Australian Prudential Regulation Authority

Chapter 3 - The prudential framework
The prudential framework in Australia, as is now well acknowledged, played an important role in ensuring that the Australian financial system coped successfully with the unprecedented stresses created during the global financial crisis. Its mettle has continued to be tested, by the recent spate of natural disasters and by the renewed turbulence in global financial markets over recent months. The robustness of the framework in the face of these pressures is anchored in APRA's behavioural standards that support strong governance and prudent risk management, and in its conservative, risk-sensitive approach to setting capital requirements for its regulated industries.
A prudential framework cannot afford to stand still. APRA had a substantial prudential policy workload in 2010/11 that is intensifying in the current year and is stretching its policy resources. Much of this workload has been generated by the global regulatory response to the crisis, now moving into the implementation phase, but APRA also has substantial initiatives under way to improve the coverage of risks through harmonised prudential standards and to prepare for the Government's Stronger Super reforms.
The core of the global reform agenda, an agenda to which the G-20 Leaders have been strongly committed, was finalised at their Seoul Summit in November 2010. As noted earlier in this Report, the first pillar of that agenda is a strong global regulatory framework that will materially raise the level of resilience of banking systems and enable banking institutions to withstand severe distress without extraordinary government support. The Basel Committee on Banking Supervision and the Financial Stability Board have had carriage of reform measures under this pillar. The Basel Committee's comprehensive reforms aimed at increasing capital and liquidity buffers held by internationally active banks were largely finalised and released after their endorsement at the Seoul Summit. APRA has been actively involved in these initiatives and, with its fellow Committee member the Reserve Bank of Australia (RBA), has sought to ensure that, where relevant, the unique circumstances of the Australian financial system have been taken into account. The complex task of implementing the new global capital and liquidity framework in Australia is now underway.
In addition to its multi-year project to implement the Stronger Super reforms, APRA's domestic policy agenda includes two major initiatives. One is an updating and, where possible, harmonisation of capital requirements for general and life insurers, which offers scope for a significant improvement in the risk-sensitivity of the capital framework. This path-breaking work is drawing on a significant amount of APRA's (and the industry's) intellectual capital. The other major initiative is the development of a prudential framework for conglomerate groups.
Changes to the prudential framework are finalised by APRA only after it has consulted extensively with industry and other interested stakeholders. Such consultation is vital if APRA is to achieve high-quality reforms within reasonable implementation timetables. Consultation can take a number of forms, including formal submissions, quantitative impact studies, workshops, presentations by APRA staff and targeted consultation with select stakeholders if appropriate. APRA has also been making increasing use of industry-wide public conferences on its proposals. It has already conducted one such conference on the new global capital and liquidity framework in banking and is planning a second, both hosted by the Financial Services Institute of Australia (Finsia). Three conferences have been held on the proposed reforms to general and life insurance capital, hosted jointly by the Insurance Council of Australia, the Financial Services Council and the Institute of Actuaries of Australia. APRA's proposals must also comply with the Government's policy on best practice regulation and, in this regard, APRA has always fully met the requirements of the Office of Best Practice Regulation.
Response to the global financial crisis
Enhancements to the Basel II Framework
As the first stage of its comprehensive reform program, the Basel Committee announced a package of measures to enhance the three Pillars of the Basel II Framework in July 2009 (as adjusted in June 2010). These included, under Pillar 1 (minimum capital requirements), an improved coverage of risks arising from complex structured products and from securitisation as well as higher capital for market risk, resulting in part from the requirement to use data from periods of financial stress in the modelling of such risk. Under Pillar 2 (the supervisory review process), supplementary guidance was issued to address flaws in risk management practices revealed by the global financial crisis. The guidance covers institution-wide governance and risk management processes, management of risk concentrations and the capture of risk from off-balance sheet and securitisation activities. Enhancements to Pillar 3 (market discipline) strengthen disclosure requirements for these same activities. The Basel Committee expected banks and supervisors to begin implementing the Pillar 2 guidance immediately but set the start-date for the Pillar 1 and Pillar 3 changes at no later than the end of 2010. That date was subsequently deferred by 12 months.
