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Topical Issues in APRA's Patch

Graeme Thompson
08 May 2002

It’s a great pleasure for me to be addressing this Securities Institute luncheon in Perth.
 
I would like to say a little about APRA’s mandate - then touch on some particular current areas of interest and activity.
 
Our mission: Keeping the community’s money safe
As prudential supervisor for the Australian financial system, APRA’s objective is that regulated financial institutions remain capable of meeting the financial promises they make to their customers. Put simply, our aim is to keep your money safe from mismanagement or excessive risk-taking. With this purpose we regulate banks, credit unions and building societies, insurance companies and superannuation funds - several thousand entities managing some $1.4 trillion in assets.
 
I am pleased to say that the West does not occupy the thoughts of prudential regulators as much as it did a decade or so back. We do have many "clients" here - our Perth Office is responsible for supervising ten deposit-takers, eight general insurers, six friendly societies and over 100 superannuation funds. (We do not supervise finance brokers.)
 
APRA pursues its objectives by:
  • licensing institutions that pass entry criteria to do with financial substance and management capacity;
  • setting standards for prudent management - these may be for balance sheet measures like capital adequacy ratios, or more qualitative requirements for risk management systems and prudential controls; and
  • monitoring compliance with those standards - this involves off-site analysis of information reported by financial institutions, face-to-face consultation and on-site visits to observe management and control systems on the spot.
Unlike our colleagues at ASIC we are not primarily an enforcement agency - our aim is to prevent things going wrong, rather than to punish wrongdoing after the event. But we have enforcement powers and we use them vigorously when warranted.
 
Where compliance with our standards remains unsatisfactory or the financial condition of an entity is deteriorating for other reasons we have a range of powers to secure rectification or to help facilitate an entity’s exit from the scene with, ideally, minimal loss to depositors, policyholders or fund members.
 
Continuous improvement
Since APRA was established almost four years ago our strategy has been to pursue continuous improvement in prudential supervision on behalf of the Australian community. We have made a good deal of progress and we have several important initiatives on the go at present.
 
We are about to introduce a new and much improved system for risk rating all of the entities we regulate. These ratings - which take account of management capacity and risk controls as well as balance sheet strength - highlight areas of greatest risk among our financial institutions and help us to allocate our time and effort most effectively.
 
We are also compiling an inventory of our responsibilities and powers across all industry groups. This is to help identify the gaps to be filled if we are to do our job as effectively as the community expect - and also help assess how far our powers should be harmonised across industry boundaries.
 
We are also looking at the need for formal compensation arrangements for depositors and insurance policyholders to cover loss in the event that their financial institutions fail - as a few inevitably will from time to time. Australia is in the minority of countries without such schemes and our first step here is a survey of overseas models and experience.
 
Of more immediate matters, we are in the midst of implementing a radically new prudential supervision regime for general insurance companies.
 
This regime becomes effective on 1 July this year and is the culmination of 3 years intensive work starting soon after APRA began. It includes prudential standards that are both more comprehensive and more discriminating in addressing general insurance risks than under the regime we inherited. These standards will be much more demanding of companies’ internal risk controls and governance and will place more responsibility for compliance on directors, auditors and actuaries. Minimum capital required across the industry will on average rise by 50 per cent.
 
All 150 insurers need to apply for a new licence - we expect to re-license most companies, although with conditions attached in many cases. Some small companies probably won’t meet our tests and will have to exit the industry.
 
This new regime will give us a world-leading supervisory system for general insurers. Modesty almost dissuades me from quoting a senior executive of Moody’s who said recently that APRA’s new regime will put Australia way ahead of insurance reforms in the UK and continental Europe.
 
A second major reform area with a rather longer time horizon is in capital adequacy for banks and other deposit-takers.
 
We are working with banking regulators around the world on a thorough overhaul of the Basel Capital Accord - the set of rules determining how much capital banks must have for regulatory purposes. The new rules will be more complicated. But they will explicitly encourage banks to improve their internal risk control systems, and have those recognised for calculating regulatory capital. For the first time, there will be a capital charge for operational risks. Even so, the new requirements could mean lower overall capital requirement for banks with the most advanced risk management systems.
 
