John Trowbridge, Executive Member - Institute of Actuaries of Australia, Sydney
APRA is the prudential regulator for four industries, namely banking, general insurance, life insurance and superannuation and it is charged under the APRA Act with 'balancing the objectives of financial safety and efficiency, competition, stability and competitive neutrality'.
Today I will talk about how the global financial crisis has affected each of these industries and what we might expect in future regarding industry activity, prudential regulation locally and prudential regulation internationally.
To get under way, let us have a look at industry structure: what has changed?
In banking, the mid tier has diminished. St George and BankWest have been absorbed by Westpac and CBA respectively. Is this the result of the GFC? In BankWest's case, clearly the answer is yes because the UK parent, HBOS, ran into difficulty. As for St George, if one reads the rationale in the corporate documents at the time, it is evident that both boards believed they saw the writing on the wall in early 2008. It is odd, incidentally, that the ACCC waved through the Westpac acquisition of St George and then later challenged CBA’s acquisition of BankWest. As Queen Gertrude said to Hamlet, ‘My lady doth protest too much methinks.’
We have also seen the Bank of Adelaide merged into Bendigo Bank, Suncorp withdraw from most of its commercial lending, Elders Rural Bank become majority-owned by Bendigo and Adelaide Bank and renamed simply Rural Bank. There have also been some credit union mergers and no new banking licences. So clearly the competitive landscape is changing. And most of the transactions that have occurred can be traced to capital scarcity.
It is worth noting that the government's deposit guarantee has protected the deposit base of our smaller institutions, the credit unions and building societies, and its wholesale funding guarantee has protected the offshore funding base of our mid tier and larger banks.
In life insurance and wealth management we have seen three significant acquisitions, all attributable in some measure to capital problems of the parent. MLC is purchasing Aviva, Australian Unity has purchased Life Plan, one of our largest friendly societies, and ANZ has just announced the purchase of the other half of ING in Australia.
In general insurance, we have also seen some movement. Australian Unity sold its portfolio to Calliden and two parent companies have secured their survival by selling their general insurance subsidiaries. PMI, the US mortgage insurer, sold its Australian business last year to release $1 billion of capital and Elders should consummate tomorrow the sale of its insurance business to release nearly $400 million of capital. In both cases the purchaser was QBE Insurance.
In superannuation, there has been no structural change but there is much soul-searching going on regarding both product strategy and investment strategy, since the capital base, i.e. the wealth, of large numbers of superannuation fund members has been damaged by the events of the last two years. In particular the choice regime with, in many cases, a plethora of investment choices, is now being seen as commercially less interesting than previously thought as many fund members turn their attention to preservation of the value of their accumulated contributions.
Impact of recent events
Let us now look at the impact of recent events on each industry.
We now have a more sober banking system, where we believe individual banks are much better tuned into:
- liquidity risks and needs;
- funding risks and needs, including the risks of offshore funding and securitisation;
- the perils of unfamiliar products, especially complex ones, and reliance on credit rating agencies;
- stress tests that are carried out properly;
- remuneration risks;
- the importance of sound and robust risk management and governance;
- the positive influence of good prudential regulation and supervision;
- the risks of thin capital, as to both quality and quantity, as well as the inefficiencies of excess capital; and
- the limitations of accounting standards, especially regarding loan provisions and fair value requirements.
Going into the GFC, we had an improved regulatory capital regime, introduced in 2008 after extensive preparations, in the form of Basle II. Coming out of it, we have the prospect of enhancements to Basle II, especially for capital, liquidity and procyclicality.
Note that some commentators have suggested that Basle II was a factor in the GFC. This is a misunderstanding. Basel II is a clear improvement on its predecessor. Many countries implemented it during 2007 and 2008 but the United States was not one of them.
We have in APRA a prudential regulator who is aware of the same things and who takes a proactive and preventative approach to prudential oversight. An important part of our oversight is our reliance on the board to take full responsibility for the company. i.e. APRA holds the board directly accountable for the company meeting APRA’s prudential standards.
