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Annual Report 2013 - Chapter 1

From the Chairman

The Shadows Lift
 
The long shadows cast by the global financial crisis began to lift, albeit slowly, in 2012/13. Exceptional monetary policy actions in a number of major economies played a pivotal role.
 
The low interest rates and ample liquidity generated by these actions underpinned a continued moderate expansion in the US economy and a strong pick-up in Japan. A recovery, finally, also appeared to gain a foothold in Europe, although that foothold may be tenuous while repairs to public finances, and to private and bank balance sheets, remain incomplete. However, slower growth in key emerging economies, particularly China, kept global growth a little below average over the year.
 
Investment markets were buoyed by the easing of global financial conditions. Global equity markets reached record highs during the year and long-term yields fell to record lows. Concerns about the integrity of the euro receded. In this climate, the re-emergence of euro-area banking strains in Cyprus in March 2013 had little lasting market impact. However, volatility resurfaced around year-end, and markets retreated for a time, as the prospect of an exit from exceptional monetary policies, particularly in the United States, began to loom larger. In the early months of the current financial year, global equity markets resumed their momentum but long-term yields remained above their earlier lows.
 
The Australian economy grew at a relatively steady pace over 2012/13. That pace was, however, a little below trend, as the economy began to adjust to the decline in the terms of trade and as record levels of mining investment approached their peak. The high exchange rate, though off its recent peak, and weak domestic demand continued to weigh on business sentiment. Consumers, too, remained wary about adding to debt burdens in the face of somewhat subdued labour market conditions and slowly rising unemployment. Inflation was moderate over the year.
 
Overall, the more positive global context meant that the operating environment for the industries regulated by APRA was more settled in 2012/13 than in the previous year, even though the economic picture was a touch softer. Compared with most other advanced economies, this environment remained an enviable one.
 
Authorised deposit-taking institutions (ADIs, including banks, building societies and credit unions) were particular beneficiaries of this environment. Over the year, their asset quality improved further as non-performing loan ratios declined across all significant portfolios and the flow of newly impaired assets eased. Bad debt charges levelled out. This factor, together with stable net interest margins and various initiatives to control costs and enhance productivity, kept ADI profitability strong, and generally above pre-crisis levels. Profit retention, in turn, enabled a further build-up of ADI capital positions. Liquidity and funding positions also improved. The easing of global financial conditions assured Australian banks of reliable access to global term funding markets at spreads that fell to their lowest level since the crisis began.
 
The general insurance industry also improved its financial performance and capital position over 2012/13. Industry profitability was bolstered by strong underwriting results in the property classes of business, reflecting relatively benign weather conditions and increases in premium rates. In contrast to the previous year, these results were not offset by the revaluation of long-tail insurance liabilities due to falls in interest rates, as the falls in rates in 2012/13 were smaller. For the same reason, investment income (including realised and unrealised gains on fixed-income investments) was lower than the previous year. Following the catastrophic floods of late 2010/early 2011, insurers have increased the availability of riverine flood cover. This poses underwriting and pricing challenges that require careful management by insurers.
 
In contrast, the profitability of the life insurance industry declined in 2012/13. While the rally in global and domestic equity markets supported income, the contribution to profitability from risk insurance business fell noticeably. A number of life insurers have faced a continuing deterioration in their claims experience, particularly for individual income protection business and group insurance, and increases in voluntary discontinuance ('lapse') rates. As a consequence, a small number of insurers needed to replenish their capital buffers. This response, and other initiatives in anticipation of APRA's enhanced capital requirements, ensured a strengthening in the capital position of the life insurance industry.
 
The superannuation industry also benefited from the rally in investment markets, with double-digit returns contrasting with the flat result the previous year, and from a pick-up in contributions from members.
 
The Low Interest Rate Environment
 
Though crisis pressures have waxed and waned, the broad environment for APRA-regulated institutions has not changed fundamentally for several years now. It has been 'steady as she goes', with modest volume growth, more realistic pricing for risk and strong competition on both sides of the balance sheet. Adjusting to this environment after the exuberance of the pre-crisis years, and its dramatic puncturing, has posed strategic challenges for boards and management and their responses have been a focus of APRA's supervision. In APRA's judgment, strategic ambitions have been measured and realistic and there have been few signs of adventurism or over-confidence that have needed to be reined in.
 
