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Speeches

Key issues for the year ahead: Bank capital and the approaching BEAR

Wayne Byres, Chairman - Finsia 'The Regulators', Sydney

Thank you to Finsia for again inviting me to this year’s regulator panel. The title of my remarks today draws on my comments at last year’s event: Bank Capital and Boiling Frogs. Few people were surprised last year that I intended to talk about bank capital, but many were quite perplexed about a reference to frogs. This year, I suspect many of you already anticipate what the reference to the bear is about.

Unquestionably strong capital ratios

I’ll start with bank capital.

The quest for an answer to what ‘unquestionably strong’ capital ratios look like has been with us since the Financial System Inquiry (FSI) reported in late 2014. We had been keen to wrap up this recommendation alongside the international reforms we had hoped would emanate from the Basel Committee well before now. Once the Basel Committee’s deadline was missed, we indicated we didn’t think it appropriate to wait any longer to respond to the FSI.

So as you know, in July this year we set out our assessment on how much APRA’s minimum capital requirements would need to be strengthened for the banking sector to have capital ratios that would unquestionably be considered strong. For the major banks, for example, we flagged that we intended to increase their applicable capital requirements by 150 basis points, with a view to having them operate with a Common Equity Tier 1 (CET1) capital ratio of at least 10.5 per cent. For smaller ADIs that don’t use internal models to determine their capital requirements, the increase in minimum CET1 requirements will be less – in the order of 50 basis points. And we set out our expectation that these new benchmarks could be achieved in an orderly fashion by the beginning of 2020, if not before.

This announcement was designed to give the industry greater clarity as to the ultimate destination, and the time they had to reach it. What we haven’t done yet is identify exactly which parts of the capital framework we’ll adjust to deliver this increase. The adjustments – which we plan to say more about around the end of this year – are expected to accommodate domestic measures to target residential mortgage lending – about which I’ll comment more shortly – as well as changes eventuating from (we hope) the finalisation of the outstanding Basel III reforms.

I think our information paper was fairly well understood, but there’s possibly still some uncertainty about the impact of the future changes, and whether this will mean, for example, more capital might be required beyond that needed to meet the 10.5 per cent benchmark. That’s not our intent. If a major bank has sufficient dollars of capital to be above the 10.5 per cent benchmark under the current capital framework, we expect that – all other things being equal – it will have sufficient capital to meet whatever new requirements we implement.

However, its reported capital ratio may well change. When we change measures of capital and risk weights, we’re effectively using a new measurement system. A bank’s underlying position doesn’t change, even though the measure used to signify it generates a different ratio. The best analogy I can offer is when I switch from measuring my height in inches to centimetres: the number I report is larger but I haven’t gotten any taller. So as we revise the measurement of capital, it’s possible that the 10.5 per cent benchmark for the major banks may also change. But what’s important to remember is that that is primarily a difference in the units of measurement, rather than a change to the underlying capital requirement.

Housing lending

In thinking about where and how we allocate increases in capital requirements, we’ve flagged that at least some of it will be generated by addressing the risk in housing loan portfolios. There are two inter-related aspects to this: risk sensitivity (ensuring higher risk lending has appropriately higher capital requirements) and concentration risk (dealing with the dominance of housing lending on the balance sheet of the banking system). That shouldn’t be taken to imply that there will be a dramatic increase in capital requirements for housing lending. But housing is an obvious place to start in delivering stronger capital ratios.

Having said that, we don’t see more capital as the sole means to build resilience in bank balance sheets. We are spending just as much time on the quality of lending, and reinforcing sound lending standards. We do so for good reason. Done well, housing lending can be an important source of stability to bank balance sheets in times of stress. Overseas experience shows us what can happen when done poorly.

Here I’d like to like to make a distinction that will be important for our work in 2018: oversight of lending policies, and scrutiny of lending practices. For credit standards to be genuinely raised, both need attention: policies should be strengthened where needed, but they also must be genuinely put into practice.

Prudent policies

APRA’s oversight of lending policies has involved several steps. We’ve sought assurances from Boards that they were actively monitoring their credit standards. We’ve collected more granular data. We issued industry guidance on prudent mortgage risk management. As the risk environment continued to elevate, we took the somewhat unusual step of establishing specific benchmarks for investor loan growth and interest rate assumptions in serviceability assessments. Earlier this year, we added an industry benchmark on interest-only lending.

Overall, we see these measures as having a positive impact. We’ve seen serviceability assessments strengthen, investor loan growth slow and high LVR lending reduce. New interest-only lending has also fallen, and appears on track to fall below our benchmark later this year. All of these moves are strengthening the quality of banks’ home loan portfolios, in an environment that continues to be one of heightened risk.

