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ARCHIVED CONTENT

The Prudential Regulator of the Future

Graeme Thompson
21 Aug 2000

1. Introduction
 
This morning I will touch on some of the forces that are driving prudential supervision and that will progressively alter the relationship between supervisors and industry, remind you of why APRA was established, and finish with some remarks about our project to reform general insurance supervision.
 
2. What’s driving prudential supervisors?
 
Prudential supervisors like APRA have two main functions. One is to promote the soundness of financial institutions by requiring them to observe minimum standards of prudent business behaviour. The second is to help manage the situation of financial institutions that have a life-threatening weakness. In both cases, the ultimate responsibility and accountability of the supervisor is to the policyholders or depositors or their equivalents – not to the financial institution itself. Most financial institutions would probably – though I think unwisely – be content to do without prudential supervision. Their customers generally place more value on what we do.
 
It’s rather trite to say that we all have to cope with the ongoing march of globalisation, technological change and financial sector rationalisation. We do, but the specific aspect that’s critical if prudential supervisors are to do their job well is the need to understand the risks that these trends create for financial institutions. Not always an easy task, in itself. Then supervisors need to impose, or promote, means by which institutions can be protected from those risks. The aim is not risk elimination. It is risk identification, measurement and control.
 
The prudential regulator of the future will adapt its policies and processes to deal with evolution in the risks confronting regulated institutions. To illustrate with some examples:
  • we are presently devoting resources to understanding the risks in electronic commerce and its application to financial transactions. In time this work will probably lead to some prudential standards – quantitative or qualitative – to help ensure that the risks in this technology are contained
  • a particular aspect of e-commerce is the greater ease with which retail services can be offered and purchased across national borders – the internet can quite easily undermine the carefully developed criteria governing entry to most financial markets
  • we are also getting our mind around the trend for provision of financial services to be unbundled - with some components kept in-house and under the direct control of the regulated institution while others are out-sourced to third party providers who are not subject to our regulatory authority.
None of these issues was on the agenda five years ago.
 
3. General trends
 
There are some general trends in the world of prudential supervision – trends that cut across industry boundaries – and at the risk of over simplifying a complex scene I will identify the main ones that I see.
 
Risk-based supervision
 
Supervisors are aiming to focus their attention more closely on the areas that pose greatest risk to the health of financial systems and to the solvency of individual financial institutions. This is to minimise overall regulatory burden and make the most effective use of scarce supervisory resources.
 
For similar reasons supervisors are also moving to design prudential standards that are less blunt and more finely calibrated to the risks that financial institutions have.
 
This trend recognises that very broad and simple requirements for, say, regulatory capital or solvency are unlikely to take adequate account of changes in a companies’ business mix (and therefore risks) over time or of variations in business mix between companies. It’s also a response to complaints by more sophisticated companies that regulatory capital and economic (or “real”) capital requirements are too far apart.
 
At the same time, it’s accepted that complex capital requirements are not needed or wanted by smaller less sophisticated financial institutions or financial systems in early stages of development.
 
Recognition of internal systems
 
A second important trend is toward accepting regulated institutions’ internal risk measurement systems – where they meet certain minimum criteria – to determine regulatory capital or solvency. This trend is related to the first – it accepts that internal systems might (should!) be more attuned to the particular risks of a company than any one-size-fits-all standard model.
 
It also reflects the reality that, as the business of financial institutions becomes increasingly intricate and their corporate structures more complex, the task for supervisors to understand the detail of their activities and “second guess” their management becomes more and more problematic.
 
The internal model option can also be used as a carrot to encourage companies to upgrade their own systems. If a company develops better internal risk control and, in doing so, is excused from having to calculate and report against some prescribed standard we have a win-win.
 
There are, of course, costs in building more sophisticated internal risk management systems, and these might not be warranted for smaller players. The investment could however be very worthwhile for larger companies, particularly if development costs can be offset against a lower overall regulatory capital requirement. There are also costs for the supervisor in acquiring the expertise to assess internal systems. But if the outcome is better informed supervisory staff, reduced ongoing regulatory effort and more reliable capital calculations then that investment will have big payoffs in both safety and efficiency.
 
Operational risk
 
Supervisors are taking more interest in operational risks – which are all the risks that are not readily quantifiable. They include risks from computer malfunction, internet security breakdown, weak corporate governance due to poorly informed Boards and reputation damage from misadventure in related companies.
 
