Flattening the curve
Good afternoon, and thank you to the Trans-Tasman Business Circle for organising today’s event. Given the Circle’s role in bringing people and ideas together, it is great to see its active program of events is continuing in a COVID world, and I’m certainly happy to contribute to the program today.
Nearly five months since the Australian Government declared COVID-19 as a global pandemic, there is unfortunately no end in sight to this health and economic crisis. It is difficult to predict the path ahead, although we can at least take some comfort that some of the most dire forecasts of a few months ago for the Australian and New Zealand economies look like they may have been avoided. That is reflective of the fact that the health outcomes, notwithstanding recent setbacks in parts of Australia, have been relatively manageable overall (certainly compared to other parts of the globe), and the substantial economic support packages on both sides of the Tasman have played a major role in cushioning the unprecedented economic shock.
In the time I have today, I want to talk about APRA’s role and contribution to managing the current crisis. We are obviously just one of many players involved on the economic front, and we are certainly not a leading actor in the story being played out. But we do have an important supporting role to play in ‘flattening the curve’ – the economic and financial curve, that is.
APRA’s counter-cyclical role
To some degree, you can think of flattening the curve as the permanent job of a prudential supervisor – pandemic or not. Prudential supervisors exist first and foremost to restrain excessive risk-taking and exuberance in good times. It is often said that central banks exist to “take away the punchbowl just as the party gets going”. Prudential supervisors have a similar role – acting to ensure the temptation towards risk-taking and leverage that is inherent in the financial system is countered with appropriate financial strength and resilience. In good times, that means preparing for a rainy day even when there are no storm clouds on the horizon.
Just as we try to dampen excessive swings on the upside, prudential supervisors also have an important role to play in limiting the downside. We cannot avoid or hide from the long-run impact of a shock, but macro- and microprudential measures can assist in making the adjustment process more orderly and limit unnecessary costs. In the same way that governments and health professionals have sought to flatten the curve of new infections, the challenge from an economic and financial perspective is to find a way to reduce the speed and depth of the contraction, as doing so is also likely to minimise its longer-term damage.
During a frenetic period of activity in March, a large number of significant support measures were developed by Governments, regulators and financial institutions to counter the biggest and the most sudden economic contraction since the 1930s. As I outlined in a speech in May, there were three main ways APRA initially sought to contribute to dampening the impact of COVID-19:
- by easing the operational burden on regulated firms to allow them to focus their attention and resources on supporting their customers and responding to the pandemic;
- by offering temporary regulatory concessions to complement the economic support measures introduced by Government, the Reserve Bank and the industry itself; and
- by explicitly communicating APRA’s view that the industry’s financial resilience had been built up to be deployed precisely in times such as these.
We were able to adopt this facilitative approach – rather than rush to batten down the hatches in the face of heightened risk – because Australia’s financial system was, and remains, fundamentally sound and stable.
Our banks and insurers remain soundly capitalised and highly liquid. APRA’s stress testing of the banking sector indicates the industry is well-placed to withstand any major economic headwinds ahead: even when faced with severely adverse scenarios, our analysis indicates the banking industry would remain well above minimum capital requirements.1 The insurance sector remains willing and able to support customers in times of need. Both sectors have also proven operationally resilient in the face of severe disruption to many aspects of their business activities. And the superannuation sector has demonstrated the financial and operational resilience to respond rapidly to the temporary early release scheme, taking just over three business days on average to process 3.6 million applications to a value of $25.3 billion and counting. It has done so while also supporting the extensive capital raising by the corporate sector over the past few months: a critical role that should not be underestimated.
As a result, support from the financial sector, contributing to the broader package of emergency responses by the Government and RBA, is helping bridge the economy through the worst of the health crisis. By and large, these actions collectively seem to have worked to avoid some of the more dire economic forecasts of March and April, and most projections now suggest things will be better than originally feared. That said, the outlook is still a difficult one. Moreover, the initial emergency package of measures had, for many components, a common six-month timeframe. That produced what came to be known as ‘the cliff’, and a concern about what would happen when many of the support measures that have underpinned Australia’s economic resilience since March came to an end.
