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Australian prudential reform: Where are we now and where are we going?

Wednesday 26 September 2012

Charles Littrell, Executive General Manager - Chief Risk Officers Forum 2012 Conference, Sydney

You would all be aware of, and possibly suffering a bit from, the wave of regulatory reform currently loose in the world. I have some good news for you, and some bad news, and some additional good news.

The first good news is that the current APRA-generated pace of change will not continue much longer. In fact we expect something of a crescendo early in 2013 as major banking and insurance reforms become effective, followed by a very busy six months in the superannuation industry. From about this time next year, APRA and its regulated industries should have broken the back of the major reform challenges currently facing us.

The bad news is that together, we are facing a challenge to get through the next year without dropping any balls. Meeting this challenge will require material management time and spending. You would all be aware that the changes APRA will require are in addition to changes many of you will face from other Australian and international regulatory initiatives. This is an excellent time to be in the regulatory change management consulting business, but perhaps a less happy time to be running the risk management function for a financial services firm.

The final and best good news is that having survived and hopefully prospered through 2013, Australia will possess a significantly reformed and stronger prudential framework, further bolstering our already strong financial sector.

What are the major changes?

APRA is undertaking material reforms to all four of its major industries, plus financial conglomerate groups, at the same time. In addition, in conjunction with our regulatory colleagues on the Council of Financial Regulators, we have made and will continue to make great progress in strengthening Australia’s ability to respond effectively to failed and failing financial institutions, and in protecting Australians from financial system instability. APRA has never undertaken such a broad reform task previously, and my hope is that we will not need to do so again in the foreseeable future.

How did we end up with, more or less, six reform programs running simultaneously? The answers differ depending upon the reform.

In the banking industry, the current scope and pace of reform is dictated by the Basel III capital and liquidity initiatives, in the first instance driven by the Basel Committee on Banking Supervision, but with a close and urgent interest taken by the G-20 at both finance minister and heads of government level. As a member of the Basel Committee, APRA fully supports these initiatives.

The superannuation industry reforms are driven by the Government’s legislative initiatives. I note that the great majority of super funds are not part of financial conglomerates, so the correlation of reform across industries in this instance is perhaps more of a challenge for APRA than for the superannuation industry.

Our reforms to the general insurance and life insurance industries were APRA-driven and scheduled, but as this project developed it became evident that running the Life and General Insurance Capital project (LAGIC) in conjunction with Basel III made sense. Many of the issues, particularly in the definition of capital, but also in a broader approach to capital and risk governance, are identical or very similar across industries, and APRA is striving to minimise any unnecessary regulatory differences.

Again, most insurers by number, though not by premiums or asset size, are not part of financial conglomerates, and they will be able to focus upon their industry reform without the need to worry about the larger reform agenda.

Let me repeat in passing what we have emphasised at great length in the extensive LAGIC consultation and refinement process. The general insurance reforms under LAGIC are meant to modernise, harmonise, and incrementally strengthen that industry’s prudential framework. Among other things, these reforms fix what was an insufficient treatment of multiple catastrophe perils in an insurer’s book. The need for this fix was unfortunately emphasised by the spate of natural disasters that occurred shortly after our initial consultation paper was released in 2010.

For life insurance, APRA by 2009 was convinced that the extant regulatory arrangements, however robust when introduced in 1995, would with the passage of time become obsolete. As with general insurance, there was a clear need to harmonise the life capital regime, and make it more risk sensitive. Furthermore, by creating the joint industry LAGIC project, we were able to ensure that the necessary and fundamental reform to life insurance would progress, and not be indefinitely delayed for many years while we dealt with the other regulatory challenges facing us.

APRA’s work on conglomerate regulation and supervision has a long history, and in fact a project was started and then deferred in the late 1990s. At this point, nobody in the world has a fully satisfactory multi-industry financial conglomerate regime. One lesson from the global financial crisis, particularly from AIG, was that we couldn’t afford to keep waiting for somebody else to take the lead on this. Accordingly, APRA has devoted considerable resources to its so-called Level 3 reforms. These reforms will affect no more than a dozen Australian financial conglomerates, but these conglomerates control a substantial majority of Australia’s prudentially regulated assets.

Finally, we have reforms associated with failed and failing financial institutions, and also with financial system stability. There is no single project here, but instead a number of coordinated projects, often involving some combination of APRA, the RBA, Treasury, and ASIC.

