For five years now, the Australian financial system has operated against the backdrop of considerable - at times acute - uncertainties about the strength of the global economy and the functioning of global financial markets. A banking crisis that had its origins in the US subprime mortgage market has widened to ensnare banking systems and public finances in a number of European countries and has, increasingly, called into question the integrity of the euro. No immediate end to these uncertainties is in sight.
Over 2011/12, the mood of global financial markets swung in waves. A period of heightened market volatility in the first half as sovereign debt problems in the euro area came to the fore gave way, for a time, to improving market sentiment and asset market rallies after actions by the European Central Bank eased the funding risks facing European banks. The respite proved short-lived. Over the final months of the period, market confidence was again sapped by mounting concerns that governments in some euro countries may no longer be able to support their banks or their economies. Most major equity markets gave up their earlier gains and a 'flight to safety' saw yields on high-quality sovereign debt (including Australian Government debt) fall sharply. Economic activity in much of Europe contracted. Concerns about the US fiscal outlook and about the growth paths of the US and Chinese economies also weighed on global economic prospects.
The performance of the Australian economy over 2011/12 stood in sharp contrast to this global picture. Although the terms of trade declined from recent record highs, the Australian economy returned to growth at around its trend pace, boosted by historically high rates of business investment in the resources sector and a pickup in consumption expenditure. However, the growth pattern was very uneven across industries and regions outside the resources sector. Inflation eased and the unemployment rate remained relatively low. Despite that, consumer and business sentiment (outside the resources sector) was still subdued.
This supportive domestic environment again proved a bulwark against global vagaries and ensured that the industries regulated by APRA ended 2011/12 in sound financial condition.
The asset quality of authorised deposit-taking institutions (ADIs, including banks, building societies and credit unions) improved, although the patchwork quality of domestic economic growth reflected in a steady flow of newly impaired assets. ADI profitability was strong, helped by relatively steady net interest margins — despite continued strong competition for deposits — and restraint on operating expenses. Profit retention allowed a further strengthening of ADI capital positions. Liquidity and funding positions also improved and Australian banks maintained good access to global term funding markets for all but the most extreme periods of market volatility; however, funding costs were elevated.
The general insurance industry remained profitable and well capitalised. The underwriting result reflected a significantly lower incidence of natural disasters, after a spate the previous year, but this was more than offset by falls in interest rates that increased the value of long-tail insurance liabilities. Those same falls in interest rates, however, produced significant realised and unrealised gains that boosted investment income. The substantial claims arising from the spate of natural disasters over recent years have been largely covered by reinsurance. This in turn has led to increases in reinsurance premia that in part have been, or will be, passed on to policyholders.
Compared to general insurers, life insurance companies hold proportionately less in fixed-income assets and more in other assets, such as equities. For that reason, falls in interest rates over 2011/12 had a more significant impact on the valuation of liabilities than on investment income, particularly for life insurers with large books of guaranteed business. Profitability for the industry was largely unchanged, with the impact of investment volatility largely offset by underwriting profits on risk insurance business. The industry's capital position fell a little, but still provides a strong buffer against future shocks.
Returns for superannuation funds were flat on average, after two years of positive returns.
Over the five years of the crisis, APRA-regulated institutions have strengthened their resilience through higher capital levels and improved capital management, more durable funding structures and, where relevant, larger liquidity buffers. The institutions are battle hardened but, fortunately, very few have been battle scarred. Though the possibility of failure must never be dismissed, boards and management have lifted their sights beyond survival to the strategic challenges of operating in an environment that is likely to remain very different from that before the crisis erupted, when volume growth seemed assured but risk was underpriced and capital and liquidity underappreciated. Strategic challenges have moved to centre stage in APRA's more intensive engagement with the boards of regulated institutions.
The challenges vary across regulated institutions and industries but have three broad themes. One theme is the choice of business model appropriate to a macroeconomic setting in which subdued business volumes, low investment returns and global uncertainties may persist for some time. A second is responding to changes in the competitive environment as industries consolidate but innovation spawns new participants. A third and common theme is adjusting to the more robust regulatory environment that is emerging from global and domestic reforms.