Following consultation with industry, APRA released amendments to relevant ADI prudential standards and prudential practice guides in May 2011 that give effect to these Basel II enhancements. APRA also made other amendments to its capital adequacy requirements for ADIs to clarify existing provisions and to support the implementation of the enhancements. The prudential standards and revised reporting requirements come into effect from 1 January 2012, in line with the internationally agreed timetable. The Basel II enhancements are expected to have only a limited impact on ADIs in Australia, which have largely avoided higher-risk trading activities in the lead up to and since the global financial crisis.
Strengthening banking system capital requirements
The more significant milestone in the Basel Committee's comprehensive reform program was the release of a package of proposals (now known as 'Basel III') to strengthen capital and liquidity requirements for internationally active banks in December 2009. The capital reforms covered a number of key areas and included proposals:
After reviewing the various potential impacts of the proposals, the Basel Committee announced in July 2010 that it had reached broad agreement on the overall design of the capital reforms including, in particular, the definition of capital, the treatment of counterparty risk and the leverage ratio. Broad agreement on the calibration and transition arrangements for the capital reforms was announced in September 2010. The minimum requirement for common equity (after deductions) was set at 4.5 per cent of risk-weighted assets and the minimum requirement for Tier 1 capital at six per cent. (This compares with minima of two and four per cent, respectively, that apply currently.) A capital conservation buffer was set at 2.5 per cent above these new minimum requirements. When capital levels fall within the buffer range, banking institutions will be subject to constraints on capital distribution that increase in severity as the buffer reduces. In addition, a countercyclical buffer up to 2.5 per cent will apply when excessive credit growth and other indicators point to a system-wide build-up of risk. A minimum leverage ratio of three per cent based on Tier 1 capital will be tested during a parallel run period from 1 January 2013 to 1 January 2017.
The Basel Committee's proposals were endorsed by the G-20 Leaders at their Seoul Summit in November 2010 and the Basel III rules text was released in December 2010. The timetable envisages that implementation of the reforms in member countries will begin on 1 January 2013 and the new minimum capital requirements will be phased in by 1 January 2015; implementation of the broader package of reforms will be substantially completed by 1 January 2019. However, the Basel Committee also emphasised that national authorities have the discretion to impose shorter transition periods and should do so where appropriate. After the Basel III rules text was released, APRA wrote to ADIs reiterating its full support for the new global standards and advising of its intention to begin consultations in 2011 on their application in Australia.
That process began formally in September 2011, when APRA released its proposals for implementing the Basel III capital reforms. APRA proposes to broadly adopt the minimum Basel III requirements for the definition and measurement of capital for ADIs. This will require APRA to amend its current policies in a number of areas, taking a stricter approach than at present in some but a less conservative approach in others. In certain areas, however, there are strong in-principle reasons to continue APRA's current policies. These areas are the treatment of deferred tax assets, investments in non-consolidated financial institutions and investments in commercial institutions. APRA also proposes to introduce the new Basel III capital buffer regimes and the leverage ratio. Following consideration of submissions received on this paper, APRA will undertake a second round of consultation in early 2012 on detailed prudential and reporting requirements.
In APRA's view, ADIs in Australia are well placed to meet the new minimum capital requirements and APRA is therefore proposing to accelerate aspects of the Basel Committee's timetable. It is proposing to require ADIs to meet the revised Basel III minimum requirement for common equity (after deductions) from 1 January 2013, and the capital conservation buffer from 1 January 2016, without any additional phase-in arrangements.
Strengthening banking system liquidity requirements
The comprehensive reform package released by the Basel Committee in December 2009 also included a global framework for promoting stronger liquidity buffers to ensure that banking systems are more resilient to liquidity stresses. The centrepiece of this framework is a new standard for liquidity risk (the Liquidity Coverage Ratio) that aims to ensure that banking institutions have sufficient high-quality liquid assets to survive an acute stress scenario lasting for one month. This standard aims to strengthen short-term resilience. A second global standard, the Net Stable Funding Ratio, aims to promote longer-term resilience by requiring banking institutions to fund their activities with more stable sources of funding on an ongoing basis. The proposals also include a common set of metrics for identifying and analysing liquidity risk trends.
