David Lewis, General Manager - Banking Seminar held at Edmund Rice Centre for Social Justice & Community Education, Sydney
Thank you for inviting me to participate in your discussion panel today.
I thought I’d start with the topic of the moment and make a couple of observations about the global financial crisis.
The Global Financial Crisis
Today, ‘crisis’ is a much over-used word. I can remember when there had to be a war or a natural disaster for something to be called a ‘crisis’; now, ‘crises’ are everywhere. This was brought out to me recently while watching a television program about the global financial crisis where Gerry Harvey was one of the program guests. He made a comment along the lines of: “Why are we talking about an economic crisis? Unemployment is under 5 per cent and interest rates are at record low levels? That’s not a crisis.”
And it’s true: compared to most other developed countries in the world, Australia has so far come through the global financial crisis pretty much unscathed. But, if you look at what’s been happening in some other countries, the picture is very different. In the United States, some of the world’s largest global investment banks have succumbed to the crisis. In the United Kingdom, the Government has felt compelled to step in and bail out its banks such that most of the banking system is now in Government hands. Of five major ‘High Street’ banks in operation a year ago, only two remain in private hands.
In Australia, we’ve had none of this: no banks have failed; the Government has not had to open its cheque book; and our banks’ balance sheets are not weighed down by toxic assets. And, while indicators of economic activity in Australia are not looking particularly healthy, they are nowhere near as sick as those of some of our overseas counterparts.
But, unfortunately, that’s not the end of it. The Global Financial Crisis has become a Global Economic Crisis.
As the impact of the financial crisis overseas works its way through to the real economy, economic activity in many countries is contracting sharply. Overseas, unemployment is rising sharply and housing prices have slumped. The December quarter GDP numbers for Australia’s major trading partners make for particularly grim reading – declining by 2 per cent after a long period of steady growth. The slowdown in international demand will inevitably spill over to the domestic economy, and eventually work its way on to the balance sheets of Australian banks in the form of a rising tide of non-performing loans.
So, while Australian banks have weathered the ill-effects of the financial storm so far, they will nevertheless have to remain vigilant to threats still in the pipeline. But, whereas last year the crisis was all about access to funds and liquidity, the next phase of the crisis will put pressure on banks’ asset quality, profitability and capital adequacy. This is where APRA will be focussing its attention for the immediate future.
The turmoil in financial markets: What happened?
The current crisis had its origins in some very poor lending decisions in the United States, which were made on a massive scale through the securitisation markets. Many banks – particularly in Europe – bought into these problem assets by acquiring Collateralised Debt Obligations (CDOs). Australian banks, on the other hand, managed to avoid the worst of this. So, why have Australian banks managed to fare so much better than many of their overseas counterparts in coping with the crisis? Was it down to good luck (“dumb luck” as one commentator has suggested)? Or was it a result of good regulation?
Well, I don’t think that luck had all that much to do with it.
I recall when the golfer, Gary Player, was asked about the impact that luck had on his game he answered: “It’s a funny thing: I find that the more I practice, the luckier I seem to get.”
But, I certainly would not suggest that Australia’s success was just a matter of good regulation either. In fact, I think that the resilience of the Australian financial system can be attributed to a number of factors:
1. Structural differences
Firstly, the dynamics of mortgage lending in Australia differ significantly from those in the United States. The problems that emerged in the United States were exacerbated by a dysfunctional loan origination model and some seriously misaligned incentive structures. Basically, the people making the loan decisions at the point-of-sale did not have to live with the consequences of their decisions. This led to many unsound loans being made and sold off in the form of mortgage-backed securities. While securitisation has also long been part of the Australian lending scene, Australian banks have not embraced the originate-to-distribute model that prevails in the United States. They have remained predominantly intermediaries. This has meant that incentives and risk-taking have stayed, more or less, in sync and have acted to constrain pressures to expand loan volumes without paying adequate regard to risk.
2. Strong financial institutions
Secondly, the Australian financial system is dominated by financial institutions that are large relative to the size of our economy. And, as former Reserve Bank Governor, Ian MacFarlane has observed, they have been spared from the excessive takeover pressures that have been evident in many overseas markets by the operation of the ‘four pillars policy’. For the most part, Australian financial institutions are profitable and well managed. Healthy risk management cultures can be observed in the vast majority of Australian financial institutions. Without doubt, this has been a considerable source of stability in the current crisis.
3. Effective regulation
But effective regulation, too, has played its part. Let give you a couple of examples:
The first is APRA’s approach to broker-originated loans. We have never said that ADIs cannot use third party loan originators. Rather, we insist that, where this is done ADIs must ensure that the originator applies the ADIs’ own credit assessment standards. Moreover, the ADI must monitor and audit loans being originated via a broker to ensure on-going compliance with its lending criteria. Prudent best practice for ADIs is also to include a risk-based component in the fees it pays for broker-originated loans.
Second, APRA has always been wary of “sub-prime” lending which has been prevalent in the United States. In this vein, we introduced significantly higher capital charges for “low-doc” loans in 2004. It is often observed that APRA adopts a more conservative stance on capital adequacy than many of its overseas counterparts. We make no apologies for this. We think that healthy capital buffers are an important source of confidence for our financial institutions.
APRA’s Approach to Regulation
More generally, APRA’s regulatory approach is one that focuses on ‘substance over form’. As a regulator, we don’t believe in trying to tie-down everything that moves. Rather, we take a ‘risk-based’ approach to regulation. APRA has nowhere near the volume of prudential regulation that applies to financial institutions in the United States. Prudential regulation in Australia relies much less on ‘black letter’ law and more on adherence to sound risk management principles.
At APRA, we believe that prudential regulation works best its goals – sound risk management – are internalised within regulated institutions. This is a method academics refer to as “meta-regulation” – and we are adherents of it.
Of course, we don’t just take an institution’s word for this. We devote considerable resources to assessing the risk positions of Australia’s regulated financial institutions; seeking to ensure that they have in place robust internal risk management processes; and, where necessary, intervening to ensure that improvements are made.
In closing, let me say just one thing about organisational culture. A lot of financial institutions talk about the importance that they place on having a strong risk management culture. But, when you go from institution to institution as we do, you can quickly see that this means different things to different people. It’s how you implement it that counts. In my experience, the most effective risk management cultures are those which are open to views that challenge an existing mindset. These are the cultures that are best-placed to deal with the unexpected – be it improper trading in foreign currency options or a global economic crisis.