John Laker, Chairman - Customer Owned Banking Association and AM Institute Convention, Melbourne
Perhaps we are all a little jaded from living under the clouds of the global financial crisis for so long. Previous Conventions had a theme that was always positive and ambitious ― you will recall ‘Optimism and Opportunity’, ‘Building our Advantage’, ‘Exploring New Territories’. I would then rain a little on your parade by warning of the dangers of unbridled ambition and uncharted territories and, in recent years, cautioning that the crisis had further rounds to run. I may have over-achieved! This year, the theme is just ‘Mutuals 2013’. It has a simple and sober ring to it, quite appropriate for these times. But I can’t resist my usual caution. As the recent fiscal dramas in the United States remind us, the clouds have not rolled away fully.
A final address is an opportunity to look back at how the mutual movement has evolved over the past decade. And to look ahead to the challenges facing mutuals. In an environment, now, characterised by low interest rates and an economy adjusting to the coming end of the resources boom.
Mutuals over the past decade
What a remarkable period the last decade has been for authorised deposit-taking institutions (ADIs), mutual or otherwise! From the highs of the final years of what has come to be known as the ‘Golden Decade’ or the ‘Great Moderation’, when inflation and interest rates were at generational lows, global funding markets were flush with liquidity, confidence was high, and Australian households borrowed enthusiastically to purchase homes and investment properties. To the lows of the global financial crisis, and periods of severe global market turbulence in 2008 and 2009, which jolted consumer and business confidence and brought the Australian community’s seeming love affair with debt to an end. To the more recent period of slow and steady grind, as ADIs came to terms with continued consumer and business caution, low credit growth and intense competition in both lending and deposits.
Mutual ADIs have emerged from this period, and what was no doubt a very unsettling experience during the worst of the crisis, in solid shape. As a sector, mutual ADIs have continued to grow balance sheets sensibly, earn good profits (around $450 million in 2012/13) and maintain healthy capital positions. No mutual ADI failed during the crisis and no mutual ADI breached any of APRA’s key prudential requirements. A record to be proud of and one that mutual movements in other countries must envy.
Let me fill in some details. To provide context, the mutual ADI sector has changed in numbers and shape over the past decade. Consolidation has seemed an inexorable process, although it has slowed in the last couple of years. From a total of 187 at the end of June 2003, the number of mutual ADIs has fallen to 102 over the decade. This latter number includes nine mutual banks ― a term that did not exist before 2011 ― after these ADIs passed APRA’s longstanding ‘substance’ test for bank status. The driving forces for consolidation have included the gradual breaking-down of the ‘common bond’, difficulties facing small mutuals in
maintaining board and management bench strength, and the pressure of competition. Along the way, names like The Scallop Credit Union Cooperative and The Breweries Union Credit Society have gone.
The mutual ADI sector has, you might say, bulked-up over the decade. In 2003, the largest mutual ADI had assets of $2.95 billion or around 0.20 per cent of total ADI assets; a decade later, the comparable figures are $8.75 billion or 0.23 per cent. In 2003, the smallest mutual ADI had assets of only $0.1 million; a decade later, that figure is $3.5 million. As a percentage of total ADI assets, the smallest mutual today is ten times the size of the smallest mutual a decade ago. The sector has also consolidated at the top. In 2003, the largest 10 mutual ADIs accounted for around 47 per cent of total mutual ADI assets and that figure is now 61 per cent.
At this point, let me nail a myth. From time to time, we hear grumbling that APRA has an agenda to exit small ADIs. I thought I had debunked that notion in my address to credit unions in 2004. I said then that APRA does not have a view about the ‘right’ size of the credit union industry or the ‘right’ number of credit unions. In my words, ‘APRA accepts the cards dealt to it by the workings of the market place.’ That remains our view. Yet the grumbling continues. We want, as you do, a vibrant and healthy mutual ADI sector made up of well-capitalised and well-managed mutuals that can ‘punch their weight’ in a tough competitive environment. A sector that also provides room for smaller ADIs that have found their competitive niche. At the same time, we do not shirk from difficult conversations with the Board of an ADI whose strategy and performance have left the ADI in the position where its members’ best interests would be served through its orderly exit from the industry.
The destiny of each mutual ADI is, fundamentally, in the hands of its Board and members. And can I suggest there may well be a correlation between Board renewal and pressure to consolidate. APRA’s prudential standard on governance promotes Board renewal to ensure a Board ‘…remains open to new ideas and independent thinking, while retaining adequate expertise.’ In our experience, Boards that do not renew themselves become too entrenched and comfortable with the status quo, do not accept change or challenge easily and become strategically ‘stuck’, unable to adapt to changing circumstances. An inability to alter strategic direction when needed will inevitably see the viability of the institution erode over time and the institution pushed into the exit lane. As you know, APRA has spent a lot more time with ADI Boards over recent years, certainly since the crisis began.