By their nature it is not easy to determine what capital should be held against such risks. Initial attempts by supervisors are likely to be broad brush and rough, with fine-tuning to follow as more refined techniques emerge. In the meantime, strategies to mitigate operational risk will be particularly important.
 
Transparency
 
Prudential supervisors are increasingly embracing the idea that well-informed markets can be their powerful allies. They are encouraging more and better disclosure by regulated companies about their present financial condition, their exposures to loss and their internal risk control practices. This is to help markets exert their own informed discipline on companies that have excessive risk or poor systems to protect against risks. Clearly, if this mechanism is to be effective published information must be prepared on a consistent basis and be readily comparable across companies with similar business.
 
Supervising the supervisors
 
Another trend worth noting is that we supervisory agencies are increasingly being made subject to tests of good practice ourselves. Good regulatory practice, that is. This stems from the globalisation of financial markets and the recent instances of disturbances in some countries being transmitted to others.
 
In the banking field the Basel Committee now has a well-developed set of Core Principles for Effective Banking Supervision. The International Association of Insurance Supervisors is not far behind with a corresponding set of principles for insurance. There are also standards for securities regulators and for good governance in monetary and fiscal policies. International agencies such as the IMF and World Bank are using these to assess and rate supervisory arrangements in both developing and advanced countries. These assessments, and corresponding ones by private sector rating agencies, will be published in edited form. Countries that are rated as deficient in important areas will pay a price, if only at the margin, in access to international funds and new business.
 
In addition to this international scrutiny supervisory agencies like APRA are increasingly being called to account by parliamentary committees, audit offices and government inquiries. All in all, the development of performance indicators for prudential supervisors is in its infancy, but growing fast.
 
Integrated supervision
 
The final item on my list is the trend to combine prudential regulation of different industry sectors under one roof. Several countries have had this arrangement for some time – including Canada, Japan, Sweden, Denmark, Norway and Singapore. In recent years the United Kingdom, Korea and, of course, Australia have joined the club. Several other countries are considering the same step.
 
Institutional integration is only the first step to a truly integrated approach to financial sector supervision. Combining industry-based supervisory silos within the combined agency is the second. And moving to a fully integrated methodology for supervision is the third, the most challenging and not yet achieved anywhere. This brings me to APRA. While we’ve now been on the scene for just over two years we still find industry (and others) puzzled at times about what we are doing and why. So I will spend a couple of minutes going over the history and the rationale.
 
4. The Australian scene – APRA
 
The Wallis Committee recommended that the pre-existing 10 or so agencies be combined in a single prudential regulator because it believed this would deliver more cost-effective supervision into the future – taking into account how it saw the financial system developing.
 
The Committee and the Government saw four or five main benefits flowing from APRA’s creation.
 
More consistent and integrated regulation of similar financial activities and risks wherever they occur
 
A single agency should more readily achieve consistency in prudential supervision of similar risks and activities across industry boundaries. Consistency here, as well as in information-gathering, powers of enforcement and wind-up arrangements, is desirable for financial system efficiency and competitive neutrality.
 
This does not, of course, mean that every financial institution can be regulated in exactly the same way. But there is no reason why, for instance, the techniques used to supervise operational risks or market risks should be markedly different for an insurance company and a deposit-taker.
 
APRA will also be aiming for more uniformity across industries in licensing arrangements and enforcement powers; in the mix of black letter law/standards/ guidelines; in statistical collection technology and content; and so on.
 
More efficient and effective regulation of financial conglomerates
 
Conglomerate groups comprising significant-sized banks, insurance companies and funds managers are growing in importance. In the past the banking and insurance arms were answerable to different regulators. An integrated supervisor like APRA cuts the number of regulatory contact points for such groups. We’ve also begun to conduct joint prudential consultations. APRA is also better able to assess the overall financial health of a conglomerate, to see where weaknesses in one component might threaten the health of other parts, and to arrange preventative action.
 
Handling structural change in the financial system
Specialised regulatory agencies might, in trying to protect their own patches of the system, impede useful reorganisation and innovation in financial markets.
The Wallis Committee thought that, as the financial system evolved and traditional boundaries and categories became less clear, APRA’s broad view of the scene would be a major advantage. It should oversee a more enlightened and flexible supervisory regime.
 
More effective use of scarce supervisory talent
 
Australia’s limited supply of skilled supervisors was previously scattered among several agencies. Bringing these people together in APRA allows them to be deployed most efficiently on the issues and pressure points where they are most needed - that is, where the risks are greatest. While we inevitably lost some experienced staff in establishing and restructuring APRA we have still had big benefits from cross-fertilisation of the different experiences, skills and ideas of staff from the predecessor agencies. And we are getting a major boost from the fresh ideas and energy of our newly recruited staff.
 
