Let me commence by outlining APRA’s role in the Australian financial system.
APRA’s first focus is on protecting depositors, policyholders, and superannuation fund members - the people we regard as the beneficiaries of our efforts - from a financial institution’s failure to meet promises. Statistically speaking there will be failures; APRA tries to regulate tightly enough to make failures rare, but not so tightly that we choke the system’s innovation and competitiveness.
Some external observers have difficulty separating our duties from those of other regulators, particularly the Australian Securities and Investments Commission.
In broad terms, APRA is an economic regulator. We control legal but risky behaviour, such as lending money or writing insurance contracts. Our focus is strictly on our regulated industries.
ASIC’s role is much wider; they look at Australian corporate behaviour and most investment behaviour. Again speaking broadly, ASIC is a legal rather than economic regulator.
APRA’s goal is to ensure that our beneficiaries receive the financial promises made to them. ASIC's goal is to ensure that Australia’s corporations and investment industry observe the disclosure, process, and other conduct rules relevant to them. Both regulators are fated to sometimes fail in their roles; it is statistically certain that some financial institutions will fail to meet their obligations, and equally certain that some institutions and people will fail to observe the corporations law. ASIC and APRA try to work together productively for mutual support as we each aim to achieve our missions.
Investment entities that mistreat their investors are unlikely to be truly interested in ethical investment.
Corporate governance gives us a valuable signal about an entity’s ability to repay APRA’s beneficiaries. Corporate governance is about managing conflicts of interest. The relationship between creditors and shareholders is a nearly permanent short-term conflict, though hopefully not a long-term conflict, in the entities we supervise.
When APRA considers the risk rating for an entity, we start with the honesty and integrity attaching to the senior responsible persons. Honesty combined with competence is the key recipe for financial soundness.
Soundness issues vary by industry. In banking, soundness is essential not only to protect depositors, but to ensure that banks as a group continue to lend money and support economic growth. For insurance, soundness means that policy claims are paid, but also that essential risk transfer at a reasonable price, critical in a developed economy, is continuously on offer.
In the life and super industries, the major issue is good investment management, including good risk management. Good investment and risk management not only minimises controllable losses, but ensures that overall economic growth and ultimately retirement incomes are well supported.
Superannuation and life insurance are unusual in that trustees and board members have a statutory duty to look first to the interests of members and policyholders. Normally a board’s first duty is to shareholders, so life and super entities face acute agency risks. The super fund member assumes both the traditional customer role and shareholder role, but trustees have other competing interests to manage, notably employer sponsor expectations, and in for profit funds the corporate manager expectations.
For the rest of this talk, I will focus on the regulated life insurance and superannuation industries, and particularly on their agency or ethical risks.
Let me commence by noting that these entities are major listed equity holders, so life and super agency risk management feeds directly in many cases into the broader corporate governance arena.
Agency risk starts with a fundamental distribution conflict: much and possibly most discretionary retail investment is directed through financial advisors. These advisors are largely commission based: their remuneration ultimately comes from the investor, but is filtered through one or more product providers. This filter raises the question: who is the advisor working for?
We observe that much institutional equity is either not voted or not carefully voted. We also see cases where value for money is questionable, and where relationships with investment managers and other service providers are less than arm’s length.
Imagine you went to a doctor with a sunburn, and the doctor prescribed you medicine for diabetes. When you asked why this unusual approach was taken, how would you feel if the doctor explained that the diabetes medicine company paid him more in commission than the sunburn ointment company? There is at least the potential for this outcome in commission driven investment advice.
Our colleagues at ASIC deal with the direct investor effects of poor financial advice. At APRA we worry about the effect on the regulated entity taking in the funds from this distribution system. In particular, there is potential for commission driven advisors to inadequately vet the risks of the investments they are selling. If enough investors buy enough risky product from the same super fund, life company, or other regulated entity, then in short order that entity’s balance sheet will be concentrated in overly risky business, and APRA will be forced to intervene.
Institutional investor unwillingness or inability to vote shares is a puzzle. Votes are clearly valuable: in Australia this is obvious in the price difference between News Corp ordinary and non-voting equity, and in the recent turmoil at Coles-Myer.
Perhaps votes are wasted because votes are dangerous to the institutional investor. There is the risk that voting against a board or management team will come back to haunt the investor or the investor’s group affiliates another day.
In any event, deliberately not voting is deliberately wasting an asset. From the APRA prudential viewpoint, this is a sign that the institution in question could have a less than perfect regard for the individual investor’s interests.
I will briefly address value for money in the fees and expenses area. Recent British evidence collected by the U.K. Treasury indicates that retail investors face a broad spread of charges for essentially the same service; as a rough rule of thumb investors seem to earn a net 250 basis points per annum under the relevant indices, against perhaps 100 basis points with the more efficient providers.
In the Australian context value for money inefficiency chips away at the retirement lifestyle on offer to accumulation fund members. For defined benefit funds, inefficiency cuts into corporate sponsor equity.
APRA’s research on the Australian position is far from definitive. This slide demonstrates that among large super funds, there is no obvious relationship between returns and expenses. Why should the bulk of funds get along on 50 to 150 basis points in cost, but with a substantial tail of costs out to 350 basis points per year? We are currently looking more closely at such issues via our research department.
For superannuation funds in particular, there is substantial agency risk in the external fund manager relationship. It is not clear that trustees in some funds make arm’s length decisions about appointing related funds managers. It is also not clear why Australian funds are relatively heavily invested in actively managed products. A cynic might claim that the higher fees associated with active management are driving the decision, but I know that there aren’t any cynics at an ethical investment conference.
Many commentators in other forums have dealt with soft money and biased research. When APRA considers these issues we are grateful that ASIC and the ASX are the primary regulators for Australia’s equity markets.
Finally, we observe that it is possible for super trustees to fool themselves into thinking they have a moral duty to continue business with a supplier. In many super funds, the trustees see far more of the administrator and fund managers than they do of the fund members; this can lead to relationship capture.
After the prior litany of problems, let me note that overall APRA views Australian corporate governance as reasonable. Australian agency risk, on the other hand, may be less reasonable. As already noted most agency risk issues lie with ASIC, but APRA is increasingly addressing these issues when they impact upon prudential soundness. Also, we are increasingly ramping up our data collections and analysis to help identify agency and other risks.
In summary, APRA very much prefers to see ethical investor treatment by its regulated entities. Ethical action implies but does not guarantee a sound prudential position, and ultimately APRA is firmly focused on a sound and prudent Australian financial system.
Thank you for your attention.