It would be fair to say that when we first started looking at this issue in 2005, APRA was concerned that our then-extant legislative infrastructure would be insufficient to the task of helping us avert the failure of a troubled institution, or efficiently managing any such failure or failures. Since then, APRA and other agencies have benefitted from considerable additional analysis, including financial institution distress simulation exercises, and we are more confident today that we can deal effectively with failed and failing institutions.

Our work in this area has been influenced to some degree by the lessons of the global financial crisis and the international work that has developed in response to those lessons, including the work of the Financial Stability Board and Basel Committee.

Our confidence is based, notably, upon a significantly improved statutory framework. In 2008 and 2010, Parliament passed financial system reform bills which addressed many failure management potential deficiencies. The final leg in this statutory reform – at least for the foreseeable future - is the Government’s consultation paper Strengthening APRA’s Crisis Management Powers, which is currently under consultation.

So there you have it: a hopefully concise summary of APRA’s major regulatory reforms, and the motivation for their concurrent timing.

Benefits of reform

APRA’s statutory requirement is to balance financial safety and systemic stability with, among other things, competition and efficiency. The aggregate effects of these reforms will enhance individual regulated entity soundness, as well as systemic stability. Furthermore, it is the case that the great majority of these reforms are accepted by the great majority of our regulated flock.

Since 2009, I would add, Australia and other developed countries have become much more exposed not only to market risk aversion, but to ongoing peer review by, among others, the G20, Financial Stability Board, the IMF, and various international standards-setting bodies. The bar has been lifted for what constitutes global best practice, and the penalties for failing to clear this bar may have become higher. APRA’s reforms, while not primarily driven by a desire to please or impress inquisitive foreigners, will generally have that effect.

Where to from here?

Once we clear the current very large stock of reforms, what is next? In banking, APRA has already announced its intention to review its securitisation arrangements, and the Basel Committee’s next wave of reforms will encompass liquidity, special rules for systemically important institutions, large exposures, and reviewing and likely strengthening the framework for risk-based modelling. The authorised deposit-taking institution sector’s pace of reform should slow, but there will still be a lot of work to undertake.

In our other industries, by contrast, we are hopeful for a period of relative, though far from absolute, calm.

In both the banking and insurance industries, we plan to put more effort, which may or may not involve changes to the regulatory framework, into recovery and resolution planning.

Noting that predictions are always subject to risk, we expect to see the following themes emerging from say late 2013.

First, it has become clear in recent years that supervising regulated entities works most effectively when they are well governed; when boards and risk officers are empowered, informed, and engaged. It is not APRA’s job to be the first to prevent regulated entity executives from making foolish risk decisions. Management, internal risk controls, and the board are the first three lines of defence. We are perhaps the fourth, but hopefully a firm line of defence. We expect that APRA will be able to clear sufficient space in its reform agenda, probably in the context of updating its behavioural prudential standards, to further empower these critical earlier lines of defence. At the same time, we would like to undertake a reasonably comprehensive review of APRA’s requirements on boards and individual directors, in order to ensure that these requirements are both effective and efficient, without becoming unduly onerous.

Second, APRA has, where possible, taken the opportunity to simplify and harmonise its prudential standards and guidance material, and we would like to increase our focus upon this work.

Third, the increased international peer review attention we are receiving will likely result in the need to amend, hopefully slightly, some aspects of APRA’s prudential framework. In a world of perpetual peer review, this will become the new normal, and part of our ongoing maintenance.

Finally, APRA will need to devote resources to thinking more deeply about lessons learned in recent years, and how we might respond to these lessons in a considered way. A non-exclusive and non-prioritised sample of potential topics includes:

  • are we and industry happy with the processes for creating and maintaining the internal risk-based models that drive prudential capital requirements for many of our larger regulated entities?;
  • how do we ensure that regulated entities meet their prudential requirements without resorting to artificial, or form-over-substance, structuring?;
  • how can we reduce the risk, in cooperation with other agencies, that APRA’s prudential framework produces unintended macro-economic consequences?;
  • should APRA encourage superannuation trustees to move away from an objective function that is apparently based upon nominal relative performance, and focus more upon preserving the long-term purchasing power of member contributions?; and
  • how can we encourage regulated entities to focus upon sustainable customer-oriented growth, and avoid the temptations of speculative ‘froth and bubble’ growth?

Some cultural and practical observations

Given that I am addressing risk professionals, I take this opportunity to pass along a few cultural and practical observations.

