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APRA - The Way Forward

Jeffrey Carmichael
22 Nov 2002

Let me start by saying what a great pleasure it is for me to be addressing this CEDA meeting in Melbourne.
Today I want to give you a potted summary of where APRA has been heading over the past few years and some of our priorities for the next few years. Since we have now completed our appearance before the evidentiary stage of the Royal Commission I would like to close with some reflections on that experience.
Where Have we Been?
APRA 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 of our existence.
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 harmonising 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 standardise regulatory approaches internationally, generally improving our supervisory practices, and a host of other "smaller ticket" items.
Let me address just a few of the big-ticket items.
a) Internal Restructuring
The challenge posed by 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. The wisdom of this decision was examined during the Royal Commission.
The restructuring decision, of course, is faced by every merged entity. The best outcome is always situation specific and always involves a balancing of risks.
One of the key challenges we faced in 1998 was the need to build a new culture for APRA. 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.
It was clear to us that, during the period of structural re-organisation, there was some risk that supervisory activity would suffer while the re-organisation took place and while staff attained specialisation in their new roles.
The risk associated with rapid change was, however, partly mitigated by the alternative risk of persisting for too long with the old, and, in some cases, irrelevant and out-dated, inherited regulatory framework and practices.
We believed that the overall risk would be minimised by moving quickly to reform those areas where the inherited framework was weakest. Importantly, we decided that it was critical to achieve APRA’s internal structural changes while the economy and financial system were strong. The last thing we needed was to have staff distracted by personnel and organizational issues at a time when supervisory activity was also peaking.
Given the circumstances and the objectives behind our formation, we believed at the time that we had little choice other than to move quickly. It is a decision that I would make again in the same situation.
Fortunately, most of the staff that 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 in the former ISC moved to Sydney – following the Government’s decision on our head office location - than it did with dissatisfaction over positions in APRA. As a result, we are only now starting to reach the staff numbers and skill mix that we targeted back in mid 1999.
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.
Time does not permit a full exposition on the new framework. The comparison of the new framework with the old Insurance Act 1973 and related prudential system is nonetheless like cheese and chalk.
  • The new framework provides APRA with much greater flexibility to set prudential standards and to intervene where we believe prudential behaviour is not up to best practice.
  • The new framework gives general insurance companies much less flexibility to be creative in their accounting and actuarial practices.
  • Importantly, the new framework is risk based, in the sense that riskier lines of insurance and investments will attract higher capital charges.
While no framework can guarantee that a failure will not occur, especially where there is deliberate misrepresentation or fraud, one indication of the impact of the new framework can be seen by applying the new capital adequacy rules to HIH. Even based on the numbers reported by HIH, the company would have been in breach of capital adequacy as far back as the mid 1990s.
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.
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 contain 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 that we regulate.
  • 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, and
  • We will be moving forward with reforms to our supervision of superannuation funds.
This is just a small sample of the projects currently on APRA’s plate.
The Royal Commission
I would like to finish with a few reflections on APRA’s experience with the HIH Royal Commission. While it would not be appropriate for me to comment publicly on issues that are still being dealt with by the Royal Commission or to pre-empt anything that the Commissioner might find, there are nonetheless many issues now on the public record as a result of APRA’s witness statements and our appearance at the Commission a couple of weeks ago. I want to comment on just three of these matters: first, the Palmer Report; second, the difference between APRA and ASIC; and third, the difficulties we face in assessing the performance of a prudential regulator such as APRA.
Palmer Report
Let me start with the Palmer Report. That report was commissioned by the APRA Board to provide an independent and impartial review of our actions and inactions with respect to HIH.
The Report was critical of APRA in a number of respects. We have reviewed those criticisms and, with very few exceptions, we have accepted the recommendations of the Report and have gone about implementing them. Some, of course, were well under way before we received the Report. Others, such as those dealing with resourcing and legislative issues, are appropriately matters for Government. There were nevertheless some important areas of internal practice and culture that we were able to address directly.
Going beyond the criticisms, however, there were some important features of the Report that have not received much attention. One of these is context and the question of what is reasonable to expect of a prudential regulator.
Prudential regulation is about providing an extra layer of oversight over institutions that offer financial promises that are inherently difficult to keep and, because of the complexity of the institutions making the promises, are also inherently difficult to assess.
Prudential regulation, however, is not a guarantee. To provide regulation to the point where it became a guarantee would not only be unreasonably costly, it would eliminate the risk spectrum that is fundamental to a healthy competitive financial system.
A second topic that has recurred a number of times in discussions before the Royal Commission is the difference between APRA and ASIC. I fear that this distinction is still not well understood.
At a technical level the distinction rests on the difference between prudential regulation and market conduct regulation. The distinction is best understood by analogy, and the one I like best is usually credited to Howard Davies, Chairman of the UK Financial Services Authority. Howard describes the distinction as that between a doctor and a policeman.