Avoiding the cliff
Clearly, no one had any interest in falling off a cliff. But equally, temporary support measures can’t go on indefinitely. So as we have thought about how to move from the immediate emergency response phase to a new phase of (hopefully) orderly adjustment over the coming months, we are being guided by some key principles:
- Firstly, the financial resilience that has been built up in the system needs to be available, and utilised, to absorb losses and support economic activity;
- Secondly, the regulatory and supervisory actions we take should be designed to smooth the economic and financial impacts of the pandemic, but not to avoid or ignore the inevitable;
- Thirdly, regulated firms should be incentivised to work with and support stressed customers where there is a reasonable prospect of the customer’s recovery, and to recognise and deal responsibly with the issue if there is not;
- And finally, in times of heightened uncertainty, increased transparency is important.
Let me illustrate these principles with a couple of examples.
The most topical is loan repayment deferrals. As part of the emergency response packages announced in March, we granted a temporary and concessionary capital treatment in response to the banking sector’s offer of six-month loan deferrals to housing, personal and SME borrowers. Left unadjusted, the regulatory treatment would have treated all these borrowers as impaired, even though many can and will return to repaying their debts once government-mandated restrictions are eased. Of course, some borrowers will not, and our normal conservatism would have said it is better to overstate the problem than understate it. But we decided to grant a concessionary treatment for three main reasons:
- as I have noted, bank capital ratios are high and some short-term understatement of non-performing loans would not change that fundamental view (especially as banks are still required to provide for future credit losses under accounting standards);
- it would buy everyone some time until the economic outlook and scale of the problem was slightly clearer; and most importantly
- excessive conservatism would be counter-productive in this instance – making banks less willing to support their customers, which in our view would ultimately produce more negative economic outcomes for everyone.
Based on preliminary data for end June, about 10 per cent of loans by the banking system – worth $269 billion – have had repayments deferred.2 This is a substantial stock, and in thinking about how to avoid the September cliff we had to consider how best to facilitate an orderly transition out of the deferral program. Ceasing all deferrals in October would not be helpful. Equally, just rolling over deferrals without any exit strategy is unlikely to be in borrowers’ or banks’ interests.
The approach we adopted sought to strike a balance.
By extending the concessionary approach until the end of March next year, we sought to remove regulatory disincentives to banks offering additional support beyond the end of September. At the same time, we have made clear that banks should only offer further repayment deferrals in cases where they have some degree of confidence the borrower could return their loan to performing status. We also granted a window of time and an incentive, via another concessionary capital treatment available for a limited period, for banks to restructure borrowers’ debts with a view to putting them on a sustainable financial footing. This second concession is designed to encourage banks to work with their customers now, rather than simply defer again and hope for the best. And finally, to maintain transparency, we will require additional, regular disclosure of banks’ deferred and restructured loan portfolios – there is no hiding the issue.
Recalibrating our response
Another area where APRA is revisiting its initial emergency response is capital management. In early April, we had experienced a very turbulent period – for example, equity markets had just fallen 35 per cent in the space of five weeks – and we considered prudence was definitely the best strategy. We therefore wrote to all ADIs and insurers recommending they seriously consider deferring decisions on dividends until the outlook was clearer.
In our letter we referenced a time period of “at least the next couple of months”, so that guidance is now reaching its use-by date.
A few things have changed since early April:
- the degree of uncertainty around the domestic economy, while still high, has reduced overall;
- capital markets are functioning in an orderly manner, and access to capital has proven to be available to those who seek it;
- we understand better the scale and nature of the support packages being offered by industry to their customers; and
- we have been able to conduct a range of stress tests on Australian banks and insurers to understand how and when pressure will emerge under severely adverse scenarios – including the extent to which the impact of COVID-19 will play out differently for banks and insurers.
