Translating prudential policy into prudent practice
Wayne Byres, Chairman – Financial Stability Institute (FSI) Executives’ Meeting of East Asia-Pacific Central Banks (EMEAP) – Basel Committee on Banking Supervision (BCBS) High Level Meeting, Sydney
Good morning, and welcome to this year’s FSI-EMEAP-BCBS High Level Meeting.
To repeat last night’s welcome, let me say again that the Australian Prudential Regulation Authority (APRA) and the Reserve Bank of Australia (RBA) are pleased to be hosting this year’s event. I’ve attended many of these meetings over the years and, by bringing public and private sector representatives together to discuss the latest macro-financial and regulatory developments, they invariably generate a great deal of interesting and informative dialogue. I’m sure this High Level Meeting will be no different, since there is much to discuss in an increasingly complex, fractious and uncertain world.
I’d especially like to welcome our many esteemed international guests to Sydney. Having made the journey, I very much hope you will enjoy your time here.
Implementing international reforms
I’ve been asked to speak this morning about the challenge of translating prudential policy into prudent practice. From a global perspective, that’s an important issue to focus on because policy reform will mean little if it does not translate into improved practices and behaviours.
Translating global reform proposals to improved banking practice is a four-step process:
- global reforms have to be agreed as international standards;
- agreed international standards then need to be translated into domestic regulation;
- bank policies, systems and frameworks then have to be modified to comply with new regulations; and
- actual banking behaviours and practices need to adjust to a new set of constraints on the way business is done.
The first of these steps is pretty much complete. A decade on from the financial crisis, the marathon international policy-making efforts to restore and protect the resilience of the global banking system have, by and large, reached the finish line. Greatly strengthened risk-based capital requirements, a supplementary leverage ratio, with additional buffers for systemically important banks, liquidity and funding requirements in the form of the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), tighter large exposure limits and new margining requirements for OTC derivatives, and an enhanced disclosure regime provide a comprehensive package of prudential policy reforms. The Basel Committee has worked long and hard, and should be commended for the final product.
The Basel Committee’s output – besides lots of paper! – are agreements on the design and calibration of minimum standards. Those agreements are critical to global financial stability. Unfortunately, they are not worth the paper they are written on if they are not translated into domestic regulation by member jurisdictions – the second step in the process I referred to earlier. To repeat the frequent exhortations of the G20 leaders, to achieve the desired objective of a resilient global financial system the reforms need to be implemented in a "full, timely and consistent manner".
A quick look at the Basel Committee’s latest implementation monitoring report shows something of a mixed scorecard. While the core Basel III risk-based capital requirements and the LCR are largely in force around the world, there has been less progress in some other areas: many requirements are subject to lengthy transitional periods, implementation of the NSFR has been disappointingly slow in a number of jurisdictions, and margining and disclosure requirements can be described as a little patchy.
In short, not all commitments to act have been met by action. That is disappointing. While some delays and trade-offs are valid, on occasion it appears to reflect a regulatory version of the "first mover disadvantage" that supervisors often criticise the industry for – jurisdictions not wanting to do the right thing and move promptly because of a concern that other jurisdictions may not follow suit. This reveals a disappointing penchant to put the interests of banks and their shareholders above that of their depositors and the broader community – something that prudential supervisors must constantly guard against.
For our part, we’ve made good progress on the financial reform agenda in Australia. While the banking sector here escaped the worst of the crisis a decade ago, that didn’t mean APRA was complacent about the importance of building resilience. The core capital, liquidity and funding reforms of Basel III are all in place, with a conservative overlay in many areas. Moreover, we have done this without the extensive transitional periods that have been necessary in other parts of the world. I acknowledge, though, that we don’t have a perfect record and still have a few gaps to close, such as the enhanced Pillar III disclosure requirements. We are committed to addressing these as soon as we can.
A job just starting
There is still much to do around the world, including in the Asian region, to deliver on what the G20 leaders tasked us to do. But even if the new regulations are promptly implemented by policymakers in all our respective jurisdictions, for prudential supervisors the job is only just starting. That’s because the flaws in the global financial system revealed by the crisis had, at their core, poorly managed banks. Regulation and supervision globally were unable to prevent the problems building (nor unfortunately can they ever offer such a guarantee). Ultimately, it is the actions and practices by managers and staff within banks that determine whether banks are safe, and the system is stable.
We don’t just want banks to have stronger capital and liquidity ratios. We also want them to have stronger capital and liquidity management, founded on a strong risk culture. There are too many examples of financially sound institutions that frittered away their strength through poor risk management and reckless decision-making to suggest we can rely on stronger prudential metrics alone to deliver the requisite levels of safety and stability that the community expects.
In Australia, a similar clarion call has sounded recently from the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. The Commission’s Final Report, which was released a little over a week ago, firmly placed primary responsibility for misconduct on the financial institutions concerned and those who managed and controlled them: their boards and senior management. Of course, just as there was a need to improve the regulation and supervision of financial risks following the events of 2008, the Commission also exhorted regulators in Australia to be more forceful, particularly in relation to standards of governance and culture within the financial sector. We will certainly do so. But to generate lasting change, sound principles and policy reforms must ultimately be accepted and genuinely embraced by those who operate financial businesses as the way business must be done, and not just an impediment to getting on with business.