It is clear to all of us that properly implementing systems and controls to deal with the current wave of regulatory change is, in many cases, going to cost serious money, and require serious management and board time. If any of you fear that the prudentially regulated firm you are associated with is failing to commit sufficient time and money, by all means have a conversation with your APRA responsible supervisor. We are happy to explain, in our normal gentle way, to your CFO, CEO, and indeed board, our minimum expectations in these areas. One price for maintaining a licence to operate in an APRA-regulated industry is that the firm is both committed to, and clearly capable of, observing the prudential framework.

As a corollary to this observation, some of our impending reforms allow individual firms to ask APRA for transition arrangements. A wise risk officer will point out to his or her management that early transition requests, documenting both the reasonable reasons for the request, and the firm’s vigorous and credible plans to move rapidly to full compliance, are more likely to secure a favourable response from APRA.

In a similar vein, many of the current reforms will feed through to changes in APRA’s statistical reporting framework. We are increasingly unimpressed when reporting entities, after the extensive consultations attendant upon these reporting changes, fail to commence their systems work in time or devote enough resources to produce a decent product by the reporting due dates. APRA’s usual policy has been to forego fining, or alternatively naming and shaming, entities that submit late or faulty returns. Over the past decade, however, we have reached the point where we have 99 per cent on-time compliance, and high accuracy compliance. Firms falling short of these standards will increasingly look like negative outliers. I am reminded of the Japanese proverb: ‘The nail that sticks up will be hammered down.’

More generally, we observe that many people associated with the Australian financial sector assert that we ‘survived’ or ‘avoided’ the global financial crisis. In an aggregate sense, this is true, but the lesson to be taken from this is not that Australian regulated entities can afford to take more risks. Rather, the lesson is that low risk strategies and sound execution, however boring during a boom, produce remarkably good long-term returns. There was no Australian financial crisis; there wasn’t even an Australian recession. Successfully surviving an economic slow-down does not qualify Australian financial firms to start taking more risks. Such survival should instead cause us to continue avoiding unnecessary risks, and closely managing intended risks. It is also worth noting that the global financial crisis may have some way to run yet, as the western world reduces leverage and re-builds bank, household, and sovereign balance sheets.

As a final point, I propose to touch briefly upon the differences between compliance and risk management. These differences are remarkably relevant to the differences between behaviour regulation and outcome or risk regulation. The former is associated with black letter rules, lawyers, and punishment; the latter with principles, various risk management professions, and prevention.

No regulator of which I am aware is entirely a behaviour or a risk-based regulator. ASIC, for example, is towards the behaviour end of the spectrum, and spends a lot of time in court, but also devotes considerable resources to risk-based analysis and communication. APRA is towards the risk-based end of the spectrum, but we find it necessary from time to time to take a black letter or legal approach.

APRA-regulated firms typically need to meet both behaviour and risk expectations from regulators. In Australia, the former emanate more from ASIC, the ATO, and AUSTRAC, among others, and the latter more from APRA.

It is not sensible for APRA-regulated firms to try to meet both behaviour and risk requirements with identical tools. This does not mean that we do not allow a business unit that combines both functions, but it does mean that this business unit, or relevant separate units, must be structured, resourced, and empowered to differentiate between these requirements, and meet both equally. Try the following mental experiments to get a sense for the issues.

In the first case, imaging saying to an ASIC officer: ‘I know we violated the Corporations Act, but our customers didn’t lose very much money as a result, so you shouldn’t punish us.’

In the second case, imagine saying to an APRA supervisor: ‘Our capital requirement is eight per cent, and we have 8.01 per cent, so we are in full compliance with the capital rules.’

I will leave ASIC’s representatives to describe what they might do in such a circumstance. In APRA’s case, I can assure you that we seek considerably more than bare compliance with our prudential standards, and considerably more than rote observation of good risk management practice.

One implication for regulated firms is that compliance professionals are not necessarily the same as risk management professionals. Compliance officers ask: ‘Is this within the rules?’. Risk managers ask: ‘Is this sensible in the context of our firm’s strategy?’ APRA certainly expects you to stay within the rules, but our real value-added is to encourage you to make sensible risk decisions.

In closing, I wish you every success in managing your firm’s risks. Thank you for your attention.

The Australian Prudential Regulation Authority (APRA) is the prudential regulator of the financial services industry. It oversees banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, private health insurers, friendly societies, and most members of the superannuation industry. APRA currently supervises institutions holding $6 trillion in assets for Australian depositors, policyholders and superannuation fund members.