In anticipation of the Basel Committee's liquidity reforms, APRA had released a consultation package in September 2009 on its proposed enhancements to its prudential framework for ADI liquidity risk management. The key changes involved more demanding stress-testing parameters, introduction of a standardised reporting framework to improve APRA's ability to assess ADIs' liquidity risk profiles, and enhanced qualitative requirements consistent with the Basel Committee's revised Principles for Sound Liquidity Risk Management and Supervision of September 2008.
In parallel with the Basel III capital reforms, and after reviewing the various impacts of its proposals, the Basel Committee announced revisions to its Liquidity Coverage Ratio requirement in July 2010 and foreshadowed modifications to its Net Stable Funding Ratio. After endorsement by the G-20 Leaders, the final rules text for the new global liquidity framework was released in December 2010. The framework incorporates scope for alternative treatments for jurisdictions, such as Australia, that do not have sufficient high-quality liquid assets (particularly sovereign debt) for inclusion in liquidity buffers.
Within that scope, the RBA and APRA announced in December 2010 that an ADI will be able to establish a committed secured liquidity facility with the RBA, sufficient in size to cover any shortfall between the ADI's holdings of high-quality liquid assets and the Liquidity Coverage Ratio requirements. The facility will incur a market-based commitment fee. For its part, APRA will require participating ADIs to demonstrate that they have taken all reasonable steps towards meeting their liquidity requirements through their own balance sheet management, before relying on the RBA facility. In February 2011, APRA clarified the treatment of high-quality liquid assets it will apply when implementing the new global liquidity framework.
Under the Basel Committee's timetable, the Liquidity Coverage Ratio (including any revisions) will be introduced on 1 January 2015 after an observation period beginning in 2011. The Net Stable Funding Ratio (including any revisions) will move to a minimum global standard by 1 January 2018. APRA intends to release a discussion paper setting out its proposals for implementation of the Basel Committee's liquidity reforms in the latter part of 2011. APRA's quantitative requirements for ADI liquidity risk management proposed in its 2009 discussion paper will be subsumed into the new global liquidity framework but its enhanced qualitative requirements, which reflect the Basel Committee's revised principles in this area, will be unchanged.
Financial Claims Scheme implementation
During 2010/11, APRA continued to deal with a number of implementation issues associated with the Financial Claims Schemes in the ADI and general insurance industries. APRA has responsibility for administering the two Schemes.
The Financial Claims Scheme for the ADI industry provides depositors with timely access to their deposit funds up to a defined cap. The original cap was set at $1 million per depositor per institution but was to be reviewed by the Government by October 2011. In May 2011, the Government released a consultation paper canvassing a number of proposed changes to the design of the Scheme, including the cap on the size of protected deposits and other refinements to the existing framework. In September 2011, the Government announced a new permanent cap of $250,000 per depositor per institution, to be introduced from 1 February 2012. This new cap reflected advice from the Council of Financial Regulators and feedback from public consultation.
APRA has been consulting with the ADI industry and other parties on the proposed reporting requirements needed to make the Early Access Facility for Depositors (EAFD) operational, and on options to facilitate payout. APRA released a discussion paper on these issues in January 2010 and a response to submissions on that paper in August 2010. Submissions generally supported APRA's proposed framework for operating the EAFD but also identified operational issues and suggested changes to minimise compliance costs. Most operational issues related to the essential requirement that ADIs be able to generate aggregate deposit data at short notice on a 'single customer view' basis. This requirement and the mechanics of prompt payout raise a number of IT challenges for ADIs and APRA that will be taken into account in implementation of the final arrangements. APRA conducted workshops in September and December 2010 to seek industry's views on how best to bring the EAFD into operation. Further details on APRA's proposed framework, including a draft prudential standard, were released in September 2011.
The Financial Claims Scheme for the general insurance industry ensures that claims from eligible policyholders and other claimants, with no defined cap, will be met in the event of the failure of a general insurer. It also provides a limited period of time within which policyholders of the failed insurer remain covered against claims pending their establishment of new insurance policies with another insurer. During 2010/11, APRA developed its internal arrangements for putting the Scheme into operation. These arrangements include guidance on matters such as eligibility assessment, claims determination and payout arrangements.