Life insurance and superannuation
We now have a superannuation system in reflection mode, reflecting on the traumas of the last two years and what it means for the future. It is notable that the current SGC regime, introduced in 1983, and the progressive disappearance of defined benefit funds are now reaching a point where:
- many retirees are relying on their accumulation benefits to sustain them financially;
- the needs and expectations of retirees will continue to grow, such that the age pension will increasingly fail to satisfy many in the community;
- as the demographics play out, the number of retirees is beginning to expand, especially as the baby boomers are now reaching retirement age; and
- the number of people retiring on employer-sponsored pensions or final salary-based lump sums is diminishing rapidly.
At the same time the investment results of the last two years are generating questions around:
- the values of assets and the valuation of assets;
- the freezing of some investments;
- the riskiness of many forms of investment, especially when considered against retirement needs; and
- importantly, in a defined contribution world where investment, inflation, health and longevity risks are borne by the employee or super fund member, a growing appreciation of the value of various kinds of insurance or guarantee arrangements to deal with the contingencies of death and longevity, salary continuance and investment volatility.
And there are some lessons for retail superannuation funds, many of which are within life companies or within groups that own life companies. APRA is the collector and publisher of super statistics and so is a force for transparency in the industry. Along with increasing evidence that low-cost funds on the whole tend to perform better than higher cost funds, debates are emerging about the unbundling of sales and advice expenses from distribution and other operational costs, and about the suitability and sustainability of various commission arrangements.
Two consequential phenomena are now beginning to interact directly with the risk underwriting segment of the life insurance industry (noting there is another major segment, namely superannuation and investment management): These phenomena are:
- firstly, an interest in protection against investment risk and longevity risk
- likely to spawn a new range of products that give some form of asset or income protection against the volatility and uncertainty of investment performance and also against the risk of living longer (and, incidentally, if we have a bout of high inflation, people will also seek protection against future inflation risk), and
- secondly, growing use of life insurance and salary continuance insurance by superannuation funds, including industry funds. The larger industry funds are already generating a form of indigestion within the life industry: because of the large scale and limited period of their insurance contracts, we now have an inefficient market operating, as evidenced by many of the larger life insurers not participating in the industry fund tenders because of the upheaval that occurs at each renewal, usually every three years.
- likely to see a restructuring of this market, perhaps along the lines of the coinsurance practices managed by general insurance brokers on behalf of large corporates when they buy their insurances.
The prudential regulator has a couple of roles to perform here:
- regarding new life risk products, assessing capital requirements and risk management requirements to ensure the risks are properly understood and managed; and
- review of capital and other prudential requirements generally, occurring because of the passing of responsibility for prudential regulation last year from the LIASB to APRA.
The message from these developments, as I see it, is that after a couple of decades of concentration on contribution arrangements and on employers’ costs and risks, attention is now turning to benefits for individual members of super funds. Are we about to turn the clock back 100 years?
We have a general insurance industry that has had a wake-up call, a sharp reminder of the traps of volatile investment conditions and uncertain economic times:
Large and rapid interest rate falls during 2008 affected reported profits and the composition of balance sheets. Although most companies did not have a serious mismatch problem, nor investment difficulties (because their equity and property portfolios were small,) the pricing implications were clear: lower interest rates require higher prices.
Although a recovery in confidence, a fall in credit spreads and a rise in longer interest rates since December last year have ameliorated the position, relatively adverse economic conditions are very likely to generate increased claim activity in the period ahead.
With such portents, the general insurance industry is now very much on its guard.
The major questions to have arisen from the GFC for banking regulation revolve around capital, liquidity and pro-cyclicality. The Basle committee has these subjects at the top of its agenda and is applying very substantial resources to moving quickly towards revised international standards. It is a tall order, for the technical requirements are difficult and so are the politics. There has also been considerable interest in some aspects of accounting standards, particularly the valuation of assets, and in executive remuneration.
APRA will follow the Basel Committee (and we are now a member) but interpretation, country discretions and implementation details will all be the responsibility locally of APRA.
Solvency II is coming to Europe, for both life and general insurance. It has been much talked about and much written about, it has been a long time in gestation and it is complicated. The combination of political compromises on the regulations, levels of technical difficulty and implementation challenges make Solvency II a very uncertain venture when viewed from outside Europe.
