I have been asked to speak about financial reform and prudential regulation in an open financial system. The term ‘open’ is a reasonable description of Australia’s financial system.
- Our system is open in the sense that it is relatively straightforward for new institutions to obtain a license to operate in various parts of the financial system - provided they meet the necessary regulatory constraints, such as capital and governance requirements.
- It is open in the sense that it is relatively straightforward for foreign financial firms to establish operations in Australia - again provided they meet the regulatory requirements.
- It is open in the sense that there is healthy competition among financial institutions and also between markets and institutions.
- And, finally, it is open in the sense that we compete with international markets for business that could easily migrate elsewhere, if our markets or institutions prove to be either unsafe or uncompetitive.
These characteristics of openness are common to many developed financial systems. With growing pressure from globalization of financial markets as technology continues to erode national boundaries in commerce I suspect that it will be common to most countries by the end of the present decade. It was against this background of openness and globalization that the Australian Government has implemented a wide-ranging set of regulatory reforms over the past few years. These reforms have been designed to provide Australia with a regulatory framework appropriate to the challenges of an open financial system.
In the time I have left, I propose to say a few words about:
- the reforms;
- the principles behind our approach to prudential regulation; and
- some of the challenges that we face in prudential regulation over the next decade or so.
Let me start with the reforms.
You are probably aware that the reforms in our regulatory structure followed a 9-month review process commissioned by the Government in the middle of 1996. This was the third such broad review in our history.
The Committee of Inquiry, which became known as the ‘Wallis Committee’, made some 115 recommendations, almost all of which have been subsequently adopted by the Government.
The most important of these was a restructuring of our many then-existing regulatory bodies into just four. Our financial regulators now consist of:
- The Australian Competition and Consumer Commission (ACCC) - responsible for competition;
- The Australian Securities and Investment Commission (ASIC) – responsible for market conduct and consumer protection;
- The Australian Prudential Regulation Authority (APRA) – responsible for prudential regulation of deposit-taking, insurance and superannuation; and
- The Reserve Bank of Australia (RBA) – with responsibility for overseeing systemic stability through its influence over monetary conditions and through its oversight of the payments system.
On the surface, this appears very similar to structures put in place in the United Kingdom, Japan, Korea and a number of Scandinavian countries.
In practice, our system is quite different and in many ways unique. Allow me to explain.
Our four regulators have each been given responsibility for a single regulatory function. For example, the ACCC has responsibility for competition regulation. That responsibility extends across the entire economy, including the financial sector. Thus, if two banks wish to merge, or if one insurance company wishes to take another over, they must deal with the ACCC – not with their prudential regulator, APRA.
Similarly, the ASIC is responsible for regulating market conduct, particularly as it pertains to consumers. Thus, if there is a complaint about the way in which a particular bank is selling its products, or a concern that a particular insurance company is misrepresenting its products, that concern is dealt with by ASIC, not by APRA.
This structure is quite unique internationally in that it is not based on institutions or products, but rather on regulatory functions.
The reasons we adopted this structure are many and reflect the issues considered by the Wallis Committee.
First, a functional division of regulatory responsibilities is consistent with the underlying reasons for why we regulate. Ultimately, regulation constitutes an interference with the natural forces of the market. Thus, regulatory intervention must be justified on the grounds of market failure. Financial markets fail for four main reasons:
- anti-competitive behavior;
- market misconduct;
- information asymmetry; and
- systemic instability.
What is interesting about these four sources of market failure is that, by and large, they require different regulatory tools to counteract the market failure. Thus, we believed that there was a strong case to create one regulator to deal with each of the four sources of market failure.
The second reason for adopting this model was regulatory neutrality. By regulatory neutrality I mean that all institutions making the same promises should be regulated in the same way. Under our structure, all firms are treated the same where they act the same. For example, all financial institutions are required to meet the same disclosure regime, because it is administered by a single agency, ASIC. Similarly, all institutions that solicit deposits from the public, are regulated in the same way in terms of capital adequacy, provisioning, governance requirements and so on, because they are all regulated by a single regulator, APRA. This is in strong contrast to our old institutional framework under which there were many different regulators covering essentially the same functions.
Third, relative to our old institutional framework, the new functional framework is relatively efficient, both in terms of dollar costs and in the sense of economising on scarce regulatory skills, in that it brings together all regulators of a particular orientation and focus into the one agency.
We did consider going a step further and combining market conduct and prudential regulation under the one roof, as has been done in the super-regulator models of the UK and elsewhere.
Our biggest concern with the super-regulator model was that there could be a fundamental clash of cultures from putting two regulatory functions under the same roof. It was our assessment that market-conduct regulation and prudential regulation were so different in their methodologies and scope that bringing them together under the one roof would inevitably lead to tensions between cultures, resource allocation and regulatory focus.
The second topic I want to cover briefly is the way in which we go about prudential regulation in Australia. The following speakers will talk about competition and market integrity regulation.
As I mentioned, all prudential regulation in Australia is carried out by APRA. In Australia, we have defined prudential regulation to cover all institutions offering:
- life insurance products;
- general insurance products; and
- superannuation (or pension) products.
In practice, the promises inherent in each of these products are different, and so the particular approach to prudential regulation can be quite different.