Market conduct regulators, such as ASIC, deal largely with human weakness – namely greed. It is a sad but undeniable characteristic of human nature that many people will steal or misrepresent information in order to line their own pockets if they think they have half a chance of getting away with it.
Some of you will be familiar with the recent Tom Cruise movie, Minority Report, in which the police are able to perfectly anticipate crimes and charge the intending criminal in advance of the event – thereby heading off the actual commitment of the crime. I suspect this is a favourite movie of every market conduct regulator in the world.
Unfortunately, since we not yet as sophisticated as Tom Cruise, market conduct regulators are left focusing on how to reduce financial crime by catching those who break the rules. It is in this sense that they are like policemen. They work within a set of laws and legal sanctions, to which they add rules (especially rules about governance, disclosure and proper behaviour in markets) and administrative penalties.
However, it is widely agreed that the real deterrent to crime (both civil and financial) is no so much the severity of the penalties as the likelihood of being caught. Thus the market conduct regulator’s greatest weapon is its ability to investigate, catch and successfully prosecute those who violate the rules and laws. In short, the conduct regulator’s credibility is largely tied up in enforcement – what is sometimes referred to as the demonstration effect or "heads on pikes".
In contrast, a prudential regulator such as APRA, like a doctor, is more concerned about maintaining health and, if possible, preventing failure – in this case, the failure of financial rather than physical health. Like the doctor, the prudential regulator must work closely with the patients involved and, like the doctor, the regulator is heavily reliant on having the patient reveal honestly the symptoms that it is experiencing.
For this reason, prudential regulators must place substantial reliance on the data provided by financial institutions and to regard it as accurate unless there are strong signals to the contrary. The accuracy of the information is sufficiently important that independent market experts, such as auditors, and in some cases actuaries, are brought into the process to verify its accuracy. But, where institutions engage in deliberate, co-ordinated and large-scale misrepresentation of their financial health, the prudential regulator has little hope of managing an orderly exit from the industry without losses to depositors, policyholders or fund members.
An important part of this distinction between regulators is that, whereas a conduct regulator is focused primarily on enforcement, a prudential regulator is focused primarily on rehabilitation. The prudential regulator does have an enforcement role, but it is the last resort, rather than the main resort. To illustrate my point, at any point in time, there are somewhere between 100 and 200 financial institutions in the ‘infirmary’ at APRA. Around 20% of these by number, and a higher percentage by assets under management are, in the normal course of supervision, returned to active duty. The vast majority of the others are merged voluntarily with other, stronger institutions.
The focus on rehabilitation, however, increases the risk of loss when an institution proves to be beyond recovery or beyond the regulator’s efforts to raise their standards of prudence. This risk requires careful balancing. In reflecting on the HIH experience APRA has, in the past year or so, signalled a clear move in the direction of being more enforcement oriented and less rehabilitation oriented. It is nevertheless a matter of degree rather than of mutual exclusivity.
Judging the Performance of a Regulator
My final topic concerns how we judge the performance of a prudential regulator. This is an issue that has focused the minds of the APRA staff and Board for some time.
With HIH and CNAL being such high-profile problems in the past couple of years there is an understandable tendency in some parts of the community to assume that APRA is failing completely in its responsibilities as a regulator.
The difficulty for a prudential regulator is that it is much easier for the community to identify when you are doing a poor job than it is for them to identify when you are doing a good job. Unlike a conduct regulator, which can at least count heads on pikes, there is no ready metric for APRA’s performance.
My first comment on the tendency to focus on problems is that our legal responsibilities do not actually extend to preventing all failures. Section 8 of the APRA Act, which defines APRA’s purpose, requires us to balance institutional safety with other objectives such as efficiency, competition and competitive neutrality. It does not contain any explicit or implicit guarantees. As such, it clearly contemplates failure, and even losses to policyholders, depositors and superannuation fund members.
Second, the focus on problem institutions fails to recognize that the vast majority of institutions under APRA’s care are well managed and meet their obligations. APRA has some 4,000 institutions under its charge, managing over 1 1/2 trillion dollars of assets. If we measure performing institutions as a percentage of all institutions, the ‘performing entity ratio’ is currently 100%. Even in 2001, with HIH and CNAL, the ratio was 99.9%. Measuring the ratio in terms of assets rather than institutions paints a similar picture.
I should add that, in the rare cases in which policyholders or fund members have suffered losses, almost all been characterized by fraud or misrepresentation of one type or another.
Concluding Note
In concluding, let me say that APRA has had a rocky first four years. We have had our share of challenges and we have not always performed to the standard that we would like. We are nonetheless committed to learning from our experiences, to raising the level of our performance, and to continuing the development of a prudential framework that will be second to none. Thank you for your attention.