The ADI industry, accustomed to vigorous balance sheet growth in pre-crisis days, is confronting a period of sluggish credit demand and high funding costs. Consumer and business caution has resulted in a strong increase in household savings and the slowest pace in credit growth since the early 1990s recession. These developments have been helpful to funding dynamics, with strong deposit growth enabling the larger ADIs to shrink their reliance on short-term wholesale funding. At the same time, however, these developments are denying ADIs the volume growth that had been the key driver of revenue and profitability. Wisely, ADI boards and management have to this point resisted the temptation to 'break free' by pursuing aggressive volume targets that would inevitably put pressure on their credit standards. Growth ambitions are generally realistic, but credit standards need to remain under close watch.
ADIs are looking elsewhere for ways of maintaining their financial strength and profitability. Strategic responses have included, with varying emphasis, increasing efficiency and enhancing productivity through cost-cutting; technological innovation and systems enhancements; expansion into new markets and products; and greater focus on wealth management activities. Outsourcing and offshoring are coming to play a more prominent role in the efficiency programs of many ADIs.
The strategic challenges for general insurers are to maintain profitability in the face of lower interest rates, higher reinsurance premiums and new forms of competition. Balance sheets are largely immunised against interest rate movements because of asset/liability matching, but a sustained lower interest rate environment would have an impact on emerging profitability as maturing assets are reinvested at lower rates and existing policies are renewed or new ones written. The rise in reinsurance premiums has led some insurers to retain more property risks on their own balance sheets, which may increase future earnings volatility, and to look for new ways of accessing reinsurance capacity through capital markets. In the retail insurance market, the internet has become an important distribution channel with the arrival of new specialist insurers and direct-marketing 'aggregators' that compare and sell offerings of multiple insurers. These participants are yet to have a significant impact in Australia, as they have done in retail insurance markets overseas.
Low and volatile investment returns pose more significant challenges for the balance sheets and profitability of life insurers because of the broad range of asset classes that they hold. Low interest rates, in particular, also place upward pressure on pricing and can make some types of life insurance products, such as lifetime and term-certain annuities, less attractive in the market place.
Life insurers as a group have steadily lost market share in superannuation over many years, although they do manage significant superannuation business outside the life insurance companies themselves. The increasing popularity of self-managed superannuation funds for high net-worth individuals has seen an attractive market segment seep away from life insurers. Some insurers are developing administration, advice and investment services for self-managed superannuation funds to capture part of that market. New distribution channels are also emerging for traditional life insurance products. To compete more effectively, life insurers have been seeking scale through takeovers, investing heavily in technology and distribution networks, and building financial planning teams under insurer-owned dealer groups.
The superannuation industry itself is in the midst of its most significant change for a number of years. After a long pre-crisis period of strong growth in member balances and high investment returns, APRA-regulated superannuation funds have seen their member contributions virtually stall and returns swing into the negative in more recent years. Members have become more aware of returns, risks and costs. In a low investment return environment, superannuation funds including those provided by life insurers are offering more basic products with lower fees. Superannuation funds, too, are seeking scale through merger activity.
This environment has also heightened the focus — not just by APRA but in the community generally — on the quality of superannuation trustees and their governance and decision-making processes. Reinforcing this focus are the Government's Stronger Super reforms, which clarify and sharpen the onus on trustees to act in members' best interests. Trustees of APRA-regulated funds will need to adjust to a new and more robust prudential framework based on prudential standards, being developed by APRA under new powers. In the other APRA-regulated industries, in contrast, reforms are largely building on existing prudential frameworks.
An institution's strategic choices are, quite properly, the ultimate responsibility of its board. APRA does not direct these choices; it is neutral on such matters as the level of staff expenses or the selection of technology. Rather, APRA's role is to test and, where necessary, challenge the perceived risks and the realism of key strategies. APRA's dialogue with boards covers high-level issues such as the board's ability to articulate its strategy, its 'ownership' of strategic decisions and the information on which they were made, as well as specific issues such as the robustness of assumptions underlying the strategy or business model, the nature and types of risk being assumed, and the risk controls in place.