Harmonised prudential standards
General and life insurance capital standards
APRA is proposing to update its capital standards for the general insurance and life insurance industries. APRA's intention, set out in an initial discussion paper in May 2010, is to make the capital standards more risk-sensitive, improve their alignment across regulated industries where appropriate, and consider the standards in light of international developments.
For general insurance, APRA is completing the refinements commenced in 2008. The proposed changes will ensure that all material types of risks, including asset/liability mismatch, asset concentration, insurance concentration and operational risks, are adequately addressed within the capital standards.
For life insurance, the proposed changes are more fundamental. APRA is proposing to simplify the current dual reporting requirements for solvency and capital adequacy and, by introducing the concept of a 'capital base' for life insurers, to align the capital structure for life insurers with that for general insurers and ADIs. This improved alignment of capital requirements will also facilitate adoption of APRA's proposed framework for the supervision of conglomerate groups.
APRA has also confirmed that, in undertaking these reforms, it would carefully assess their individual and industry impacts. To this end, it undertook a quantitative impact study (QIS) for insurers and released three supplementary technical papers in the first part of 2010/11. In March 2011, APRA issued a response to the main issues raised in submissions and arising from assessments of the QIS responses. APRA proposed revisions to a number of aspects of its original proposals to simplify them (where appropriate), reduce some of the procyclical effects and address areas where the proposals were overly conservative; in other aspects, however, its proposals have been retained. APRA has also undertaken a second QIS to assess the impact of the revised proposals.
APRA is currently reviewing submissions on the revised proposals and the QIS results and expects to release a further response paper and draft prudential standards for consultation in late 2011. Final prudential standards are expected to be released in the first half of 2012, to take effect from 1 January 2013.
Supervision of conglomerate groups
During 2010/11, APRA made further progress on its proposed prudential framework for conglomerate ('Level 3') groups. These are groups (containing APRA-regulated institutions) that have material operations in more than one APRA-regulated industry and/ or have one or more material unregulated entities. The objective of this substantial initiative is to better protect the interests of depositors and policyholders by limiting the risks to APRA-regulated institutions (from contagion, reputation and operational risks in particular) that may arise from that institution's membership of a conglomerate group and by ensuring that both APRA and the group itself have a broader understanding of the financial and operational soundness of the group, irrespective of its structure and industry location.
APRA outlined its proposals for the supervision of conglomerate groups in a discussion paper released in March 2010. The proposals seek to ensure that a conglomerate group holds adequate capital to protect the APRA-regulated institutions from potential contagion and other risks within the group and that the parent company meets a range of principles-based risk management standards. The proposals, which build on APRA's existing requirements for stand-alone institutions (Level 1) and single-industry groups (Level 2), would put in place a complementary layer of prudential requirements that harmonise existing standards and industry-specific supervision frameworks at the group level, to provide a group-wide view.
APRA conducted a QIS with potential Level 3 groups during 2010/11 to assess the impact of its capital adequacy proposals and it has been reviewing the QIS submissions prior to finalising its policy direction. In May 2011, APRA advised industry that it was revising the timetable for this reform so that it would be appropriately sequenced with related initiatives in the ADI and insurance industries. APRA aims to release draft conglomerate prudential standards for comment in the second half of 2011/12 and, after further consultation, to finalise these standards in the second half of 2012/13. The new standards are intended to take effect shortly after they are finalised.
Consolidation of prudential standards
Since its establishment, APRA has been committed to harmonising its prudential standards across its regulated industries where appropriate. Behavioural standards, in particular, lend themselves to a harmonised approach since prudence should be a fundamental attribute of boards and management across all these industries. Accordingly, APRA's prudential standards for governance, fitness and propriety, business continuity management and outsourcing, though developed on an industry-by-industry basis, contain nearly identical requirements across the ADI, general insurance and life insurance industries in many areas. However, minor variations have remained.