The new element in this setting is the low interest rate environment. Official interest rates in Australia are currently at record lows and are expected by markets to stay low for a sustained period, if not fall further. Low interest rates provide a boost to business and consumer confidence and a support to employment and the rebalancing of economic growth. These are positive impacts for APRA-regulated institutions but a sustained period of low interest rates is not unalloyed gold. Low interest rates can pose immediate risks by encouraging a 'search for yield', and risks that build over time by masking the creditworthiness of borrowers or eroding the profitability of products. More generally, low interest rates can test even the most restrained of risk appetites.
 
For these reasons, negotiating the low interest rate environment has become a major theme of APRA's more intensive engagement with the boards and management of APRA-regulated institutions.
 
For ADIs, low interest rates are helpful for asset quality in the short term as they reduce interest payments and facilitate faster repayment of principal. Risks will build, however, if low rates come to be seen as the 'new normal' and distort assessments of borrowers' ability to repay. Unless that ability is carefully tested, borrowers who entered the market during an extended period of low interest rates may come under stress when interest rates ultimately rise. In the housing market particularly, sustained low interest rates can lead ADIs to lower their lending standards to gain or retain business in a resurging market, leading to excessive housing credit growth and overheated property prices. The damage still being inflicted on banking systems in countries most affected by the crisis is a telling reminder of the importance of maintaining robust lending standards at all stages in the cycle. There is no excuse for ADI memories that are selective, or short.
 
Other advanced countries have recently expressed concern over rising household indebtedness and house prices in a low interest rate environment and have taken so-called 'macroprudential' measures, rather than monetary policy action, to guard against the build-up of systemic risk. APRA has similar measures in its armoury and will use them if necessary; it has done so previously. However, as a risk-based supervisor, APRA has a range of options to address any emerging risks in this area before recourse to more blunt-force measures. For some time now, APRA has been warning ADI boards against allowing a deterioration in housing lending standards and it holds boards to the assurances it has received. It has stress tested the resilience of ADI housing loan portfolios. APRA has also enlisted external auditors of ADIs for targeted reviews of housing lending practices: collateral management and foreclosure management in 2010/11 and loan serviceability criteria in 2012/13. And, of course, credit quality is a central element of APRA's ongoing supervision of ADIs. These various activities identify ADIs that are outliers in credit risk management, and lending practices that fall short of prudent norms, for vigorous follow-up on APRA's part.
 
Sustained low interest rates will have an impact on the majority of general insurers because they have significant long-tail insurance liabilities, the valuation of which is sensitive to movements in interest rates. As a protection, insurers generally employ duration-matching strategies, which means that the impact of recent interest rate falls on the valuation of long-tail liabilities has been offset by unrealised gains on fixed-income investment portfolios backing these liabilities. Over time, however, insurers will need to reprice business to compensate for lower investment income, giving rise to repricing risk. The price increases needed in some long-tail business, particularly professional indemnity and public and product liability classes, may be difficult to achieve because of competitive pressures. As a consequence, insurers may be led to underwrite new business of poor profitability.
 
In addition, a low interest rate environment may tempt general insurers to pursue higher returns by increasing their appetite for risk in their investment strategy or assuming more risk in other areas of their operations as they seek to reduce costs, such as by changing their reinsurance arrangements. A 'search for yield' by tilting asset allocations towards lower grade or alternative investments comes at the cost of assuming higher market, liquidity and credit risk. The environment may also tempt some insurers to sustain short-term profitability by inappropriately weakening the reserves held to meet their long-tail insurance liabilities, leaving them exposed to large losses if their claims experience were to deteriorate.
 
The impact of sustained low interest rates on life insurers (including friendly societies) will depend on their mix of business. For investment-linked business, which accounts for the bulk of life insurance assets, low interest rates may encourage higher levels of policy surrenders, with consequent downstream implications for fee revenue; however, no material prudential risks arise since policyholders bear all investment risk. This is not the case, however, for certain types of business - such as lifetime annuities, traditional whole-of-life and endowment policies, disability income insurance and capital-guaranteed products - that face reserving, reinvestment and repricing risks. While life insurers also employ duration-matching strategies, asset-liability mismatches that erode profitability may still arise. This may be because appropriate assets of matching duration are not available and so proceeds from maturing fixed-income portfolios are reinvested at yields lower than necessary to support pricing or meet promises to or expectations of policyholders. Investment strategy may also be constrained by policy documents, promotional material or expectations created by past insurer practice. Life insurers have some flexibility in the pricing of new risk business but, in a low interest rate environment, sales of rate-sensitive products such as term certain or lifetime annuities may be harder to achieve if policyholders are reluctant to lock in historically low returns for long periods. A low interest rate environment may also tempt life insurers to search for yield, with its attendant risks.
 