For example, institutions making deposit promises are effectively offering capital guaranteed investments with virtually instant liquidity. In this case, the institution retains almost all of the credit and market risk involved with these investments. Since this is a very demanding promise to meet, our regulatory approach includes:
- minimum risk weighted capital requirements;
- liquidity requirements;
- restrictions on ownership;
- governance requirements; and
- accounting requirements such as with respect to provisioning.
At the other end of the spectrum, superannuation products transfer most of the investment risk back to the investor. In this case, the main residual risks are poor governance and fraud. In regulating institutions that manage superannuation funds we concentrate on governance requirements.
In pursuing our regulatory responsibilities APRA pays close attention to the international standards set by the Basle Committee – in the case of banking – and the International Association of Insurance Supervisors (IAIS) – in the case of insurance. We have sought to shape those standards to suit our particular Australian environment and to extend them where appropriate.
We are also conscious of the difference between words and actions. It is sometimes easy to build an impressive book of rules that meet all the international standards and yet, if they are not implemented and monitored diligently, the financial system can still be very exposed to poor practices and to collapse. In Australia we put much of our efforts into implementing policy and to on-site inspections. I should add that our task of building and maintaining a healthy financial sector has been made easier by a supportive government, sound foundations in terms of laws and accounting principles, and an industry that, in many areas, is near world best practice.
The other feature of our approach to prudential regulation that warrants comment is that our Act explicitly requires us to balance regulatory effectiveness with the efficiency of the industry. This requirement is unusual and reflects an awareness of the international competitive pressures that arise from operating an open financial system.
In practice, we have sought to integrate this balance into our regulatory culture. In particular, we have been conscious of reducing the cost of regulation as much as we can, without endangering its effectiveness. We have also adopted a highly consultative approach to industry, so that all proposed changes in policy are discussed thoroughly and industry participants have an opportunity to express concerns about the impact of such changes on industry efficiency.
Our new regulatory structure has posed several challenges for APRA over the next few years.
One of the largest of these challenges is the objective of achieving a greater level of harmonization in the way we prudentially regulate different institutions within our responsibility. For example, there are significant differences between the ways in which banks and general insurance companies operate. These differences have resulted in the historical evolution of very different regulatory rules for insurance and banking – not only in Australia, these differences are world-wide.
However, while the major risks may be quite different, there many other risks in banking and insurance that are common to both. Both carry market risk and credit risk and both carry operational risk. In some cases, where a bank engages in underwriting of share issues, either directly or through a stock broker subsidiary, the bank may be exposed to a form of insurance risk.
The challenge for APRA is to build a prudential framework that can be applied to all prudentially regulated institutions. This framework should recognize the differences where they are genuine but treat similar risks in a similar way. If banks are required to hold capital for market risk, then so should any other prudentially regulated institutions that incur market risk – regardless of whether or not they are banks.
The development of this framework is a long-run project and may take many years. To some extent we are constrained by international agreements about how to regulate particular groups. At the same time, we are making some progress. Last month we issued a draft standard on capital adequacy for general insurers. In that standard we addressed a number of risks that had previously been missing from the regulatory framework for general insurance. Without mechanically replicating the banking regulations on market and credit risk, the draft standard drew heavily on the experience with banking regulation in drawing up the new standards.
The second challenge relates to the danger that regulation can sometimes be seen by financial institutions as a substitute for their own responsibility to manage risks. The challenge for us is to evolve our prudential regulation in such a way that it encourages industry to adopt better risk management, rather than to rely on the regulator to do the job for them. One way of doing this is to develop two-tiered prudential standards, particularly in respect of capital adequacy and allocation. This idea of two-tiered standards started with the Basle Committee’s standard on market risk in 1997. The idea behind the 2-tiered standards is to have one that is fairly blunt in its application, and a second that is built around the institution’s own internal risk management systems.
Provided the internal risk management system is judged by the regulator to be superior to the blunt regulatory rule, there should be scope to allow the institution to use its own model to assess capital needs. In this way, the institution has an incentive to develop better risk measurement and management systems, which is compatible with the regulator’s desire for a safer financial system.
In Australia we have instituted a number of two-tiered standards and have aimed these not only at banking but also at the insurance sector. We are trying to be flexible in applying this two-tiered approach because we recognize that financial institutions will come to better risk measurement and management in stages – hopefully in stages consistent with the risk management demands of their businesses. We believe that it is important that our prudential structures do not inhibit this process or clash with it in a counterproductive way. Therefore we are allowing institutions to use their internal models to value some risks, without requiring that they use them for all risks.
I should add that this two-tiered approach is very demanding on staff skills and resources. If APRA is to approve an institution’s internal risk management model for use in calculating part of its regulatory capital requirement, it is critical that we have staff capable of understanding the latest risk methods and techniques.
In concluding, let me say that our regulatory structure in Australia is unusual, if not unique, in that it reflects a genuine attempt to create a functional allocation of regulatory responsibilities aligned with the four main regulatory functions.
This new structure has created APRA and thrown down a number of challenges for the future. As we approach those challenges we intend to keep firmly in mind our legislated responsibility to find an appropriate balance between efficiency and effectiveness. That is, to find the balance between the needs of the market to get on with doing what it does best and the needs of market participants to know that they are dealing in a safe and fair environment.