Therefore, new policies are not enough. Our Australian experience has shown that they must be supported by the right incentives, robust assurance mechanisms, and clear accountability. Policy-makers can issue new rules, but if they don’t translate into changes in actual behaviour – to more prudent management, to a stronger focus on risk, and to a culture of compliance in substance as well as form – then little will be achieved and history will repeat.
Unfortunately, the quality of management, and the risk culture that pervades an institution, can’t be prescribed. That is why supervision – examining whether prudential policy is translating into prudent practice – is so important. If I have a criticism of the Basel Committee, it’s that it spends too little time on initiatives to lift standards of bank supervision. Certainly, the Core Principles for Effective Banking Supervision set out a clear framework for what needs to be done, but the global supervisory community would undoubtedly benefit from further work on how it can most effectively be done. Effective supervision is absolutely crucial to making sure the regulatory regime achieves its purpose.
Translating policy into practice – easier said than done
Before I come back to the task of supervision, I’d like to say a few words about some of the challenges in ensuring prudential policy is translated into prudent practice.
First, Basel standards are, by their nature, minimum standards. We don’t want banks to just "do the minimum", however. Regardless of whether the requirements are quantitative (such as capital and liquidity) or qualitative (such as governance and risk management practices), it’s best for all concerned if banks operate a safe distance from minimum acceptable practice in the normal course of business. There are inevitably going to be differences between the bank and the supervisor in their judgements as to how far beyond minimum requirements a bank might be expected to operate. Furthermore, those judgements might justifiably vary over time.
In addition, prudential policy is often principles-based. Principles-based standards have much to commend them, not the least of which is that they are likely to improve the efficiency, proportionality and effectiveness of the prudential framework. Moreover, rarely is there disagreement over the principles themselves: after all, who will argue against the principle that, for example, risk management must be robust and comprehensive?
Unfortunately, that does not mean principles-based regulation is easy. It inevitably requires considered judgement – by both banks and their supervisors – as to how principles should be applied in a particular set of circumstances. Again, as all in this room know every well, the judgement of a bank and the judgement of its supervisor will not always reach the same conclusion on a given set of facts.
Thirdly, prudential policy inevitably responds to history, reacting to the problems of the past. Only supervision can ask whether practices make sense in the current environment, and in the environment that could prevail into the future. Supervisors do not have a crystal ball, but they can be forward-looking and anticipatory in a way that regulation cannot.
Finally, managers manage and supervisors supervise. Supervisors doing their job well will be continually assessing the way the prudential framework is applied in practice, and cajoling and harassing management – backed up by the threat of sanction in more serious cases – to improve a bank’s operations. They will not wait for a requirement to be breached before suggesting improvements. But for the most part, supervisors must take care to stop short of managing the bank themselves.
All of this means that much of what a supervisor grapples with is not black and white – there is much grey. Sound judgement is critical. As is experience, foresight and persistence. An ability to challenge, but always with an open mind, is important. Supervisors must have credibility amongst those they supervise so that their views carry weight. At the same time, they must engender trust that will encourage open and frank discussions and information flow, so they are not left looking for a needle in a haystack. And they must see both the forest and the trees, able to identify not just deficiencies and areas for improvement, but also the root cause of those issues.
Quite simply, it is no easy task.
We have been looking at our supervisory approach in Australia quite a bit lately. We’ve reflected on the lessons learnt from our own supervision activities in recent years; we’ve benchmarked ourselves against peer prudential supervisors in other jurisdictions; we’ve benefited from the observations from an IMF FSAP assessment last year; and of course we have the lessons drawn from the recent Royal Commission.
The overall conclusion from all of this feedback and reflection is that our supervision methodology is generally in line with evolving international practice, but our supervision intensity needs to be increased, and our focus broadened. We made this one of our strategic priorities a year ago; recent events have only reinforced the importance of doing so.
As with many things in life, it’s easier said than done. To state the obvious, prudential supervisors can’t be everywhere. APRA has a touch under 600 institutions – banks, insurers and pension funds – to supervise, and a little over 600 staff to do it. Of that complement, only about 300 of the staff are directly involved in frontline supervision. In the case of banking, we have around 135 frontline supervisors covering 143 authorised deposit-takers – a ratio of just under one frontline supervisor per bank. Those organisations collectively employ over a quarter of a million staff and have aggregate assets of more than A$4.7 trillion. These figures and ratios will differ in each jurisdiction represented in the room today, but one basic fact will not: supervisors have a lot to watch over.
Because supervisors can’t be everywhere, it’s necessary to focus supervisory attention on the strength of a bank’s own policies and systems of governance, risk management and control. These must always be the primary lines of defence, and making sure they are as robust as possible is the typical modus operandi of supervisors around the world. However, our experience in recent times has highlighted some important ways that these lines of defence are undermined, and to which we will need to pay more attention in future.
