Thank you for the invitation to be part of this year’s Banking and Wealth Summit.
It’s an understatement to say that much has happened in the past 12 months. We have, as a community, been severely tested and can expect many more challenges ahead.
From a financial system stability perspective, however, the news thus far has been positive. The industry has responded extremely well – particularly in an operational sense – and while there have inevitably been some minor hiccups, the system has remained robust and important services to customers have continued fairly seamlessly. Moreover, the industry was able to lean in to the task of helping the community navigate a very severe economic shock. That is as it should be, but very welcome nonetheless.
The real-world stress this crisis has inflicted upon us has provided valuable lessons. Most importantly, it has underscored the value of resilience, and diligent preparation for a wide variety of risks ahead of time, because we can never really know which risks will occur, and even when we have foreseen a risk the reality of a crisis never perfectly replicates the scenarios we envisaged.
For everyone participating today, I’m pretty sure the start of 2020 was very similar. Whatever well-laid plans you had for the year ahead very quickly went out the window when COVID-19 struck. To use three of the most over-used words of 2020, everyone had to quickly pivot in response to unprecedented events and a challenging environment.
APRA was no different, and I’ve spoken previously about how we responded to the onset of COVID-19 with a rapid change to our priorities.1
In particular, almost all of our policy agenda for 2020 was suspended. That was a necessary pause to allow time and space – for regulators and industry – to focus on the urgent issues of the moment. But the urgent can’t be allowed to always dominate the important. We need to start to re-engage on important prudential policy issues that are incomplete. They will not play a role in helping manage this crisis, but they will certainly be part of the foundation for dealing with the next one – whenever that may be.
The first cabs off the rank for the recommencement of APRA’s regulatory program are critical reforms that were inflight when COVID-19 descended. There are three I want to highlight today: our work on remuneration, bank capital, and superannuation data.
I’ll start with last week’s announcement on remuneration – work that is as important as it is controversial.
Given the debate on this issue quickly goes to details, I want to start with a recap on what we are trying to achieve, because that hasn’t changed.
We see an effective remuneration framework as an important component of a resilient financial system. There is plenty of evidence over the past decade or so – ranging from the global financial crisis, to APRA’s supervisory reviews and the CBA Prudential Inquiry, to the Royal Commission – highlighting that long-term financial soundness requires prudent incentive structures and clear accountabilities for outcomes.
Given these lessons, and the specific recommendations from Commissioner Hayne, our work on remuneration is designed to deliver three things:
- stronger incentives for individuals to manage non-financial risks;
- appropriate financial consequences where material risk incidents have occurred; and
- increased transparency to drive stronger board accountability for remuneration outcomes.
There is little argument as to these objectives. The debate invariably goes to the issue of how they are achieved. I will talk about some of the specifics in a minute, but before doing so, I want to emphasise three points.
First, we see the individual components of the draft standard – governance, the use of non-financial measures, risk adjustment, deferrals, transparency – as a mutually reinforcing package. The individual components are important, but it is how they combine that ultimately determines the effectiveness of the framework.
Second, we have adopted a more principles-based approach where possible. This allows for a more tailored and nuanced application of the standards to better fit the wide range of firms to which they will apply. It is also aligned with our well-established supervisory approach. But it will require ongoing engagement by regulated firms and APRA to ensure remuneration arrangements are genuinely effective. So the new standard will not be set and forget.
And third, we have been more risk-based, targeting the new regulation where it is most needed. For smaller firms outside the definition of a Significant Financial Institution, their regulatory requirements have been scaled back from what was initially proposed. Our intent is to implement measures that are manageable, proportionate and effective.
Let me now turn to some of the specifics.
One of the most contentious aspects of APRA’s proposals was a limit on the use of financial performance metrics in determining variable remuneration.
Such a limit was not just APRA’s whim: it was part of recommendation 5.3 of the Royal Commission.2 At this event in March last year, I posed the question: when it came to the appropriate mix of financial and non-financial metrics, why wouldn’t 50:50 be a good starting point?
There is no doubt that our consultation process delivered plenty of answers to that question! Many were not particularly compelling, but within the responses there were some good points made.
As a result, in our revised proposals, we have moved away from a prescriptive limit. In particular, we have accepted the argument that hard-coding a 50 per cent cap into the standard would effectively lock entities into a ‘scorecard’ methodology, would discourage consideration of other remuneration tools (e.g. gateways and modifiers), and could restrict the opportunity for boards to adopt more innovative approaches that may be more suitable for their particular business.
That said, we have not resiled at all from the principle that a sole focus on financial metrics is unacceptable. A true assessment of performance requires consideration of both financial and non-financial dimensions. Therefore, the revised standard requires that Significant Financial Institutions (SFIs) assign a material weight to non-financial measures and have risk adjustment mechanisms that can dial variable remuneration down to zero should non-financial considerations warrant it.3
Just as we have accepted that one size doesn’t fit all when it comes to the use of non-financial metrics, we have also retained the view that one metric doesn’t deliver all when it comes to performance. This approach is contrary to the view put by some that Total Shareholder Return (TSR) or Return on Equity (ROE) were adequate measures to capture all relevant financial and non-financial risks. We haven’t accepted that proposition. Historical experience has shown that TSR and ROE reflect entity-wide and shareholder-centric assessments of performance, and do not reinforce individual accountability for effective management of non-financial risk. The track record of their use has not delivered sufficiently good outcomes, which is why the Royal Commission recommended change. That is not to say those metrics can’t be used as part of a suite of measures, but on their own they are inadequate.
