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APRA - The Way Forward

Jeffrey Carmichael
14 Aug 2002

Let me start by saying what a great pleasure it is for me to be addressing this CEDA meeting in Sydney. Unfortunately, I fear that by the end of my presentation you may be left feeling that the pleasure was all mine.
 
The timing of this presentation could not be trickier. Since APRA is scheduled to appear before the Royal Commission within the next month or so I am in the difficult position of having to be careful not to pre-empt anything that might transpire there. That eliminates about 70% of what is most interesting about APRA at the moment – at least as far as you are probably concerned.
 
I had originally proposed to speak about superannuation reform – which accounts for much of the other 30% - and is relatively uncontroversial, at least with respect to the Royal Commission. But, I understand that you have been "super’ed" out over the past few months, including by APRA staff. Not only would I have had little to add to what they have already said, I would undoubtedly have done a worse job than they did. So that put paid to super reform.
That leaves me a very limited field of topics.
 
In that context, let me say that someone very creative at CEDA made up a topic for me today. However, lest I be accused by the ACCC of false and misleading advertising, let me say that I will not be speaking about straight jackets, or anything quite that sexy.
 
In the interests of full and open disclosure let me reveal that I am going to give you a potted summary of where APRA has been going over the past few years and some of our priorities for the next few years.
 
Where Have we Been?
APRA has just recently celebrated its 4th birthday. When we started out 4 years ago we had a reasonably clear mission of what we hoped to achieve over the first 5 years.
 
High on that list were the following:
  • Consolidate and integrate our internal structure to create a genuine integrated prudential regulatory agency;
  • Work with the Government and industry to reform the legal framework for regulating general insurance and to create a modern set of prudential standards for general insurance;
  • Establish a framework for the regulation and supervision of financial conglomerates.
  • Harmonise the prudential standards for all deposit-taking institutions;
  • Harmonise the prudential standards for life insurance companies and friendly societies;
  • Commence working with the Government and industry to reform the supervisory framework for superannuation; and
  • Begin the long process of harmonizing our regulatory and supervisory approach to different sectors.
These are the main big-ticket items. There was also a swag of other policy and practice issues on our agenda, including working with the international associations such as the Basel Committee and IAIS to reform and standardize regulatory approaches internationally, generally improving our supervisory practices, and a host of other "smaller ticket" items.
 
But let me concentrate on the big-ticket items and say just a little about a couple of them.
 
a) Internal Restructuring
 
The challenge of internal restructuring cannot be overstated. When APRA was formed 4 years ago, it inherited staff from two distinctly different cultures. A year later, we absorbed staff from another 9 State agencies. We also inherited policies and procedures, IT systems and employment conditions from each.
The APRA Board and senior management believed that it was critical for us to complete a comprehensive restructuring within the first year or so.
 
In that judgment we were influenced by the experience of the Canadians, who spent the first 8 years of their integrated existence maintaining the old industry silos and watching the barriers grow higher and higher. It was not until they broke down the old barriers in their internal structure that they made genuine progress towards becoming an integrated regulator.
 
After roughly 12 months we introduced a new structure that cut across the old industry boundaries. It basically divided APRA’s front-line supervisors into two divisions, one responsible for diversified institutions (i.e. financial conglomerates and those with complex structures) and specialized institutions (mostly stand-alone institutions such as small banks, credit unions and general insurance companies).
 
We then essentially opened applications for the new positions and offered redundancy options to those not wishing to stay or unable to secure a position in the new structure. It would not be unfair to say that we had a few sleepless nights wondering whether we would retain any staff.
 
Fortunately, most of the staff we had targeted chose to remain. We did lose some specialist expertise, although that had more to do with the fact that most of the senior jobs formerly in the ISC moved to Sydney than it did with dissatisfaction over positions in APRA.
 
Three years on we are still satisfied with our new structure, although it remains under review. We have introduced some new specialist positions and will continue to bolster that aspect of the structure.
 
Our staff turnover rate, at close to 20% per annum remains high, though broadly in line with experience elsewhere in the finance industry. While some turnover is healthy, there is a significant training cost in regulation and it is not easy to replace experienced supervisors. We are hopeful that our turnover rate will decline over the next few years.
 
b) General Insurance Reforms
 
The general insurance reform program that came into operation on July 1 of this year was probably the most ambitious of our priorities for the early years of APRA.
 
The reform process for general insurance began immediately after completion of APRA’s establishment phase. Since the reforms involved a complete overhaul, they required the development of new concepts, testing of those concepts with industry, and consultation rounds with both industry and Government.
 
There are several critical features of the new framework that distinguish it from the old one defined by the Insurance Act 1973.
 
First, whereas the old framework was very legalistic and inflexible, the new one gives APRA considerably greater flexibility and a much more graduated set of powers.
 