I’ll give three recent examples:
- The first is in the area of mortgage lending. In 2014, we initiated a quite intensive supervisory effort to lift and reinforce lending standards. Our concern was that due to strong competitive pressures, policies were not suitably calibrated to the Australian environment at the time – one of high and rising house prices, high household debt, subdued household income growth and historically low interest rates. We issued additional supervisory guidance, and allocated significant resources to ensure lending policies were suitably aligned with it. Unfortunately, this provided evidence that strong incentives to grow profit and market share often saw lenders weaken and/or override policies in order to generate sales. Moreover, the dangers did not seem to be strongly called out by compliance and audit functions.
- Another example was the area of remuneration. APRA, as with most jurisdictions in this room, has standards for executive remuneration based on the Financial Stability Board’s Principles for Sound Compensation Practices. Our institutions therefore had the requisite remuneration policies and processes that provided for risk-adjusted performance assessments, deferral and malus, designed to align remuneration with sound risk management and the long-term financial health of the institution. But a deep dive into actual outcomes for individual executives found that, until a much stronger spotlight was shone on the issue, the practical application of the policies and frameworks left something to be desired. In particular, as long as financial targets were being hit, accountability for poor conduct was often lacking.
- A third example is conflicts of interest, an area that has been the subject of considerable scrutiny in the Royal Commission. Managing competing interests is inherent in financial services firms, which must balance a number of competing stakeholders in their business: most obviously, customers, creditors and shareholders. Institutions which were the subject of adverse findings from the Commission usually had frameworks and policies that set out how these conflicts should be addressed. But the policies and frameworks have proven to be either insufficient or ignored (or both) as a focus on short-term shareholder returns has come to dominate the financial sector.
The key lesson from all these case studies is the corrosive impact that a misaligned culture, driven by poorly directed incentives, an absence of real accountability, and a short-term focus on share prices and dividends, can have on an institution’s long-term financial and reputational standing. Good policies and frameworks may be established, but without the right culture they are no guarantee of good practice. And practice is what counts.
The cases draw out the importance of sufficient supervisory intensity across the board. Supervisors can’t be everywhere, but regulated institutions must certainly feel their presence.
The cases also make clear the case for a much stronger supervisory focus on governance, culture and remuneration within financial institutions – something we have been building in recent years. However, unlike financial risks, issues of culture are difficult to identify and correctly diagnose, and simply requiring more capital or liquidity to offset perceived shortcomings is not the right solution. Regulation can help with some of the design features of a good framework, but ultimately insightful and astute supervisory judgement is essential. An increased intensity will require additional resources, new skills and, in some cases, a different approach. Yet if we genuinely want to make sure policymaking efforts over the past decade change actual behaviours in the financial system, these issues need much more attention.
The marathon international policymaking effort following the financial crisis a decade ago is now complete. National implementation is well underway, but there is more to do, and we can’t let the gradually fading memory of the crisis impede us from finishing the reform agenda.
Once we do, though, it is on-going supervision that will determine whether all of the policy work actually generates more prudent practice in the long-run. The supervisor’s job must be undertaken with sufficient depth and persistence to make sure that banks fully embrace, rather than just grudgingly accept, a new way of doing business. We have to resist attempts to return to "the good old days".
On many financial metrics, banks around the world are as healthy as they have been for some time. Banks’ own frameworks of internal governance, risk management and control must always be the primary lines of defence against a deterioration in that health. The lesson from our Australian experience, however, has been incentives, assurance mechanisms, and accountability within the banking industry have not always supported prudent governance, risk management and control, and at least in some instances have generated a culture that has actively undermined it. Supervisors need to give these close attention.
My final comment this morning is to note that many of these meetings in recent years have discussed the roll-out of the Basel Committee’s policy reforms. That has been undoubtedly been useful. Going forward, however, I would encourage the Committee, the FSI, and EMEAP to strongly emphasise the importance of strengthening supervision, particularly in the areas of governance, culture and remuneration, as a central component of their future work agenda. The long-run impact of the post-crisis reforms really does depend on it.
 See Basel Committee on Banking Supervision (October 2018), Fifteenth progress report on adoption of the Basel regulatory framework, available at www.bis.org.
 The IMF’s Financial Stability Assessment Program (FSAP) is a comprehensive and in-depth analysis of a country’s financial sector, including regulatory oversight. In APRA’s case, it includes an assessment of the effectiveness of APRA’s regulatory and supervisory approach, measured against internationally-accepted standards for good supervision.
 The remainder take care of a wide range of activities, such as: licensing; regulatory approvals; legal advice; data collections and analytics (including acting as a collection agency for the Reserve Bank and Australian Bureau of Statistics); policy development; crisis and resolution planning (including our role as administrator of the Financial Claims Scheme); quality assurance, risk and compliance; training and development; and the usual range of necessary corporate functions.