Australia is not following (there is no particular reason why we would or should or could). It is not even clear that all European countries will fully support it and, in any event, implementation will undoubtedly exhibit some variations from country to country. Nevertheless we are watching it closely and assessing our own capital and other requirements against Solvency II.
Note also the convergence or harmonisation of life insurance and general insurance standards, in Solvency II and other places.
Accounting standards in insurance are also a vexed issue. Strong efforts have been made internationally over some years, through the IASB and also the FASB in the United States, to develop new and commonly agreed accounting standards. Under pressure from the G20, they have been making rapid progress recently and yet there continue to be fierce divisions of opinion on some key issues.
Internal models in banking and insurance
Basel II, Solvency II and APRA all require all models to meet three criteria: that they are technically complete, are used actively across the business and meet required standards of board-led governance.
In aggregate these criteria represent a higher standard than many companies are accustomed to (e.g. in the UK, the FSA currently requires companies to do their own internal capital assessments. These assessments do not on their own meet Solvency II requirements or APRA requirements).
The group of 20 leaders first met in November last year in Washington and have since met in April this year in London and in the last few days in Pittsburgh. There has been extensive work behind the scenes in preparation for each of these meetings. Contributors include input from international regulatory groups (they are the BCBS, the IAIS, IOPS, IASB, the Joint Forum and the Financial Stability Board) and from each member country (in Australia's case, channelled mainly from ASIC, APRA, the RBA and Treasury to the Treasurer and Prime Minister).
It is the Financial Stability Board which supplies the written material on which the G20 Leaders base their public pronouncements. The G20 issued their Leaders’ Statement at the weekend, a 23 page document, along with several supporting documents from the FSB.
Financial regulatory reform is high on their agenda, as you all know. Under the heading ‘strengthening the international financial regulatory system’, there are statements about enhancing and expanding the scope of regulation and oversight, improving risk management, strengthening transparency, promoting market integrity, implementing standards to ensure a level playing field and avoidance of fragmentation of markets, protectionism and regulatory arbitrage. There is a call:
- for robust and transparent stress tests;
- for banks to retain a greater proportion of profits to build capital and support lending;
- for securitisation sponsors and originators to retain part of the risk to encourage prudence; and
- for an adequate balance between macro prudential and micro-prudential regulation, to monitor and assess the build-up of risk.
And to quote, ‘All firms whose failure could pose a risk to financial stability must be subject to consistent, consolidated supervision and regulation’, with ‘stronger capital standards, complemented by clear incentives to mitigate excessive risk-taking practices.’ The text elaborates further on the topics of:
- building high quality capital and mitigating pro-cyclicality;
- reforming compensation practices to support financial stability;
- improving over-the-counter derivatives markets; and
- addressing cross-border resolutions and systemically important financial institutions by end 2010.
Of course some of these initiatives are more easily said than done, and one in particular is countering pro-cyclicality. Much has been said and written on this topic and its links to macro- prudential supervision and systemic stability. We need to remember that people (executives and boards) and their institutions are often pro-cyclical in their behaviour and that markets, investors and credit rating agencies can also exacerbate the problem. Further, accounting standards can operate in the wrong direction. So to move in the right direction is difficult. The G 20 report refers to ‘counter-cyclical capital buffers’, which are problematic, but it also refers to ‘forward-looking provisioning’, which can be a contributor to limiting pro-cyclicality, in much the same way as insurance claim provisioning limits pro-cyclicality in the insurance industry.
Given the influence of people on pro-cyclicality, however, our best defence beyond the provisioning possibility is through the quality of governance of our institutions — their responsibility — and the application of effective prudential supervision — APRA’s responsibility.
Let me now return now to the reference to ‘consistent, consolidated supervision and regulation’. I want to put emphasis in particular on supervision as distinct from regulation and simultaneously I will seek to give some insights into the possible factors that have contributed to system stability in Australia. That will also indicate why APRA’s response to the GFC will be modest and there will be little new regulation in response to the GFC.