We are also finalising a supervision framework for conglomerate groups that include deposit taking alongside other business activities. Here, we are seeking to balance the practical need to take a consolidated view of the health of such groups, as a whole, with our statutory responsibilities for the individual licensed member/s. Subsequently we’ll extend the key principles to conglomerates engaged predominantly in insurance.
 
In addition we plan a review of the life insurance supervision over the next year.
 
Notwithstanding the challenging issues we have with insurers and deposit-takers, the most problematic area for our supervision in the next few years is undoubtedly superannuation. I will spend some time on that. 
 
Making superannuation safer
 
Shape of the industry
 
At latest count we had prudential supervision responsibilities for 11,000 funds - of these, 375 are public offer, about 2,500 are employer-sponsored and around 8,000 are Small APRA Funds (SAFs) administered by an Approved Trustee.
 
In all, these funds have $330 billion of the $500 billion that Australians have in super savings - the rest is mostly in life office statutory funds (supervised separately by APRA) and public sector funds of various sorts.
 
Of the financial sectors we supervise super is by far the most populous and diverse. Leaving aside the SAFs, there are almost 800 funds with assets less than $1 million - while, at the other end of the spectrum, there are 78 funds with assets over $1 billion.
 
The industry’s structure is not, of course, static. Over the past decade, the management of superannuation has been progressively shifting from the workplace to the retail financial services sector.
 
This trend - which is not dramatic, but is certainly persistent - has been driven by:
  • emergence of a thriving financial planning industry and the marketing skills of its agents and advisers;
  • increasing mobility and casualisation of the workforce due to companies and staff negotiating more flexible arrangements;
  • greater use of payroll systems that can efficiently transfer contributions to multiple schemes by electronic means;
  • employer difficulties with the complexities and costs of superannuation administration; and
  • the natural spread of voluntary choice-of-fund across non-unionised workplaces.
Looking forward, mandatory choice-of-fund and portability - if they eventuate - would reinforce this trend. As will account consolidation by members seeking to avoid the accumulation of administration charges involved in running multiple accounts - an average of three per worker at present.
 
No doubt retailisation will remain a key trend in superannuation. Among other things, this will put more focus on the size of fees and charges levied on superannuation savers.
 
Reforming the supervision framework
 
APRA put reform of the prudential supervision framework for superannuation on the agenda last year in our submission to the Productivity Commission’s inquiry into superannuation legislation.
 
The reasons for doing this can be summarised simply:
  • first, the community clearly expects a level of safety in superannuation investments similar to what’s expected with other prudentially regulated sectors - the very reason that the Wallis Committee recommended that superannuation come under APRA;
  • second, some commonplace and valuable tools are presently not available to the regulator in the case of super – no licensing as a pre-requisite for start-up (except for public offer funds) being the most glaring example.
The actual incidence of serious problems in super has, historically, been very small - as industry rightly points out and the media and others often conveniently ignore. But that’s not a palatable point to make to people in quite small funds who have seen their retirement savings shrink or evaporate because of trustee mismanagement.
 
We have also come to the end of a period where high average rates of return in financial markets could camouflage poor management by trustees.
 
Furthermore, our aim is to be ahead of the game - we want to reduce as far as possible the likelihood that serious problems will occur in future; and when they do occur (as some inevitably will) we want to be able to manage the situation down in an orderly manner.
 
We also believe the structure of superannuation legislation is exceptionally complex and unwieldy - mixing as it does prudential, retirement incomes and other policy objectives. We would prefer a structure similar to the one used for banks and insurers i.e. legislation that sets broad prudential objectives and supervisory powers, supplemented by standards and guidelines.
 
To progress decisions on these and other matters the Government published an issues paper last October and commissioned a Working Group - chaired by Don Mercer, an APRA Board member – to consult with industry and prepare recommendations. That consultation occurred and the working group has reported to Government.
 
Without revealing the group’s final recommendations or anticipating the Government’s eventual response I will touch on a couple of important aspects.
 
The first I’ve already mentioned – licensing. One of the key recommendations of the Working Group’s draft report was for universal licensing of trustees - either of the corporate entity or a ‘notional trustee entity’. The Productivity Commission also supported this.
 