Board ownership of major strategic decisions is critical. A large outsourcing project or a sizeable acquisition can, if mismanaged, threaten the reputation and even the viability of an institution. APRA's discussions with boards covered a number of these sorts of decisions in 2011/12. In large outsourcing projects, APRA looks for close board involvement to ensure that the inevitable trade-off between costs savings and reductions in control are well understood and that risks are being considered in a transparent manner. For sizeable mergers or acquisitions, APRA reviews the due diligence undertaken by the board and the basis for the board's confidence that the institution has the capital, management and technical expertise to complete the integration and achieve a suitable cultural match.
In a well-governed institution, strategic planning is encompassed within the overall risk management framework. Integral to this framework is the board's appetite for risk. A well-considered risk appetite statement, against which actions can be assessed, provides a clear articulation of the degree of risk the institution is willing and able to assume in pursuing its strategic and business objectives. It sets the tone for the risk culture of the institution.
Over 2011/12, APRA continued its discussions with boards on risk appetite. An earlier review by APRA had identified a need for significant improvement in industry practice in this area; some institutions lacked a clear board risk appetite statement or even an understanding of the concept. As a catalyst for change, APRA has developed, and discussed publicly, a set of principles for use by supervisors in assessing an institution's approach to determining and managing risk appetite. The principles are grouped into four broad areas — governance, risk management, implementation and communication — and necessarily involve judgment on APRA's part, but many are objective in nature. APRA is pleased that boards are becoming more involved on risk appetite issues and improvements in the quality of risk appetite statements are becoming apparent. However, much work remains to be done, particularly in ensuring that there is a clear linkage between an institution's risk appetite and its risk, capital and operational management.
At the centre of a board's appetite for risk (for regulated institutions outside superannuation) is the target return on equity it sets for the institution. As the crisis has taught, 'stretch' targets — particularly if built into executive remuneration arrangements — can drive excessive risk-taking and push a sales culture into the ascendancy. The returns on equity achieved before the crisis would be stretch targets if the current subdued environment were to persist. Some institutions have been able to deliver returns approaching earlier highs, but time will tell whether these results are sustainable without unacceptable risks. At this point, it is also unclear how much the enhanced safety of regulated institutions in Australia, promoted by higher capital levels and other prudential reforms, has been factored into risk premia built into the rates of return sought by investors.
Under APRA's new prudential standards for superannuation, superannuation fund trustees will for the first time need to articulate the fund's appetite for risk. Trustees will need to develop a clear statement of the risks that it is comfortable for the fund to assume and those it seeks to avoid. APRA will also expect that trustees will be able to estimate the maximum impact on beneficiaries in the event that a particular risk is realised.
APRA's prudential regime is undergoing substantial upgrading in each of its regulated industries. The motivation, in the case of the ADI industry, is the global reform agenda of the G-20 Leaders, which seeks improvements in the resilience of the global banking system through raising the quality, quantity and international consistency of bank capital and liquidity. Lessons from the crisis have also been incorporated into the enhancement and harmonisation of capital standards for the general and life insurance industries, the reforms in this case being driven by APRA. In superannuation, the Government's Stronger Super reforms are aimed at strengthening the governance, integrity and regulatory settings of the superannuation system in Australia.
Major elements of these various reform initiatives will come into effect over the course of 2012/13. APRA's policy resources have been augmented to deal with this peak load but are, nonetheless, at full stretch in developing and consulting on prudential standards and associated reporting.
The Basel Committee on Banking Supervision has had the main carriage of global banking reform and its new global capital and liquidity framework ('Basel III') has been largely finalised. There are three key milestones in APRA's implementation of the Basel III capital reforms. Enhanced ADI capital requirements against the risks arising in trading activities, securitisations and exposures to off-balance sheet vehicles came into effect from 1 January 2012. Measures to raise the quality and minimum required levels of capital come into effect from 1 January 2013. A capital conservation buffer above the regulatory minimum capital requirement that can, under certain conditions, be drawn down in periods of stress comes into effect from 1 January 2016. This timetable is at the early end of the globally agreed Basel III timetable and fully consistent with the Basel Committee's view that the reforms should not be delayed in strong banking systems.