Prudent practices

However, firmer lending policies are one thing. What if they aren’t always followed? We’ve therefore looked harder at actual lending practices, seeking additional assurance that tighter loan policies are actually translating into more prudent lending decisions. While the review process is not yet complete, APRA has three core expectations in this area.

  • Firstly, it’s important that lenders accurately assess borrower income and living expenses. Living expenses, in particular, are difficult to measure, and so banks often utilise benchmarks as a proxy where borrower estimates appear too low. In fact, our recent work showed the lion’s share of loans by the larger lenders are assessed using expense benchmarks, rather than the borrower’s own estimates. There is nothing wrong in principle with using benchmarks, provided they aren’t seen as a substitute for proper inquiries of the borrower about their expenses. Benchmarks also need to be genuinely representative, incorporate a degree of conservatism, and responsive to a changing external environment. We still see scope for improvement here.

  • Secondly, a lender should have robust controls to check for information on borrowers’ pre-existing debts, to ensure that all debt repayments are accurately factored into loan assessments. Here, the industry has been slow to adopt positive credit reporting, creating a blind spot in terms of sound credit assessments. A move to positive credit reporting is needed to mitigate this shortcoming.

  • Finally, there should be effective oversight to ensure that lending practices consistently meet standards, with close management of any policy overrides, and well-targeted assurance processes. Stronger policies mean little if they can be overridden, or if data deficiencies mean compliance with policy cannot be fully monitored.

As I’ve made clear before, APRA’s supervision isn’t about managing conditions in the housing market or house prices; we have a simpler goal of ensuring that core standards stand up to scrutiny, both in policy and in practice. Given the environment that we are in – high house prices, high household debt, low interest rates and subdued income growth – that scrutiny won’t lessen any time soon.

Banking Executive Accountability Regime

I’d like now to turn to the package of measures announced by the Government in the budget to improve accountability in the banking system – now fondly known as the BEAR.

APRA has long had an interest in establishing appropriate accountability frameworks for regulated institutions. Tools to promote this are the standard fare of prudential regulators, and already exist within the Banking Act 1959 (for example, the power to remove and/or disqualify individuals from their roles) and our own prudential standards (in terms of requirements in relation to governance, remuneration and the fitness and propriety of individuals).

Therefore, the BEAR can be seen as a strengthening of the existing prudential framework. Although there are a range of new elements, it is not new territory.

Our existing regime – seen as overbearing (no pun intended) when it was introduced – would now be seen internationally as somewhat limited. APRA has therefore been providing input to Government on the overall design of the BEAR. Changes to the Banking Act will set out the overarching framework, to ensure that it achieves the Government’s objective that the BEAR has ‘teeth’, but it will then be up to APRA to implement the framework through our supervision process. It will also necessitate consequential changes to our supporting prudential standards.

Given the legislation is still being drafted, it is difficult to be precise about how the new regime will work. But the core objective – establishing clearer accountabilities for, and expected standards of behaviour by, senior executives within banks – is difficult to argue against. Indeed, once the new framework is put in place for banks, APRA intends to think about whether some of the concepts within the regime have broader application.

There have been questions raised about whether aspects of the new accountability regime will change the nature of APRA supervision. While our supervisory approach is always evolving, we intend to remain a supervision-led regulator, working to prevent problems rather than simply wait for them to happen and find fault after the event.

If we are successful in that approach, the new powers granted to APRA should only need to be used rarely. That should not be interpreted as saying we would be reluctant to use them. But the goal must be that, with clear boundaries and obligations set out by the regulatory framework, Boards and executives conduct their affairs in such a manner that intervention by APRA is not needed. It is a much better outcome, for example, that Boards hold their executives to account for poor outcomes than have to rely on the regulator to do it for them. My observation is that this has been the experience in the UK, where a similar regime is already in place. Although there are strong powers for regulators if and when needed, the industry has responded by adjusting the way it operates so that the need for regulatory intervention has been quite limited.

Concluding remarks

The three topics that I’ve talked about today are ultimately focussed on one underlying purpose: strengthening the resilience of the banking system. Whether it is in bank capital, the quality of loan portfolios, or promoting better governance and accountability, the objective is to ensure banks are well-governed, prudently managed, and financially sound. Banks that have these characteristics are most likely to meet the needs of the Australian community, through good times and times of adversity. So we see APRA’s ongoing intensive efforts in all these three areas in the year ahead as a very necessary investment for us to make.

The Australian Prudential Regulation Authority (APRA) is the prudential regulator of the financial services industry. It oversees banks, mutuals, general insurance and reinsurance companies, life insurance, private health insurers, friendly societies, and most members of the superannuation industry. APRA currently supervises institutions holding around $9 trillion in assets for Australian depositors, policyholders and superannuation fund members.