Another element that has been adjusted in the revised remuneration standard is the length of deferral periods for payment of variable remuneration. APRA is now proposing that a component of this remuneration for the leadership of Significant Financial Institutions be deferred for six years for CEOs and five years for senior managers – a reduction of one year for each cohort. Highly-paid material risk takers are subject to a maximum four-year deferral, down from the original proposal of six years.
We believe this position strikes an appropriate balance between ensuring Australian regulations are not out of line with international and regional peers, but still robust and delivering sufficient skin in the game for a sufficient period of time to allow performance outcomes to be genuinely assessed, and action taken if need be.
A key component of the new package is a greater emphasis on transparency. While the specifics will be defined through further consultation next year, we are looking at a mix of qualitative and quantitative information being made available so that stakeholders can make a much more informed judgement as to how remuneration is being managed. For example, for the larger firms subject to a risk and conduct modifier, it might show what degree of adjustments to variable remuneration had occurred and allow stakeholders to compare that with financial performance, risk management and conduct outcomes.
We will also be giving thought to how we could collate and publish entity-level data to enable external benchmarking.
So to sum up, we have released a package of measures that hold firm to our original objectives, that we think are balanced, risk-based and proportionate, and – most importantly – that will deliver a meaningful improvement to remuneration practices compared to years gone by. No doubt we will learn from experience, and the review after four years that we have committed to may well bring further change if needed. But what we are putting in place is aligned to the direction industry is already heading. The intent is to accelerate and embed that shift and provide a consistent industry baseline to promote better outcomes and underpin longer-term system stability.
I’ll turn now to another piece of unfinished business that I have spoken about at many of these events – bank capital. This has been a long-running exercise,4 influenced not just by our own views, but the direction set by the Financial System Inquiry and the international Basel reforms. We want to bring this to the finish line.
There are a number of key outcomes that these changes are designed to achieve. The first point I would make, however, is that we believe the banking system is adequately capitalised. The result of this reform will not be that the industry needs to raise additional capital.
What we are seeking to do is complex and multi-faceted. We want to make the capital regime:
- more risk-based – by adjusting risk weights in a range of areas, some up (e.g. for higher risk housing) and some down (e.g. for small business);
- more flexible – by changing the mix between minimum requirement and buffers, utilising more of the latter;
- more transparent – by better aligning with international minimum standards, and making the underlying strength of the Australian framework more visible;
- more comparable – by, in particular, making sure all banks disclose a capital ratio under the common, standardised approach; and
- more proportionate – by providing a simpler framework suitable for small banks with simple business models.
Inevitably, there are some trade-offs needed between these objectives. Making the system more risk-based and flexible, for example, does not always line up well with a simplicity and proportionality objective. We also need to make sure the proposals are calibrated to meet the previously announced ‘unquestionably strong’ benchmarks. That means adjusting one area of the framework often requires an offsetting adjustment somewhere else.
Nevertheless, we think we have developed a package of changes that will address the objectives I have outlined. We are just putting the finishing touches to the consultation package, which we will release in the next few weeks.
Without delving into all the details, probably the most fundamental change flowing from the proposals is that bank capital adequacy ratios will change. Specifically, they will tend to be higher. That is because the changes we are proposing will, in aggregate, reduce risk-weighted assets for the banking system. Given the amount of capital banks have will be unchanged, lower risk-weighted assets will produce higher capital ratios.
However, that does not mean banks will be able to hold less capital overall. I noted earlier that a key objective is to not increase capital requirements beyond the amount needed to meet the ‘unquestionably strong’ benchmarks. Nor is it our intention to reduce that amount. The balance will be maintained by requiring banks to hold larger buffers over their minimum requirements.
What we are effectively doing is changing the unit of measurement for bank capital adequacy. A simple analogy is changing from measuring your height in inches to centimetres – the number of units goes up, but you are no taller. In our case, bank capital ratios will go up, but the dollar amount of capital the banking system has to hold should be largely unchanged.5
You might then ask why we are proposing an extensive set of changes, if we don’t want to change the amount of capital held?
One reason is to improve risk sensitivity. We will be adjusting risk weights in a range of areas to help make sure capital is better allocated according to risk. Housing loans, which dominate the industry’s balance sheet, will be a particular area of focus. Within the standardised approach, for example, you can expect to see that lower risk loans – such as amortising loans with low loan-to-valuation ratios (LVRs) – will get lower risk weights, but higher risk loans – for example, loans with extended interest-only terms – will get relatively higher risk weights.