To simplify compliance, particularly for groups operating across industries, APRA proposed to consolidate these behavioural standards and associated guidance material. In December 2010, it released a discussion paper proposing that the 12 industry-specific prudential standards be consolidated into four cross-industry standards. The substantive content of the standards would not change but some changes were proposed in order to clarify the standards or to ensure consistent application across industries. Following consultation, APRA released the finalised prudential standards in September 2011, for implementation by 1 July 2012. APRA will consult on supporting guidance material for these cross-industry standards over 2011/12.
Implementing Stronger Super reforms
In December 2010, the Government announced its Stronger Super reforms to strengthen the governance, integrity and regulatory settings of the superannuation system in Australia. The reforms were a response to the recommendations of the Review into the governance, efficiency, structure and operations of Australia's superannuation system (Cooper Review) delivered to the Government in June 2010.
The Stronger Super reforms envisage amendments to the Superannuation Industry (Supervision) Act 1993 (SIS Act) to strengthen trustee duties. They also involve the establishment of a new superannuation product ('MySuper') and the streamlining of superannuation transactions ('SuperStream'). As noted earlier in this Report, MySuper is a new type of simple, cost-effective superannuation option that will take the place of existing default products; it will have a basic set of product features designed to improve fund member and employer understanding, aid comparability between products and reduce costs. SuperStream is a major initiative intended to make the processing of superannuation transactions easier, cheaper and faster, provide better information to trustees, employers and fund members, and facilitate consolidation of unnecessary additional superannuation accounts.
Since the reforms were announced, APRA has participated in the Stronger Super industry consultation process led by the Treasury and involving a peak group of chief executive officers of industry associations, consumer advocates and employer representatives. APRA also participated in four working groups dealing with governance, MySuper, SuperStream and self-managed superannuation funds. Following these consultations, the Government announced its decisions on key design aspects of the Stronger Super reforms in September 2011.
To give effect to relevant aspects of the Stronger Super reforms, APRA has commenced a multi-year project that will involve significant changes to the prudential and reporting framework for superannuation. In particular, the reforms propose that APRA be granted power to make prudential standards in superannuation. Prudential standards are the centrepiece of APRA's prudential supervision framework in the ADI and insurance industries and a standards-making power in superannuation will strengthen the protection of fund member interests. Subject to enactment of the appropriate SIS Act amendments, APRA intends to consult on the content of the prudential standards during 2011/12 and will follow this with consultation on revisions to its reporting framework and superannuation guidance material. That consultation process began with the release in September 2011, after the Government's announcement, of a discussion paper introducing APRA's proposals for prudential standards for the superannuation industry.
APRA is also preparing for the MySuper regime, which under the proposed amendments to the SIS Act will require trustees wishing to offer MySuper products to have APRA authorisation to do so.
In the context of the Stronger Super reforms, APRA will substantially enhance its superannuation data collection. The enhanced collection will allow APRA to publish data about MySuper products and promote transparency, comparability and accountability in relation to fees, costs and investments. The data will be of value to superannuation trustees, employers and superannuation fund members, and will provide APRA with more detailed information needed to supervise trustees.
Review of superannuation guidance material
APRA is continuing to update its existing superannuation guidance material and, where appropriate, harmonising the material with other APRA-regulated industries. The need for updated APRA guidance has arisen from changes in the structure of the industry and the increase in the size and sophistication of funds since the superannuation licensing regime was introduced in 2006. APRA is adopting the format of prudential practice guides as used in the other industries, in place of existing Superannuation Circulars and guidance notes.
In August 2010, APRA released in final form four prudential practice guides covering capital, risk management, adequacy of resources, and fitness and propriety. In August 2011, APRA released for consultation two draft prudential practice guides on contribution and benefit accrual standards, and on payment standards. Subject to feedback, APRA intends to finalise these guides by December 2011. As the Stronger Super reforms proceed towards implementation, APRA's guidance material will be updated as necessary.
Authorised deposit-taking institutions
Use of the term 'bank'
The Banking Act 1959 restricts the use of the terms 'bank', 'banker' and 'banking' in Australia. Under APRA's guidelines, the restricted terms 'bank' and 'banker' can only be used in the business names of ADIs that have APRA's approval to do so and hold at least $50 million in Tier 1 capital. This latter 'substance test', which has been in place since 1992, applies equally to foreign bank subsidiaries, potential Australian-owned entrants and existing credit unions and building societies wishing to change their status to a bank.