Like all good modern organisations we have Vision and Mission statements that are based on our statutory responsibilities to protect the interests of policyholders and depositors, and that you can find in our Annual Report. We also have a statement to describe our supervisory approach that says we want to be “forward-looking, primarily risk-based, consultative, consistent and in line with international best practice.” These descriptors are important to us, not just words, and we mean to live by them.
 
I now want to say a few words about one of our major policy reform projects.
 
5. General insurance reform
 
Reform of the prudential supervision framework for general insurance has been given new impetus with APRA’s formation and is a high priority project. But it’s not a new project - its origins go back to work by the Institute of Actuaries that was initiated by the Insurance and Superannuation Commission in 1996.
 
Those of you familiar with the proposals that we’ve been issuing for comment over the past year should see in them many of the themes I’ve touched on this morning. We want to introduce new arrangements that:
  • are both more discriminating and comprehensive in addressing the risks that companies have than at present – we want to differentiate more between high and low risk business, and we want to cover risks that are not now addressed in solvency calculations;
  • are more flexible, capable of being adapted over time as required;
  • allow more reliance to be put on companies’ internal risk management systems, and generally give more weight to the responsibility and accountability of a company’s board and senior executives for its prudent management;
  • will improve the consistency and transparency of indicators of companies’ strength – we are, in particular, looking for more consistency in calculations of provisions for policy liabilities;
  • are fully consistent with developments internationally; and
  • are closer in structure to the more modern supervisory arrangements for life insurers and deposit-takers.
On structure, we are proposing an amended and simplified Insurance Act that will have high level principles for prudential supervision and a power for APRA to make standards to carry out that responsibility. The standard-making power would be qualified by obligations to consult and conduct cost-benefit assessments whenever we contemplated significant changes.
 
At this stage we envisage four standards – Liability Valuation, Capital Adequacy, Reinsurance Arrangements and Risk Management – with guidance notes in support. To date we have issued discussion papers outlining our broad objectives and first drafts of three of the proposed standards.
 
Because of the breadth of the changes involved we’ve been consulting extensively with industry and other stakeholders, and we will continue to do so – both industry-wide and bilaterally. (The first industry seminar to outline our intentions was in April last year; we held a second well-attended event this May.) There will also be transition periods for companies to make any necessary adjustments. Our timetable has the new arrangements in place in mid 2002, with transition of up to five years from then.
 
The draft Capital Adequacy standard issued recently is, not surprisingly, attracting a deal of attention. I emphasise that this is a first draft and there will be at least one, and probably two, more before it is finalised. Importantly, we will be asking companies to run our proposed parameters against their own portfolios in a road-testing exercise in October. This will both help industry to understand the methodology we have in mind and be a useful reality check for us.
 
With those caveats in mind, we do expect our reforms will increase the amount of regulatory capital needed by the industry. This is mainly because existing requirements don’t, in our view, adequately address the riskier lines of business. In addition, our assessment is that the existing solvency requirements for general insurers, as set out in the Insurance Act, require companies to meet a lower overall capital benchmark than under the comparable life insurance and banking regimes. Given the objectives for APRA that I mentioned earlier, there is no justification for this to continue. We expect that the capital requirements for companies writing short-tail lines of business will not change much. But there will be significant increases for insurers writing long-tail and/or reinsurance business - although the exact impact will depend on the size, business mix and complexity of each company. Our road-testing exercise later this year will be used to ensure that the proposed calculation methodology produces results that are both sensible and consistent with our broad objective.
 
Although regulatory capital requirements in the industry will undoubtedly rise, three considerations will substantially mitigate the immediate impact.
 
First, the industry operates now with a sizeable surplus of actual capital over and above regulatory requirements - it is quite likely that the industry as a whole will not need to raise any new capital as a result of our proposals. Second, we intend to broaden the range of instruments that companies can use to meet their regulatory requirements - subject to some constraints, insurers will be able to include perpetual notes, term subordinated debt and other innovative capital instruments within their capital base. Finally, as already mentioned, we will agree lengthy transition periods - out as far as 2007 - for companies to meet the new requirements.
 
6. Conclusion
 
I hope I’ve been able to give you some feel for how we at APRA see prudential regulation and supervision developing into the future. We look forward to working through the challenging issues that will arise – many already on the agenda, others still over the horizon – constructively and cooperatively with industry.
 
Thank you.