All of that is helpful. On the other hand, there remains a strong case for prudence, at least for the time being. The primary purpose of capital is to facilitate new business and absorb losses, and APRA – and its fellow members of the Council of Financial Regulators – remain concerned to ensure the financial sector sustains the strength to continue to support households and businesses during the downturn and the subsequent recovery. And financial institutions are still the beneficiaries of substantial – and in some cases quite direct – public sector support. Capital management, including dividend distribution, needs to be determined with all of this in mind.
Balancing all of this up, as well as having the benefit of the Government’s latest economic outlook and decisions on fiscal support measures, we will be updating our capital management guidance next week. We will modify the guidance, and extend it for the remainder of this calendar year, shifting from the immediate, short-term emergency response in April to a setting with a somewhat longer-term outlook. Our goal is to combine on-going prudence with flexibility: that is, to ensure capital management practices clearly have regard to the continuing uncertainty in outlook, that stress scenarios can be overcome without having to resort to cutting business activity, and that regulated firms are not unduly constrained from raising capital if and when needed.
On this score, I also want to reiterate some comments I have made previously in relation to capital buffers, especially in relation to the banks’ ‘unquestionably strong’ benchmarks (although the same principles apply to insurers).
Capital buffers have been built up to be used in times of stress. Now is such a time. One of the first emergency measures we therefore took was to announce that we would not be concerned if bank CET1 capital ratios fell below these benchmarks3. These benchmarks were designed to put banks in a strong position prior to a period of stress; they were not intended to be sustained during a period of stress. We also suspended some other capital adjustments, such as those for disability income insurance in the life insurance sector, so as not to place a capital strain on the industry at an already difficult time.
However, there is still some uncertainty about how quickly the buffers, once utilised, might need to be rebuilt. It is difficult to be precise on this point, but I want to be clear we have no intention of creating a capital cliff-face that banks or insurers need to rapidly climb. As we have done in the past, our approach will be to allow banks and insurers to rebuild (to the extent any rebuild is even required) in an orderly manner, and in a way that doesn’t unnecessarily constrain activity or economic growth.
Finding the right balance
Banks, insurers and superannuation funds occupy privileged positions in the economy. They enjoy significant government support both in good times and bad, across a wide range of dimensions in a highly regulated sector of the economy. That has both costs and benefits to firms, but it comes with an expectation that they have a broader set of responsibilities to the community than perhaps might exist in other sectors of the economy. During the past few months, it has been pleasing to see that this responsibility is being accepted and acted upon in the community’s time of need.
In helping ‘flatten the curve’ of economic contraction, we obviously need to be careful not to undermine the confidence that underpins the stability of the system and our financial institutions. Nor do we want to weaken the prudential framework that has helped to make Australia’s financial system among the safest and most stable in the world – there would be nothing more damaging for any nascent recovery than a sense that the financial system was fragile or unstable.
APRA is able to play a facilitative role because of the work done before the crisis to build the financial and operational strength of the financial system, as well as the public sector support on offer since the crisis hit. It often involves decisions that go against our normal prudential instincts, but we are able to do that because Australia is fortunate to have a financial system that is still in good health overall, notwithstanding a challenging few months. The task before all of us is to keep it that way.
1 Key parameters of APRA’s severe downside scenario involve elevated unemployment and sharp falls in property prices: this includes a slow recovery in GDP growth over the three-year horizon, unemployment of around 10 per cent in mid-2021, and falls in housing and commercial property prices of around 30 per cent.
2 Data for the largest 20 ADIs by loan size. As at end May, the corresponding figure was $266 billion.
3 The ‘unquestionably strong’ benchmarks comprised CET1 ratios of 10.5 per cent for the four major banks; 9.5 per cent for other IRB banks; and 8.5 per cent for other banks. Fortuitously, banks were expected (and did) meet these benchmarks by 1 January 2020.