Pre-licensing is an essential feature of any supervisory system. To put it bluntly, it’s much easier to keep the chooks alive if the foxes never get into the fowl-yard.
 
Prudentially, a universal licensing regime would have many benefits. APRA would be able to conduct prior assessment of trustees and funds, impose specific licence conditions and revoke licences where warranted. It would also give us a betterunderstanding of the trustee population and the opportunity to lift base management standards across the industry.
 
While true that the most publicised failures in super in the past few years have involved licensed Approved Trustees, by far the most weaknesses are found in small employer-sponsored funds.
 
The Working Group’s draft recommendations also favoured licensing by ASIC under the Financial Services Reform Act for funds that are dealing or advising. If this eventuates there would clearly be a need for APRA and ASIC to work together to minimise duplication and compliance burdens for industry. And there would need to be transitional arrangements to ease the load on both industry and regulators in newly licensing some 2,500 trustee entities.
 
The second important point that we have put to the superannuation inquiries is the need for a standards-making power for APRA. By this I mean a power in primary legislation for APRA to specify its prudential requirements of super funds in standards, rather than black letter law or regulation. These standards would be developed in consultation with industry and would, as a safeguard on regulatory capriciousness, be subject to Parliamentary disallowance. This currently works well with other industries.
 
We favour standards over the alternatives because they give us more flexibility to deal in a timely way with evolving risks and weaknesses in the industry. Moreover, they accord with the important principle that the regulator should be primarily responsible for, and accountable for, the details of prudential requirements.
 
Supervision in the field
 
We are not, of course, just waiting on the Government’s decisions on these reforms, important as they are. Our supervision of the superannuation industry has progressively intensified over the past couple of years. This combines off-site review and on-site inspection, with the intensity of focus determined by our risk ratings.
 
Our Specialised Institutions Division (which is responsible for supervising mono-line financial institutions) conducted 565 visits to funds and 47 to Approved Trustees in the year to June 2001. Since then, the pace has been stepped up another notch, with around 900 visits to funds and 65 to Approved Trustees due to be completed this financial year. Smaller funds have been a particular focus of attention.
 
Our Diversified Institutions Division holds consultations with conglomerate groups including their associated superannuation entities over a two-year cycle. It also conducts periodic focused consultations and on-site visits to Approved Trustees.
 
We made a concerted effort to assess the risks of every fund in 2001 and, as a result, determined that about 6 per cent or 170 of them warranted closer supervision and/or enforcement action to remedy deficiencies. Such enforcement action includes placing conditions in Instruments of Approval of Approved Trustees, accepting enforceable undertakings, replacing trustees and appointing investigators.
 
Some of the problems and weaknesses we find in the field, and deal with, include:
  • inadequate definition and execution of prudent investment strategies - investment strategies that are deficient in substance, not being adhered to and/or not reviewed once established;
  • sloppy governance practices of trustee boards, including lack of involvement in key decisions, inadequate separation of trustee role from other activities and absence of equal representation where required;
  • inadequate administration agreements;
  • poor financial control.
The great bulk of our work to have such matters addressed by trustees is successful and - unlike those rare cases where fund members suffer serious loss - it goes unnoticed. The same goes for our similar activities in other financial sectors. Even if it made sense to publicise this remedial work - sometimes it does, sometimes it doesn’t - it’s hardly the stuff of tabloid headlines.
 
APRA’s resources
I have talked about the need for stronger, or better focussed, powers in several areas. These are one of our resources.
 
Following through on the problems we find in super and elsewhere also depends on skilled and experienced people. We are presently increasing our staff to meet the demands of regulating superannuation and the more intensive supervision needed for general insurers and complex conglomerate groups. And we are continually seeking to deepen our skill base, including recruiting experienced people from industry.
 
For next financial year we are budgeting for a 10 per cent increase in operating expenditure, a modest increase in view of the community’s increasing demands of us and the increasing complexity of the financial landscape we oversee. Our spending, after adjusting for inflation, will still be well below the total pre-APRA cost of prudential supervision for Australia’s financial system.
 
End piece
Once again, I thank the Securities Institute for this opportunity to talk about APRA. And thank you for your attention.