An extensive consultation process on APRA's implementation of the Basel III capital reforms is now almost complete. APRA will maintain its longstanding conservative approach to capital: the Basel III rules text as globally agreed will be adopted but the concessional treatment available for certain items in calculating regulatory capital will not, for in-principle reasons. APRA's approach reflects its firmly held view that conservatism has served Australia well before and during the crisis, that the milestones are not demanding, and that the impact of higher capital requirements on the overall funding costs of ADIs are likely to be small. Any additional costs would represent a very modest insurance premium for a safer Australian banking system that can retain the confidence of depositors, investors and the community generally, in still unsettled times.
The Basel III liquidity reforms, which seek to promote stronger liquidity buffers and more stable sources of funding, are being implemented on a slower timeframe. A 30-day liquidity coverage ratio to strengthen the short-term resilience of banking institutions will come into effect from 1 January 2015 and a structural funding ratio to promote longer-term resilience from 1 January 2018. APRA intends to follow the Basel III timetable for these new global standards. The Basel Committee will be fine tuning details in the light of experience during the 'observation periods' before implementation. Over 2011/12, APRA consulted on its proposed adoption of the Basel III liquidity reforms and, more recently, has begun discussions with larger ADIs on how they can maximise their self-reliance in liquidity risk management.
A new element in global banking reform that is particularly relevant to countries like Australia with concentrated banking systems is a framework for dealing with domestic systemically important banks (D-SIBs). Proposals developed by the Basel Committee build on the framework for global systemically important banks (G-SIBs) and respond to the G-20 Leaders' dictum that no financial firm should be 'too big to fail'. The proposals introduce a set of principles under which, most importantly, supervisory authorities would establish a methodology for assessing the degree to which banks are D-SIBs, publish an outline of that methodology and impose 'higher loss absorbency' — that is, higher common equity requirements — on D-SIBs. APRA's consideration of how the D-SIB framework will be implemented in Australia will begin after the G-20 Leaders have endorsed the proposals.
APRA's reforms to capital standards for the general and life insurance industries 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. APRA's extensive policy consultations with industry, in four rounds over the past two years, are now winding down and the revised capital framework will take effect in both industries from 1 January 2013. The reforms will lead to a modest overall increase in required capital in both industries, 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 Government's Stronger Super reforms, APRA has for the first time been granted prudential standards-making powers in superannuation. This is a major step in the harmonisation of the prudential framework in Australia, and APRA welcomes it. Prudential standards offer a number of benefits. They can be drafted using plain language conventions and industry terminology, making them a clearer and more accessible instrument for industry participants. They can enshrine a principles-based approach, emphasising the achievement of sound prudential outcomes without prescribing a 'one-size fits all' straitjacket. Over time, they will allow the prudential framework to respond to industry developments in a more flexible way than legislation. A suite of prudential standards for superannuation have been out for consultation and are expected to be finalised by the end of 2012. This will provide the basis for APRA authorisation of the new MySuper product, a simple low-cost product as a default option that is one of the centrepieces of the Stronger Super reforms.
The various reform initiatives summarised above do not complete APRA's prudential policy agenda. 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 a regulated institution's membership of such a group. It has also finalised prudential standards related to covered bonds and the implementation of the Financial Claims Scheme in the ADI industry, and has continued to consult on the latter topic.
Over the course of 2011/12, APRA participated in the second review of Australia under the International Monetary Fund's (IMF's) Financial Sector Assessment Program (FSAP), which evaluates the strength and potential vulnerabilities of a country's financial system and regulatory architecture. The first FSAP review of Australia in 2005/06 provided a strong endorsement of Australia's regulatory framework and of the effectiveness of APRA's prudential supervision. The latest FSAP report has not been finalised but preliminary indications suggest a similar strong endorsement.
If it has been a year of 'hard grind' for regulated institutions, it has been equally so for APRA's staff. The need to maintain the intensity of supervision given prevailing uncertainties, the substantial prudential policy agenda and some large infrastructure projects internally have combined to make 2011/12 the busiest period since APRA's establishment, with little sign of immediate relief. In this context, APRA welcomed a new four-year funding arrangement from 2012/13 to ensure its continued capacity to supervise the Australian financial system.
APRA staff have been unstinting in their enthusiasm, resolve and skill over this testing period. Their tireless work in promoting financial safety is not well understood and is largely unsung within the wider community, but the APRA Members are proud of their outstanding contribution.
Dr John F Laker