And one aspect of Board performance our supervisors are keen to test is the Board’s openness to new ideas, its ability to see when change is needed, and its confidence in challenging previous assumptions about how best to take its institution forward.
I have already made reference to a tough competitive environment. Tough on both sides of a mutual ADI’s balance sheet, in bringing on quality assets and raising retail deposits, even with the strong deposit franchise you have built over many years. At the moment, there is a strong public spotlight on competition in housing lending, which has become the ‘bread and butter’ business of mutual ADIs ― 90 per cent of gross loans and advances ― and the primary source of balance sheet growth. Some in this audience will recall when personal lending was the traditional motivation for credit unions and had double the share of housing lending.
Despite the ambitions expressed in previous Conventions themes, the market share of mutual ADIs in housing lending drifted downwards for much of the decade, from 5.6 per cent of total ADI housing lending to a low of 4.6 per cent three years ago. Taken on its own, this is a ‘glass half empty’ view. The ‘glass half full’ view is that housing lending has continued to generate good business for mutual ADIs and the market share of this sector has risen and steadied at just below five per cent over the past three years ― no doubt helped by active advertising campaigns. More to the point, though, this is not a market share exercise. What should matter most to mutual ADIs is the quality of the housing lending they are writing. Pursuing market share by mis-pricing risk, lowering credit standards or taking on borrowers that more prudent lenders have rejected would be short-sighted in the extreme. I will come back to this issue later.
By resisting such temptation, the asset quality of mutual ADIs has remained a source of strength. That said, the non-performing loan ratio did move upwards in more recent years, consistent with a broader industry finding that loans taken out in the final years before the crisis, when lending standards were weaker, were experiencing higher rates of impairment than in more recent lending. The ratio now appears to have stabilised, but asset quality must continue to be monitored and managed carefully.
Two other points of strength for the mutual ADI sector over the past decade stand out. Firstly, the sector has continued to enjoy solid profitability. There have been ups and downs in profits, particularly during the more intense phases of the global financial crisis, but even then there was very little red ink. Nonetheless, recent figures suggest it is difficult to achieve profit increases year after year, which had become the expectation and an easy performance target to meet in the heady days before the crisis. Declining net interest margins and low volume growth have been behind a downward trend in return on assets for mutual ADIs. Older hands, again, may be ruing the loss of higher-margin personal lending which, for various reasons, has moved to other parts of the marketplace.
Secondly, mutual ADIs have remained very well capitalised. The Tier 1 Capital ratio has been rising steadily over the past decade; it currently stands at around 16 per cent and the Total Capital ratio at around 16.7 per cent. The mutual ADI sector has a substantial buffer of high-quality capital above APRA’s prudential requirements to cope with financial stress, whatever its source.
This robust capital position has meant that introduction of the new Basel III capital framework has been stress-free for mutual ADIs. I told you so, two years ago! Mutual ADIs easily passed the first implementation milestone on 1 January 2013, when APRA introduced the new global minimum requirement for Common Equity Tier 1 (after regulatory adjustments) of 4.5 per cent of risk-weighted assets, the minimum requirement for Tier 1 capital of six per cent and for the Total Capital ratio of eight per cent.
On current holdings, mutual ADIs will also easily pass the second milestone on 1 January 2016, when the new capital conservation buffer comes into effect. This will take the minimum requirement for Common Equity Tier 1, including the new buffer, to seven per cent.
For this audience, the one piece of unfinished business in the Basel III capital framework has been the design of capital instruments that might be issued by mutual ADIs. Basel III requires that, to be eligible as regulatory capital, non-common equity capital instruments must be written-off or converted to ordinary shares if relevant loss absorption or non-viability provisions are triggered. As we know, conversion into ordinary shares is not an option for mutual ADIs. We have been working with mutual ADIs, the Customer Owned Banking Association and the Australian Securities and Investments Commission on an approach that would be practical to implement, consistent with the intent of the Basel III reforms and, at the same time, consistent with the mutual corporate structure. We released a specific proposal two weeks ago that we believe meets these tests, and we welcome your feedback. We would like to put this matter into the ‘out’ tray.
APRA’s messages over the decade
My reminiscing about the decade has led me to look back at my addresses to past Conferences. As you would expect from a prudential regulator, the key messages have been all about governance and risk management, credit risk management in particular. The messages are enduring. It is as critical today as it ever was that Boards and management of mutual ADIs ensure that the lending standards and credit assessment procedures of their institution are rigorous and in line with industry ‘best practice’. As the crisis experience abroad showed so forcefully, credit decisions can appear to reward institutions for a time but haunt them for many years thereafter.
The crisis has indeed sharpened APRA’s focus on governance and risk management. The crisis exposed serious shortcomings in these areas in financial institutions abroad, and in their underlying culture and ethics, that led to substantial losses and failures. That has not been Australia’s experience but we cannot rest on our oars. APRA will be pushing for continued improvement in these areas across all our regulated industries.