A second reason is to make the framework more flexible, especially in times of stress. Holding a larger proportion of capital requirements in the form of buffers means there is more buffer available to be utilised in times of crisis, helping preserve the flow of credit at a time when it is most needed. Some of this will involve an expansion of the Capital Conservation Buffer, and some will be achieved by establishing a non-zero Countercyclical Capital Buffer as the default setting. Both of these steps are mirroring steps being considered elsewhere in the world.
Another important reason is to make clearer the fundamental strength of our banking industry vis-à-vis international peers. Under our current framework, Australian bank capital ratios look relatively low. That undersells their financial strength. By changing the way we measure capital adequacy, without reducing our overall requirements, we will not remove this issue entirely but we will make the differential smaller and easier to understand.
And last but definitely not least, we are delivering on the ‘unquestionably strong’ objective. Reaching these benchmarks by the beginning of 2020 was an important milestone for the industry. It was achieved through an orderly build-up of capital, conducted over an extended period. The result has been to put the banking system in a strong position at a time of severe economic stress, providing confidence in the stability of the system and enhancing the ability of banks to support customers impacted by the pandemic. But the strengthening was done essentially by encouraging, coaxing and cajoling the industry to build up capital in anticipation of new standards. We now need to finalise those standards to ensure that the strength we have benefited from is a lasting feature of the system.
A third critical piece of unfinished business for APRA is our Superannuation Data Transformation project. What at first glance may be seen as simply a technical data collection exercise is, at its heart, a far more ambitious project to use data to drive better industry practices and improve member outcomes.
The past few years has seen considerable consolidation of the superannuation industry. Many trustees have, or are planning, to merge and/or leave the industry, acknowledging that their members will be better off with their savings managed in a better performing, more efficient fund. But the proliferation of trustees and products is still well beyond what is needed for an efficient and competitive industry. And this diversity of funds is generating an industry cost structure that could be substantially reduced – for the ultimate benefit of fund members.
APRA’s MySuper Heatmaps have shown what can be done with a data-driven approach. Underperformers have been called out, fees have begun to come down, and mergers and exits are occurring. We will be issuing our next version of the Heatmap shortly with some additional analysis putting the spotlight on poor performers, and the Government’s recently announced Your Future, Your Super reforms will take this to another level.
To state the obvious, however, a data-driven approach needs to be built on data. Access to data of sufficient breadth and depth is essential to adequately assess all aspects of the superannuation industry’s operations and the extent that trustees are truly delivering for their members. Improving visibility of product-level and investment option-level data beyond MySuper products is required, in addition to more granular and comparable reporting on fees and returns.
We have consulted on a substantial broadening of existing data collections, covering trustee profile, member accounts, performance, asset allocation, insurance arrangements and fees and expenses. This is extensive, but a professional and diligent trustee should want this information to perform their role. It shouldn’t be seen as nice to have or a regulatory burden.
As we gear up after the COVID pause, finalising this project is a high priority, especially as the data collections are also needed to underpin some of the Government’s Your Future, Your Super reforms. Our goal is to have at least an initial tranche of the new data provided to APRA in September next year. Better outcomes for members – in the form of better returns and lower costs – are essential, and especially so in a low interest rate environment. A data-driven approach, and shining an even brighter spotlight on instances of underperformance, is an important means by which we plan to help deliver that.
As the end of 2020 approaches, we definitely do not want to be complacent, but there are many reasons to look forward with a degree of optimism. It has been a year of considerable sacrifice by many, with painful economic costs, but there are promising signs that 2021 will be one of somewhat more positive developments.
The more promising outlook gives us a chance to get back to some important unfinished business. APRA’s policy agenda has always been one of investing in the future. Changes occurring today take time to have their full effect. But they are important foundations for the future safety and stability of a financial system that we all rely upon. As I noted earlier, delivering improved standards for remuneration, finalising our bank capital reforms, and transforming our superannuation data may not greatly help us navigate our way out of the current crisis. They will, though, further strengthen the resilience and performance of the financial system, and ensure we are better equipped whenever the next crisis comes along.
1 See The Regulators: priorities update (21 May 2021) and Going the distance: APRA’s approach to the COVID-19 fight (28 May 2020)
2 Recommendation 5.3: In revising its prudential standards and guidance about the design and implementation of remuneration systems, APRA should … set limits on the use of financial metrics in connection with long-term variable remuneration.
3 Equally, boards retain discretion to reduce variable remuneration to zero if there are concerns about financial resilience – that is, strong performance on non-financial metrics does not guarantee a bonus.
4 Following our work on setting ‘unquestionably strong’ capital benchmarks in mid-2017, the formal consultation process has been a lengthy one, beginning with the release of APRA’s discussion paper in February 2018 and a response paper in June of last year, as well as additional consultations on transparency, leverage ratios and interest-rate risk.
5 Importantly, this will mean that the ‘unquestionably strong’ benchmarks – such as the 10.5 per cent CET1 ratio for the major banks – will no longer be applicable once the new standard come into effect. The new standards will be calibrated to achieve the ‘unquestionably strong’ amount of capital, such that additional benchmarks over and above the current minimum requirements will no longer be needed. In other words, a bank meeting its minimum requirements under the new standards will be achieving the same ‘unquestionably strong’ level that banks are meeting now.