At the centre of that flexibility is the power to set prudential standards.
In the old framework, all prudential requirements and powers of intervention were circumscribed in black-letter law. For example, the regulatory solvency requirement was set in Law. Further, APRA could only initiate certain enforcement actions when regulatory solvency was breached or when APRA was convinced that it was about to be breached.
 
In contrast, under a prudential standards regime the prudential requirements and much of the graduated responses are contained in the standards themselves. This provides much greater flexibility, both to spell out the detail and intent of any particular standard and also to amend it if it is found wanting, without having to wade through the complex and time consuming processes required to amend legislation.
 
The second distinguishing feature of the new regime is its risk orientation. Under the old regime a general insurer was required to hold capital for solvency purposes equal to the greater of:
  • $2 million;
  • 15% of its outstanding claims provision; and
  • 20% of annual premium income.
The law made no distinction between the amount of capital required for low-risk insurance business - such as householders or motor vehicle insurance – and the amount of capital required for high-risk business such as professional indemnity. You don’t need to be a rocket scientist to know that the risks in these different lines of business are not the same.
 
The new regime imposes different capital requirements on different lines of business. In this way it is philosophically more closely aligned with the Basel capital adequacy regime for banks than it is with the old solvency regime for general insurers. Indeed, like Basel banking regime our new framework also requires capital to cover risks on the asset side of the balance sheet, arising from credit and market risk.
 
Another aspect of the risk-based orientation of the new framework is its requirement for general insurance companies to meet governance and risk management standards. Among other things:
  • These apply a fit and proper requirement on directors, senior managers, auditors and actuaries.
  • They require insurance companies to provide APRA with their risk management strategies.
  • They require annual board attestations that they have systems in place to ensure compliance with the law and the standards.
  • And they impose governance requirements in terms of Board and audit committee composition.
The third distinguishing feature of the new regime is that it is much stricter in terms of provisioning requirements. For example:
  • It mandates a risk margin in claims provisioning to at least the75% level of sufficiency...
  • It mandates the involvement of an Approved Actuary.
  • It limits the choice of discount rate for discounting future liabilities to the risk-free rate.
  • It requires insurers to make provision for their premium liabilities – i.e. future claims arising from events insured under existing policies.
There are many more features of the new regime but time limits me to these three major elements.
 
As part of the introduction of the new regime, all current general insurance licence-holders were required to undergo a re-licensing process. That exercise stretched our resources at APRA to the limit, but it was an important and useful experience.
 
As a result of that process, 112 of the 137 general insurance companies in existence on June 30 have been relicensed to write new business. Of the others, 15 took the opportunity to merge with other institutions – in several cases with other institutions within the same conglomerate group and 10 have gone into run-off. A number of the 112 active license holders have plans agreed with APRA to increase their capital over the next couple of years.
 
This new regime gives Australia a world-leading supervisory system for general insurers. As Graeme Thompson noted in a recent speech to the Securities Institute in Perth, a senior executive of Moody’s recently commented that APRA’s new regime puts Australia way ahead of insurance reforms in the UK and continental Europe.
 
c) Harmonisation of Prudential Standards for ADIs
 
In September 2000 APRA issued a set of harmonised prudential standards for authorised deposit-taking institutions. While in many cases the changes were more subtle than substantive these standards brought the regulatory framework for banks, building societies and credit unions into full alignment for the first time.
In a sense it marked the coming of age of the smaller institutions, from a fragmented and inadequate regulatory system in the 1980s, through the harmonised state-based FI scheme in the 1990s, to full regulatory parity with banks in 2000.
 
This was the first major step by APRA towards our eventual goal of a single flexible regulatory framework covering all regulated institutions. Which brings me to the last of the big-ticket items.
 
d) Harmonizing our regulatory and supervisory approach to different sectors
 
When APRA was formed in the warm afterglow of the Wallis Report we were never under any illusion about the magnitude of the task of creating a genuinely integrated prudential regulatory agency.
 
The Wallis Report contained a vision of financial markets that was like an express train, hurtling forward through globalization, technological change and competition, with potentially dramatic implications for the nature and composition of financial services and providers. In such a world, regulation would need to be flexible, low cost, non-intrusive and neutral in its impact across institutions making the same sorts of promises.
 
It is fair to say that the Asian crisis, and more recently the collapse of HIH, has put a brake on the Wallis express train – if only temporarily. That is not to say that the ideals of the Wallis vision of regulation are inappropriate or wrong. I believed in them then and I still do. While the experiences of the past 4 years have shifted my views on the appropriate balance between regulatory efficiency and effectiveness and on the appropriate level of regulatory intrusiveness, they have not shaken my belief in integrated regulation.
 
The basic motivation behind integration remains – namely, to provide a single regulator for financial conglomerates and to reduce regulatory arbitrage by ensuring that similar financial promises are subjected to the same regulatory and supervisory impositions. No country in the world can claim to have such a regulatory framework fully in operation, although many aspire to it.
 