Let me refresh the messages here. APRA wants strong and effective Boards with appropriate expertise, diligence, prudence, transparency and ― very importantly ― independence of thought and from vested interests. What is a strong and effective Board? It is one that:
- sets the strategic direction for the institution, identifying its competitive advantages and addressing challenges;
- establishes a clear risk appetite statement that is embedded in the operations of the institution;
- is empowered and confident to challenge management and key business areas constructively; and
- sets the tone for the risk culture of the institution.
APRA also wants a strong, independent risk management function. One that covers risks across the whole institution and has the stature, skills and authority to ensure risk-taking remains within the Board’s risk appetite. As you know, we are intending to reinforce our supervision in this area by a harmonised risk management standard and enhanced governance standard, which inter alia will set out our expectations for a board risk committee and chief risk officer. The standards capture what has become ‘best practice’ in this area in the Australian banking system, and globally.
Not everyone has warmed to our intention to raise the bar on governance and risk management. We had a spirited response, for example, from the Customer Owned Banking Association. We welcome this feedback. As a principles-based prudential regulator, we are no more attracted to a ‘one size fits all’ approach in our behavioural prudential standards than you are. We are taking the feedback on board and considering how the circumstances of smaller, less complex institutions can be accommodated in the standards. That said, APRA is strongly committed to seeing more robust risk management frameworks embedded in our regulated industries.
And one new message ― on technology. Technology has been fundamentally reshaping the way customers access banking services over the past decade. Consider the evolution from telephone banking to internet banking and now to the smart phone. The ability to offer these new services is determined by access to the underpinning technologies, and by the capability to manage the associated risks effectively.
A significant number of mutual ADIs rely on select IT service providers and off-the-shelf software vendors to meet their IT needs. APRA has had a bit to do with these providers over the past decade ― a co-operative relationship, not a supervisory one, it must be stressed. These IT arrangements provide access to a scale of resources, skills and technologies, and to a more mature and robust level of IT management and controls, that some mutual ADIs could expect to achieve on their own.
However, outsourcing is not a set-and-forget model and APRA expects active and ongoing engagement between institution and provider. The IT arrangements have worked well but they could be improved ― in areas such as formal performance reporting and oversight, clarity in roles and responsibilities, disaster recovery capability, and vigilance on cyber crime.
A word of encouragement here. Think strategically about the use of technology and the role of service providers. And central to your strategic vision must be the effective management of risks in the technology environment and continual investment in IT systems to maintain their health and security controls. As additional electronic banking services and channels are offered, security vulnerabilities arise and there will be a need for real-time, 24 by 7 monitoring and response capability. Close collaboration with your key IT providers will be essential.
Enough looking backwards, let’s look ahead.
The outlook is reassuring. The operating environment for the ADI industry is currently more settled than it has been for some time. Recent US fiscal dramas aside, the global context is more positive. The Australian economy has been growing at a relatively steady pace, although labour market conditions are a little more subdued. And official interest rates are at their lowest for more than 50 years.
In the short-term, this outlook bodes well for mutual ADIs with their substantial housing loan portfolios. Low interest rates reduce interest payments and facilitate faster repayment of principal on existing loans. As monetary policy does its job, low interest rates will also stimulate demand for new lending. There are already encouraging signs in housing loan approval data and consumer and business confidence indicators.
But, of course, things could play out differently. A sustained period of low interest rates can mask the creditworthiness of borrowers, and the combination of keen borrowers and buoyant housing markets can be temptations to brake the shackles of low volume growth and lend aggressively. If the benefits of low interest rates are to prove enduring, it is essential that ADIs, mutual and otherwise, maintain prudent lending standards and a clear understanding of borrowers’ circumstances and their capacity to service debt. Low interest rates can also encourage a ‘search for yield’ to compensate for lower returns from traditional investments and other activities. Such a search should not take ADIs into new markets or activities without robust due diligence and appropriate risk management.
Housing markets have been heating up in some capitals and, no doubt, temptations may be growing. Let me help you to resist their siren song! And how might that song sound?
(i) Low interest rates are here to stay
A courageous forecast! Markets may be expecting low interest rates to last for some time. However, interest rates have a cyclical pattern and when Australia’s economic circumstances require, they will rise. For that obvious reason, it is critical that mutual ADIs carefully test debt serviceability to ensure that borrowers who enter the market now do not come under stress when interest rates ultimately rise. Last year, a number of mutual ADIs and their external auditors took part in a targeted review of loan serviceability policies of the main housing lenders. The review confirmed that the ADIs surveyed all provide for a ‘buffer’ against interest rate increases. However, not all apply an interest rate floor. Applying a floor, based on the average mortgage rate over at least one interest rate cycle, would ensure that the buffer used is adequate if interest rates were to rise rapidly. It would be simply imprudent to base serviceability assessments on current interest rates (even with a buffer) for loans that could run for up to 30 years.