For the superannuation industry, the most significant risk from this environment is that trustees may increase their risk appetite for higher yielding assets in a similar search for yield to meet their return objectives and assumptions. In doing so, trustees may expose superannuation fund members (in defined contribution schemes) and sponsoring employers (for defined benefit fund schemes) to risks that they may not understand, and that may not be managed appropriately. Defined benefit funds, which now account for less than 20 per cent of the assets of the APRA-regulated superannuation industry, may also face funding and solvency impacts given the potential for asset-liability mismatches and lower investment returns, particularly where liabilities are inflation-adjusted. These impacts, in turn, can put pressure on the balance sheets and cash flows of sponsoring employers.
 
Risk Governance and Risk Culture
 
A low interest rate environment is only one source of potential risks for APRA-regulated institutions in the period ahead. Other types of risk, facing individual institutions or a regulated industry as a whole, are spelled out in the following pages of this Report. Managing these risks sensibly and prudently will be a test of the effectiveness of risk governance and risk culture in an institution. Good governance has been one of the silent strengths of the Australian financial system during the crisis, and boards of larger institutions in particular have generally provided clear and effective leadership on risk. However, there is room for improvement in all APRA-regulated industries. The crisis is replete with examples abroad of significant shortcomings in governance and risk management of financial institutions, and in their underlying culture and ethics, that led to substantial losses and failures.
 
Risk governance and risk culture has become a second major theme of APRA's more intensive engagement with the boards and management of APRA-regulated institutions.
 
APRA's supervisory focus, which is shaping its thinking on the prudential framework and its supervisory practices, traverses a number of aspects of this theme. One is the critical role of the board itself, in setting standards and expectations that can have a profound influence on the quality of risk governance and on organisational culture. Beyond monitoring composition and other prudential requirements for boards, APRA is keen to see the collective skills and experience of the board in action, the independence of mind and spirit - not just form - contributed by directors, and the quality of board deliberations. In particular, APRA is interested in the balance of authority between the board and management and the strength of the board's constructive challenge. Improving APRA's understanding will involve more frequent meetings with boards, occasional less formal meetings with chairs of the board and other key committees, analysis of board papers and reviews of boards' self-assessments of performance.
 
The second aspect is the risk management approach of the institution. A strong, independent risk management function is needed that covers risk across the whole institution and has the stature, skills and authority to ensure risk-taking remains within the board's risk appetite. Over recent years, APRA has stressed the importance of a clearly articulated risk appetite statement that is embedded in the operations of the institution. APRA has outlined its expectations for risk appetite statements and has engaged actively with boards on the topic; it is now seeing a marked improvement in the articulation and use of these statements. APRA's assessment of the risk management function covers the accountability, resourcing and skills of the function and, in particular, the standing and personal strengths of the chief risk officer.
 
A third and most elusive aspect is risk culture, which can be simply described as 'the way we do risk around here'. Understanding risk culture takes supervisors into challenging territory; it is territory of vital importance to boards as well. For that reason, APRA intends to rely heavily on a board's own assessments of risk culture and it is strongly encouraging boards to firm up their understanding of and leadership on this aspect. APRA will, for example, be probing boards on how they satisfy themselves that the espoused values and culture of the institution are supported by management and staff at all levels, and on how they gain an understanding of the quality and consistency of decision-making throughout the institution and whether this is driving an appropriate risk culture.
 