Four years ago we began our mission to develop such a system and we knew that it would take closer to a decade than to half that. Our first 4 years contains solid progress along the path towards full integration.
 
Apart from the obvious harmonization of ADI standards and the alignment of the approaches to deposit-taking and general insurance, there have been other milestones. For example:
  • In May 2002 we issued a common standard on outsourcing for deposit-takers, general and life insurance companies.
  • The framework for consolidated supervision of deposit-takers issued in September 2000 was designed for ready extension to other institutional groups.
  • This year we completed the development of a common data collection and analysis system for all regulated financial institutions.
Despite the progress there are still some major hurdles to jump. I will come back to these shortly.
 
That completes my summary of the ground APRA has traversed over its first 4 years. Let me turn now to some of the priorities and challenges ahead.
 
The Challenges Ahead 
Let me start with some of the more manageable ones first. In that category I would put the following:
  • We have been working on - and will continue to work on - upgrading our internal processes and procedures. For example, we have just introduced 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 looking, with Treasury and others, at a possible role for formal compensation arrangements for depositors and insurance policy holders 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. This is an emotive topic and one which will undoubtedly occupy a lot of media time if it makes it onto the political agenda.
  • 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 by recognizing them in calculating regulatory capital. For the first time, there will be a capital charge for operational risks.
  • We will be undertaking a review of life insurance supervision over the next year.
This is just a small sample of the projects currently on APRA’s plate.
 
While all of these are important, let me focus on the one remaining major reform area outstanding – superannuation. I know you are super’ed out but I cannot talk about our challenges ahead without saying at least something about superannuation.
 
APRA currently has prudential supervision responsibilities for around 11,000 superannuation funds, representing $330 billion. These are in addition to the superannuation funds managed by Life Offices. Of the financial sectors we supervise, super is by far the most populous and diverse. It will come as no surprise that it is also the most difficult - because of the diversity involved, the sheer number of funds and weaknesses in the regulatory framework.
It is the latter of these that I wish to address.
 
In our submissions to a number of recent inquiries into superannuation we have emphasized that APRA is handicapped in its supervision of the superannuation industry in much the same way that we were under the old General Insurance regime.
 
While our list of preferred reforms is extensive, there are two elements that comprise the core – mandatory licensing and the power for APRA to set prudential standards.
 
At present, not all superannuation funds are required to be licensed. The SIS Act requires licensing for Approved Trustees offering retail superannuation to the general public, but not for Trustees managing standard employer-sponsored superannuation for particular workplace and industry groups.
 
Licensing is a fundamental regulatory power. A universal licensing regime would enable APRA to conduct prior assessment of trustees and funds, impose specific licence conditions and revoke licences where warranted. It would also give us a better understanding of the trustee population and the opportunity to raise management standards across the industry.
 
Standard making powers are equally fundamental. As noted in my earlier discussion of the old general insurance regime, a black-letter law framework is too inflexible for prudential regulation. Giving APRA standards making powers would not pose any threats to well-run super funds. Standards would be developed in consultation with industry and would, as a safeguard on regulatory capriciousness, be subject to Parliamentary disallowance.
 
The Rocky Path to Integrated Regulation 
Our problems with the supervisory framework for superannuation and, similar problems prior to the reform of the Insurance Act, also underscore the enormity of the task facing a regulator such as APRA in becoming a genuinely integrated regulator.
 
While the APRA Act establishes APRA as a legal entity and appears to give it wide ranging powers, in fact our powers are all contained in the individual industry laws. As we discovered with our attempt to develop our first common prudential standard on outsourcing, APRA cannot issue a single standard covering all regulated institutions. It must issue separate industry standards under the separate industry laws. Further, because the powers are different under the different laws, the standards are often required to be quite different in format and content. Or, where APRA has no standard making power – they are non-existent.
 
To make matters worse, APRA operates under widely different enforcement powers in each of its regulated industries.
 
This same conundrum – what I might label "disintegrated" integrated regulation has been recognized by other countries that have gone down this path. To date, the UK is the only country that has attempted to overcome the problem in a comprehensive way. They resolved it by bringing all the relevant financial laws under one omnibus Act.
 
Indonesia, which is currently preparing legislation to establish an integrated regulatory agency, has taken a more elegant approach by simply consolidating all common powers into the act that creates the regulator.
 
It is high on APRA’s priorities to work with Government to find a way of resolving these significant inconsistencies in APRA’s powers.
 
Concluding Note
In concluding, I want to point out that I only mentioned HIH twice, I spent no more than a few minutes on superannuation and I did not mention straight jackets at all. Despite those omissions I have appreciated the opportunity to address you and hope that you have learned something about APRA and its challenges.
 
Thank you for your attention.