It is a pleasure to give this keynote address to your 2013 Convention. This is the eighth time I have addressed gatherings of mutuals, and their evolving industry associations, since I took the helm at APRA a decade ago. In the true spirit of Board renewal, it will be my last!
In the current low interest rate environment, mutual ADIs should also be cognisant of open positions they have taken when looking at fixed-rate deposits and loans, and associated hedges. Are these positions within your risk appetite?
(ii) Our results tell us we have good lending practices
Beware ‘short-termism’ in thinking! The objective must be to achieve sustained profitability by maintaining asset quality over time. Again, careful serviceability assessments are critical. These assessments have moved well away from conservative rules of thumb like the ‘30 per cent rule’ to more complex models that build in cost of living expenses, generally estimated using published indices. These indices are calibrated to reflect the required expenses for a basic standard of living. Be careful to ensure that these indices are reflective of the circumstances of your borrowers. As a simple test, ask yourselves whether you could live on the living expenses that are estimated in your models while paying off a large mortgage. We would expect serviceability models, at the least, to incorporate margins on cost of living indices but, ideally, to reflect the actual living expenses of borrowers.
(iii) We need to take more risks to improve profitability
The warning lights should be flashing! Mutual ADIs are in the risk-taking business but APRA expects you to take sensible and measured levels of risk, within your risk appetite. Declining net interest margins, high levels of prepayments and lower yields on investments are, we know, creating pressure to search for new sources of profit. That search might take you into riskier types of lending, new channels of origination, or into regions or markets not familiar to you. A prudent Board would want to understand fully the nature of the risks being presented, the potential losses that could be involved, the skill-set and resources needed to manage the risks, and whether the institution’s current risk management framework is up to the task.
One area of higher risk that APRA is monitoring closely is high loan-to-valuation ratio (LVR) housing lending. You may be aware that the Reserve Bank of New Zealand has placed speed limits on this type of lending in their market. We are keeping our powder dry on that option but we will take supervisory action if an ADI is skewing its housing loan portfolio too heavily in favour of high LVR lending. We are also monitoring interest-only lending to owner-occupiers more closely, so that we can understand whether this is sensible lending or a speculative play by the borrower.
Transferring part of the risk to lenders mortgage insurers (LMIs) does not negate your responsibility to maintain the quality of the lending book and to ensure that all the terms and conditions of LMI policies are met. Just as you would not accept a lending policy that says serviceability does not matter as long as there is sufficient security, you should not accept a lending policy that says security values do not matter as long as there is lenders mortgage insurance.
(iv) No need to worry as we know our customers
True, but …! Some in this audience may remember the notion of ‘name lending’ ― when lenders appeared less worried about the fundamentals of credit assessment and were happy to lend on the basis of someone’s reputation and the potential to do future business. You will also remember what happened to many of the high-flying ‘names’.
This reference may seem remote to mutual ADIs, whose strength has been built on close relationships with your customers as your owners! With your strong industrial or community roots, you do know your customers. But there is a point of principle here. When housing markets heat up and your customers are being courted by competitors, remain objective in your credit assessments and make sure you also stay on first name terms with your customers’ financial circumstances. Knowing the customer is not a mitigant to poor repayment capacity and/or security. The risk management framework should ensure that when a loan is approved outside policy, for name or whatever reason, that decision is clearly documented, is within delegated lending authorities and is captured in regular override/exception reporting to management and the Board. Our targeted review identified this as an area for improvement.
Some final thoughts
And what of prudential regulation? Prudential regulation has taken APRA and mutual ADIs on quite a shared journey over the past decade and the topic has filled many pages of my previous addresses. Governance, fit and proper, Basel II, Basel III. The debates were animated at times and the implementation tasks not always easy, but our collective efforts have helped in building robust prudential foundations for the Australian financial system.
The journey is now reaching a rest stop. Aside from some unfinished business in Basel III capital and liquidity reforms, which will have limited impact on mutual ADIs, APRA’s ‘to do’ list relevant to you has only one main item on it. And that is a simplification and streamlining of our prudential framework for securitisation which, we believe, will help to encourage the re-emergence of this important funding market.
And that is a positive note on which to end! It has been a remarkable decade for the mutual movement. The external environment, unpredictable at times, has thrown up challenges and opportunities. That won’t change. Competition pressures have been tough, and that won’t change. But, throughout, the mutual movement has continued, confidently, to offer a unique value proposition to its customers. This owes much to the commitment, enthusiasm and, if I may say so, the passion of members of this audience, and the societies they represent, for the cause of the mutual movement. And I know that won’t change, either! I wish you all the best for the future!