APRA's sharper supervisory focus on risk governance and risk culture parallels a thrust by supervisory agencies globally to make the supervision of financial institutions more intense, effective and reliable. This follows the G20 Leaders' recognition from crisis experience that a strong regulatory framework must be complemented with more intense and active prudential oversight and supervision. APRA's supervision in this area will be reinforced by a proposed harmonised and enhanced risk management prudential standard, which inter alia will set out APRA's expectations for a board risk committee and chief risk officer. To balance the ledger, APRA will be developing an 'information pamphlet' giving a plain-English view of its expectations of board members in their oversight of prudential matters and will be undertaking a stock-take of the consistency and reasonableness of its prudential requirements for boards, looking to trim where prudent to do so.
 
The Prudential Regime
 
The substantial upgrading of APRA's prudential regime in each of its regulated industries has its end in sight. This upgrading has had a number of driving forces. Globally, a comprehensive and ambitious reform agenda from the G20 Leaders, in the wake of the crisis, has sought to toughen the resilience of the global banking system by raising the quality, quantity and international consistency of bank capital and liquidity. Domestically, the enhancement and harmonisation of capital standards in the general and life insurance industries has been an APRA call. In superannuation, the Stronger Super reforms will put the prudential regime for the industry on the same footing as the other APRA-regulated industries, based on APRA's new prudential standards-making powers in superannuation.
 
The development phase of these various reform initiatives is now largely complete and major elements came into effect over the course of 2012/13. This phase put considerable pressure on APRA's policy resources, and on industry, in formulating and consulting on prudential standards and associated reporting. Although there is some unfinished business in the global agenda, APRA is over the hump on its reform initiatives and would welcome the opportunity to press the 'pause' button for a time. Bedding-down the reforms, of course, can be no less intensive for APRA's supervisory resources and can involve significant systems, operational and behavioural changes on the part of regulated institutions. APRA's extensive consultation process seeks to ensure that it understands the impact of its reforms, amends prudential standards where it can in response to industry feedback to get the appropriate balance between principle and pragmatism, and provides adequate time for institutions to prepare for change. As a consequence, industry has broadly supported the reforms and their implementation has proceeded smoothly.
 
Global banking reforms have been the responsibility of the Basel Committee on Banking Supervision. As a member of this Committee, APRA has committed to implementing the new Basel III capital and liquidity framework as globally agreed, except where APRA has strong in principle reasons to take a more conservative approach. ADIs easily passed a major milestone for the Basel III capital reforms when measures to raise the quality and minimum required levels of capital came into effect from 1 January 2013. Two more milestones lie ahead: the introduction of a capital conservation buffer from 1 January 2016 and a 'backstop' leverage ratio (still being finalised by the Basel Committee) from 1 January 2018. On present indications, ADIs will also pass these milestones without difficulty.
 
Concerns in some quarters that APRA's conservative approach and accelerated timetable for the Basel III capital reforms would disadvantage ADIs have proven unfounded. A number of other jurisdictions also did not avail themselves of phase-in arrangements. More importantly, ADIs had already taken capital management initiatives to build up their capital positions. The reductions over 2012/13 in risk premia for the larger ADIs and investor enthusiasm for their new hybrid capital instruments has been a vote of confidence in the capital strength of the Australian banking system.
 
The Basel III liquidity reforms seek to promote stronger liquidity buffers and a more sustainable maturity structure of assets and liabilities. Two new global standards have been introduced: a 30-day liquidity coverage ratio to strengthen the short-term resilience of banking institutions and a structural funding ratio (yet to be finalised) to promote longer-term resilience. Recent revisions to the liquidity standard by the Basel Committee gave national authorities discretion to count a wider range of assets as high-quality liquid assets in meeting the standard and provided for a phase-in from 1 January 2015. APRA is proposing not to exercise this discretion - in Australia, the additional assets concerned do not meet the fundamental and tight qualifying criteria - nor to phase-in the ratio. Again, any concerns that this accelerated timetable will disadvantage ADIs are misplaced. A majority of global banks already meet this standard and Australia's unique arrangements for the Basel III liquidity framework, involving the use of a committed liquidity facility provided by the Reserve Bank of Australia (RBA), will enable relevant ADIs to meet the standard from day one. APRA is now in active dialogue with ADIs on how they can maximise their self-reliance in liquidity risk management so that the committed liquidity facility is not seen as a first recourse at times of liquidity stress.
 
