any deterioration in housing lending standards. The letter was deliberately targeted at the largest lenders, which are the industry standard-setters. If these lenders choose to lower lending standards to win business, smaller competitors may feel they have little option but to follow. APRA received the assurances it sought. The decision to write such a letter to, and seek specific assurances from, boards rather than management was designed to have boards question the lending practices of their institution more deeply than they might have been doing.
One key element of effective supervision that global policymakers are now emphasising is the adequacy of staffing resources and skills in a supervisory agency. Although resourcing has always been tight, APRA has over recent years been able to build up sufficient capacity to absorb a substantial supervisory and policy workload. Even so, the resources APRA dedicates to the supervision of large and complex financial institutions is at the lower end of the scale compared to many other supervisory agencies. APRA's current staffing levels are supported by the special four-year funding from Government to deal with the global financial crisis, which comes to an end after 2011/12. In the face of the continuing aftershocks from the crisis, APRA believes it is essential that it maintains its supervisory and policy capacity over the coming period.
The remaining two pillars of the G-20's reform agenda are now beginning to shape APRA's supervisory approach and workload as well. Global reform efforts under the third pillar – reducing the risks posed by systemically important financial institutions (SIFIs) – have to date focussed on a policy framework for dealing with global systemically important banks (G-SIBs). That framework envisages a scorecard methodology developed by the Basel Committee for identifying G-SIBs, which would be subject to higher capital requirements, strengthened supervisory oversight and robust recovery and resolution regimes. No Australian-owned bank is included in the initial list of G-SIBs. The G-20 has indicated its intention that, in due course, a policy framework be put in place for domestic SIFIs but to date there has been little discussion about such a framework in the global standard-setting bodies. The intensity of APRA's supervisory activities, its supervisory response system and its setting of prudential capital requirements already have regard to the systemic importance of regulated institutions within Australia, measured broadly in terms of balance sheet size. As part of its enhancement to crisis management arrangements in Australia, APRA has begun work with the larger ADIs on their 'living wills', starting with their recovery plans for circumstances in which they suffer major depletion of their capital.
The final pillar, transparent international assessment and peer review, will see APRA subject to greater external scrutiny on its adherence to global standards and the rigour of its supervisory approach. APRA welcomes such scrutiny. During 2010/11, APRA contributed to three reviews conducted by the Financial Stability Board – a peer review of the Australian financial system, a thematic review of Australia's compliance with global principles for deposit insurance and a peer review of implementation of the Board's remuneration principles in member jurisdictions. APRA also undertook a self-assessment of its compliance with those aspects of the Basel Committee's Core Principles for Effective Banking Supervision most relevant to the Board's work on supervisory intensity for SIFIs. APRA is also preparing to participate in the second review of Australia under the International Monetary Fund's Financial Sector Assessment Program (FSAP), which evaluates the strength of a country's financial system and regulatory architecture. The first FSAP review of Australia was conducted in 2005/06.
The adequacy of staff resourcing and skills in a supervisory agency is more than a story about headcount and training budgets, important though these are. There is a less tangible dimension that cannot be overlooked, namely, having staff with the right supervisory 'mindset'. APRA has worked hard to inculcate in each of its staff an inquiring mind, a certain level of feistiness and doggedness, a willingness to challenge and intervene, the ability to see the broader industry or policy context and, of course, a strong professional ethos. That mindset, though always under development, has stiffened APRA's resolve for periods of crisis. It has also been broadly acknowledged in the positive results of APRA's second stakeholder survey, which gave two of its three top scores to APRA's staff's demonstration of integrity and professionalism. The coming period will be another test of skills and stamina but the APRA Members are fully confident that APRA staff, as they have since the crisis erupted, will meet that test. Their commitment to the financial security of the Australian community has been outstanding.
Dr John F Laker