Why is this so? Because, as I see it, in Australia we have been successful in navigating through the worst of the financial crisis and that is because we have been on the right side of several important success factors. Some of these factors are not directly attributable to the regulatory environment, for example the underwriting standards and business models of our lenders who, on the whole, were never tempted to engage in residential sub-prime lending.
There are also, however, some distinguishing features between regulatory regimes that work well and regulatory regimes that do not work so well. They include:
- regulatory agency structure;
- powers of the regulator;
- scope of regulations; and
- quality and depth of supervision or surveillance of institutions.
The first three are enabling factors and the fourth is about accountability.
Our system has the wherewithal to work effectively because:
- we have a good structure: we have a single national integrated regulator who is a specialist prudential regulator — our ‘twin peaks’ model (APRA for prudential regulation and ASIC for market conduct), where the specialisation is, I believe, a signal virtue;
- APRA has, on the whole, adequate legislative powers to do its job, including the power to make its own prudential standards; and
- APRA has developed a suite of regulatory requirements (in the form of prudential standards) with which we are largely satisfied because they give us the framework or regulatory underpinning we need to do our supervisory job.
As I see it, our system does work effectively because APRA is a vigilant and effective supervisor. It was not always so, but APRA now has the resources comprising the experience, culture, competence and strategy to operate effectively.
Our prudential standards are built around capital adequacy, effective risk management and good governance. A fundamental plank of our approach is, as I have already noted, that we hold the boards of regulated institutions accountable for meeting the prudential standards.
The quality of active supervision of individual institutions to determine this level of accountability or boards and it is a critical success factor. Prevention is not only better than cure, it is also better than punishment after a failure. Active supervision is a pre-requisite and a sine qua non of an effective prudential regulatory system.
In summary, our agency structure, with its national specialist prudential regulator with suitable powers and suitable regulations along with, above all, active supervision, are all well suited to the task. We believe we will continue to be effective as long as APRA remains competent in supervision and vigilant. And that is our primary response to the GFC.
By comparison, many other governments and regulators have much to do to meet these criteria. It is reassuring to know that the G20 Leaders have now recognised the importance of effective supervision to support regulation. A major concern for many of us has been that, in the debates that have been occurring around the world on financial regulation, faith in regulation itself has too often taking precedence over the importance of effective supervision.
To complete this tour of the prudential regulatory implications of the GFC, I will now comment on the G20 reference to consolidated supervision and regulation, with the emphasis this time on consolidated. Internationally, a major regulatory issue that surfaced was the problem of effective consolidated group supervision. It is typified by the AIG experience where, on the one hand, not one policyholder has been denied benefits in any of the hundred plus subsidiaries of AIG in the US or elsewhere but, on the other hand, a single unregulated subsidiary of the group has made claims on the parent which the parent could not meet because the insurance supervisors around the world were effective in quarantining the assets of each insurer. The US government had to either let the company fail or give support to the parent in order to prevent the collapse of the group.
International initiatives are under way, through the IAIS and the Joint Forum, on consolidated group supervision. Locally, this topic is high on APRA’s agenda. We have succeeded in introducing group supervision already for ADIs and general insurers. With the legislative power now to authorise life insurance NOHCs, we are moving towards consolidated group supervision for specialist life insurance groups and also for conglomerate financial groups.
Finally, a word on remuneration. Much has been made of this topic so I would like to explain briefly the philosophy of APRA’s approach. In the light of the GFC experience, especially in the UK and the US, we recognise that a sound approach to incentive remuneration is an important component of risk management. Our goal is to see institutions operate remuneration systems which encourage prudent risk-taking and contribute to the long-term financial soundness of their business.
APRA is therefore introducing a principles-based approach which parallels our approach to other matters of governance and risk management. We are relying not on disclosure but on accountability by boards to APRA for meeting APRA’s principles and we will concentrate on the substance not the form. We expect companies to design their own remuneration structures within the general parameters nominated by APRA, with APRA’s role being to scrutinise plans to see that they conform to our principles.
To close, we can note that the efforts of governments and regulators have been extensive over the last year because of the GFC and they will continue for some time yet. Nevertheless in Australia the effects on our regulated institutions should be little more than what a sensible and prudent board will be doing in the interests of its own shareholders, and beneficiaries.