Over coming months, APRA will begin to implement a framework for dealing with domestic systemically important banks (D-SIBs), which has been endorsed by the G20 Leaders and responds to their dictum that no financial firm should be 'too big to fail'. Under this principles-based framework, supervisory authorities must establish a methodology for assessing the degree to which banks are D-SIBs, publish an outline of that methodology and impose 'higher loss absorbency' on D-SIBs, in the form of higher common equity requirements.
 
APRA's reforms to capital standards for the general and life insurance industries came into effect from 1 January 2013, after a long and comprehensive consultation process. The reforms are intended to make the standards more risk-sensitive and improve their alignment across regulated industries. This latter goal has meant fundamental changes for life insurance through introduction of the concept of a 'capital base', which is aligned with the capital structure for general insurers and ADIs. Preliminary indications suggest that the reforms have led to a modest overall increase in required capital, although the impacts vary widely from insurer to insurer depending on their risk profile. The outcome of the reforms will be more resilient insurance industries and stronger protection for policyholders.
 
Under the Stronger Super reforms, APRA has for the first time been granted prudential standards-making powers in superannuation, a major step in the harmonisation of the prudential framework in Australia. During 2012/13, APRA finalised a suite of prudential standards for superannuation, aligning some where appropriate with 'behavioural' standards in the ADI and insurance industries but acknowledging the particular circumstances of the superannuation industry in other superannuation-specific standards. These new standards provide the basis for APRA authorisation of the MySuper product, a default option with a standard set of product features, and the authorisation process is well progressed.
 
APRA has also been consulting on a proposed prudential framework for consolidated groups, aimed at minimising contagion, reputation and operational risks that may arise from an APRA-regulated institution's membership of such a group. 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 and to understand the full range of risks that arise from group membership. Related to this initiative is APRA's proposed harmonisation and enhancement of its requirements for risk management.
 
During 2012/13, the International Monetary Fund completed its second review of Australia under its Financial Sector Assessment Program, which evaluates the strength and potential vulnerabilities of a country's financial system and regulatory architecture. APRA was actively involved in that review. As with the first review in 2005/06, the latest review provided a strong endorsement of Australia's regulatory framework and of the effectiveness of APRA's prudential supervision. The review noted a number of high-quality initiatives and practices by APRA, including its strong risk analysis and its focus on the responsibilities of boards.
 
Our People
 
APRA Members in 2012/13 – (left to right) Mr Ross Jones, Dr John Laker and Mr Ian Laughlin.
 
Photo of 2012/13 APRA members: Mr Ross Jones, Dr John Laker and Mr Ian Laughlin.
 
APRA has completed the busiest two-year period since its establishment, with intense supervision coinciding with the substantial prudential policy agenda and some large infrastructure projects internally. As the prudential policy agenda winds down, APRA has begun to return some of the staff involved to supervisory roles, at a time when new demands on supervisory resources are emerging. No quiet period seems in sight. Since the crisis began, APRA staff have not flagged in their commitment or endeavours to safeguard the Australian financial system, and the APRA Members are proud to acknowledge their skilled and sustained effort. It is particularly satisfying that the demonstration of integrity and professionalism by APRA staff gained the top two scores in APRA's third stakeholder survey.
 
APRA has begun an orderly transition to new leadership. On 30 June this year, Ross Jones ended his 10-year term as APRA's Deputy Chairman. For a decade, Ross brought intellectual rigour to APRA from his previous academic and public policy roles and was at the heart of APRA's involvement in substantial reforms of the prudential regime for superannuation, starting with the licensing of superannuation fund trustees in 2005/06 and culminating in the Stronger Super reforms. Ross's leadership and determination won him high regard in the superannuation industry. Ian Laughlin, already an APRA Member, has been appointed as APRA's Deputy Chairman for a two-year period and Helen Rowell has been appointed from APRA's ranks as an APRA Member, for a five-year period.
 
On 1 July 2014, Wayne Byres will take up his appointment as APRA's Chairman. Wayne is currently on secondment from APRA in the high-profile position of Secretary General of the Basel Committee on Banking Supervision. I have agreed to remain an extra year as APRA's Chairman to assist in the transition. That will complete 11 years at the helm during what has been a very challenging and demanding period in APRA's evolution, but a period of real achievement. It has been an honour to serve, alongside outstanding APRA Members and staff.
 
Signature of John F. Laker
 
John F. Laker
Chairman