During 2010/11, in the context of its Competitive and Sustainable Banking System package, the Government asked APRA to review its guidelines for use of the term 'bank'. The Productivity Commission had recently undertaken an assessment of the same issue and had expressed reluctance to recommend any change to the status quo. In its review, after weighing up competition and financial stability concerns, APRA concluded that any lowering of entry standards for new bank entrants, through reducing the minimum capital requirement, would run counter to the general thrust of global reform initiatives to strengthen capital in banking systems and would put at risk the enhanced reputation of the Australian banking system and Australia's regulatory arrangements. The current guidelines provide scope for a number of credit unions and building societies that already meet the substance test to become a bank if they so wish. APRA has had approaches from several institutions in this group and has recently granted authority to two credit unions to become a bank.
During 2010/11, APRA also reviewed an existing consent under the Banking Act 1959 under which a number of non-regulated financial businesses operating in the short-term money market can describe themselves as 'merchant banks'. APRA's concern is that the term 'merchant bank' has little current meaning (very few of those businesses entitled to use the term do so) and could cause confusion in the minds of the public when used by entities that are not authorised to carry on banking business in Australia. The global financial crisis has highlighted the importance of a clear demarcation between the regulated banking system and the non-regulated or 'shadow' financial sector. APRA has been consulting with relevant institutions on its proposal to revoke the existing consent and expects to finalise its approach within the next few months.
In June 2011, APRA reissued an exemption under which specified charitable religious development funds can provide limited banking services to further their charitable aims. APRA proposes to review the operation of this exemption before it expires in June 2013.
General insurance
General insurance Level 2 refinements
APRA is proposing a number of refinements to the prudential and reporting framework for general insurance groups (Level 2 groups) and released a discussion paper on this topic in May 2011. The proposals make minor amendments to the Level 2 group prudential standards and align aspects of the reporting framework between Level 2 groups and individual APRA-authorised general insurers (Level 1 insurers).
The final prudential standards, reporting forms and instructions are expected to be effective from 1 December 2011. The first reporting under the revised framework will be for the six-month period ending 31 December 2011.
APRA-regulated institutions
  Number Assets ($ billion)1
30 June 10 30 June 11 % change 30 June 10 30 June 11 % change
ADIs2 182 177 -2.7 2,693.2 2,813.4 4.5
   Banks 55 56 1.8 2,612.5 2,722.9 4.2
   Building societies 11 10 -9.1 23.7 26.4 11.4
   Credit unions 108 103 -4.6 49.4 55.8 13.0
   Other ADIs, including SCCIs 8 8 0.0 7.6 8.3 9.2
Representative offices of foreign banks 17 18 5.9      
General insurers 130 127 -2.3 99.2 114.9 15.8
Life insurers 32 31 -3.1 227.7 235.0 3.2
Friendly societies 16 14 -12.5 6.2 6.2 0.0
Licensed trustees 251 225 -10.4      
Superannuation entities3 4,458 4,054 -9.1 722.6 802.6 11.1
   Public offer funds 196 183 -6.6 546.8 619.1 13.2
   Non-public offer funds 191 164 -14.1 168.2 176.3 4.8
   Small APRA funds 3,869 3,519 -9.0 2.0 2.0 0.0
   Approved deposit funds 107 95 -11.2 0.2 0.1 -50.0
   Eligible rollover funds 16 16 0.0 5.4 5.2 -3.7
   Pooled superannuation trusts4 79 77 -2.5 79.1 86.5 9.4
Non-operating holding companies 21 25 19.0      
Total 5,107 4,671 -8.5 3,748.9 3,972.1 6.0
1. Asset figures for end-June 2011 are based on most recent returns. Asset figures for end-June 2010 have been revised slightly from APRA's 2010 Report in line with the audited returns received during the year.
2. The ADI classification does not include representative offices of foreign banks.
3. The total does not include uncontactable funds that are in the process of being formally wound-up or transferred to the Australian Taxation Office. As at end-June 2011, there were 12 such funds.
4. Pooled superannuation trust assets are not included in totals as these assets are already recorded in other superannuation categories.