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Redesigning financial regulation: do we have all the necessary ingredients?

Tuesday 22 February 2011

Wayne Byres, Executive General Manager - RACV Club, Melbourne

Good afternoon everyone. It is a pleasure to have been invited by CEDA to speak at an event such as this, and to join two such distinguished speakers in talking about what is a very important topic. When I was invited to speak today, CEDA asked me to reflect on a two-part question:

  • what initiatives are required to fix and avoid past errors?


  • what initiatives are now required to ensure stable financial markets and sound regulatory processes in the future?

Now that the worst of the crisis appears to be behind us – albeit that the clean-up in many countries will be protracted and painful, and we can't discount the possibility of further significant volatility – the latter question is clearly more important than the former. But on the basis that those who cannot remember the past are doomed to repeat it, let's first consider what's been done to try to avoid a repeat of recent years. Before doing so, however, let me stress that my comments should be viewed in an international context: they refer to the international experience of the crisis, and to the shortcomings of the global regulatory framework. The Australian experience has been a little different, and I'll make reference to issues closer to home towards the end of my remarks today.

Responding to the past

Perhaps needless to say for a crisis of the size of the GFC, there was no single cause. Rather, a combination of factors came together - gradually and subtly - to create, and compound an increasingly unstable and unsustainable situation. Broadly speaking, these factors were:

1. Misaligned incentives. These were primarily created in the private sector (eg rewards for volume rather than quality of loan underwriting), but some emanated from the public sector too (eg incentives to provide finance to those who had previously been, and in many cases still were, unable to afford it).

2. A failure of market discipline. Markets failed to keep the incentive-encouraged poor behaviour in check: even with incentives to write poor loans, they could not be written in such huge volume unless investors agreed (due to ignorance, greed, and the opacity of structures) to keep funding them.

These two failings allowed the heart of the problem – poor credit underwriting standards – to take root.

3. Weak regulation. Regulation did not manage to fill the gap create by the absence of market discipline; indeed, in some areas effective regulation was dependent on market discipline working. Amongst other things, global minimum capital requirements were set too low, and global liquidity requirements were non-existent.

4. Poor supervision. Notwithstanding (or perhaps because of) the weaknesses in regulation, many supervisors did not detect - or if they did, chose not to act on - the build up of risks in the system.

5. The absence of robust bank resolution regimes. This was certainly not a cause of the crisis, but there is no doubt that the inability of regulators in many jurisdictions to remove a bank from the system in an orderly fashion exacerbated the crisis when it was near its peak.

So, in examining the regulatory response to the crisis, our first step should be to see how well we have responded to these five factors.

Most obviously, there has been a major reform of the regulatory framework for banks. The simple term 'Basel III' belies the breadth and depth of the regulatory reform initiatives. Given the time available, I won't say too much more about Basel III, other than to outline its key features:

  • a substantial increase in minimum capital requirements (minimum equity requirements are being increased by a factor of 3-4x in many countries);
  • a considerable strengthening of the quality of capital (which has the effect of increasing the minimum requirement even further);
  • introducing a formal corrective action regime into the capital framework (in the form of the capital conservation buffer);
  • introducing a macroprudential component into the framework (in the form of the countercyclical buffer);
  • introducing a simple leverage ratio as a backstop to the risk-based regime; and
  • (last, but definitely not least) introducing the first global liquidity and funding standards.

It is, by any measure, a substantial set of reforms which will significantly strengthen the financial soundness of the banking industry. APRA is committed to implementing Basel III in Australia, at least as quickly as the international timetable provides for.

But with all the focus that is currently on Basel III, it is important to ask what else is happening, since we can't and shouldn't rely on capital and liquidity regulation as a panacea for all ills.

Supervisors are now putting much more effort into the development of recovery and resolution plans (or so-called "living wills‟) by banks. These plans force banks to face up to the potential for their own demise, and to ensure their break-up and wind-down can occur in a (relatively) orderly manner. Banks that are unable to demonstrate such a plan face higher prudential requirements, or even potentially forced restructures.

But recovery and resolution mechanisms are not just being left to the banks. Policymakers are, for example, examining the merits of so-called bail-in mechanisms for senior debt holders. Bail-in would operate in a similar fashion to a debt-for equity swap: at times of extreme stress, the bank could be recapitalised by writing down, in full or in part, the claims of certain debtholders and providing them with equity as compensation. Clearly, the mechanics of such an arrangement are complicated to make work correctly, and there are a range of potential consequences that need to be carefully thought through, but this concept is certainly on the work agenda of international policymakers at present.

Higher requirements for capital and liquidity, plus recovery and resolution plans and bail-inable debt will all go some way to reducing the risk of failure and the need for taxpayer support. But they cannot guarantee that failure cannot occur, so work on failure management powers for supervisors and resolution regimes for banks also remains a high priority reform initiative. Many countries are rethinking both their deposit insurance and resolution regimes, with major shortcomings identified during the crisis. In a number of countries, for example, deposit insurance did not serve to prevent a run on a bank, as it theoretically should. Depositors felt, quite naturally, that it would be better to have their cash now than rely on any scheme that did not guarantee immediate and seamless access to their money. Supervisors also found themselves without an adequate legal framework for the orderly closure of a failed bank, particularly where that institution operated across national borders. So work in both these areas is on-going to see how these shortcomings can be addressed.

The GFC highlighted clear deficiencies in remuneration practices and incentive arrangements within the financial sector. As I have noted in other fora, some incentive structures delivered substantial rewards to managers that have not reflected returns to shareholders. In some cases, taxpayers have been forced to bail out failing banks, only to see the bailed-out bankers continuing to receive substantial bonuses. Clearly, this quickly becomes an untenable situation politically.

Ideally, the finance industry would have reflected on its own shortcomings and produced sensible and sustainable remuneration practices for the future. But no one felt this would occur and so regulators felt the need to step in. And while perhaps more difficult to engineer than a change to global capital and liquidity standards – it will be more evolutionally than revolutionary – I don't see any reluctance amongst international regulators to achieve changes to remuneration practices.

Market discipline has also been recognised as an area for improvement in the reform agenda. Disclosure requirements are being increased. And regulators are also discouraging a blind and unquestioning adherence to the opinions of rating agencies. At its extreme, the Dodd-Frank Act requires the US regulators to remove all references to rating agencies from their regulatory framework. Elsewhere, the response is less severe, but directionally the same. The objective of this work is to promote sound credit analysis by investors, by reducing or removing incentives within the regulatory framework for the use of ratings as a substitute for proper risk assessment.

As for the final contributor to the crisis that I mentioned earlier – poor supervision – it is harder to detail specific improvements. There is no doubt the quality of supervision has been recognised as an important issue to be addressed in the aftermath of the crisis.[1] But the quality of supervision is extremely difficult to define and measure, and therefore it has been difficult in the response to the crisis to recommend specific supervisory responses, other than to urge "more‟ or "better‟ supervision. More to the point, the response to the crisis so far has emphasised rules over improved supervision, partly on the basis that it is difficult for countries to police each other‟s supervision of their financial institutions, whereas consistent rules are relatively simple and transparent to observe. (And making a rule is relatively costless to government budgets, whereas new supervisory resources have a clear bottom line impact.[2]) Overall, this area can probably best be described as still work in progress, and I will say more about it shortly.

So a lot has been done to strengthen the regulatory system in the face the shortcomings that the financial crisis revealed. From an Australian perspective, we do not see there are any major deficiencies within the regulatory framework that require major domestic policy initiatives over and above that which is being driven internationally. But, of course, the generals are always said to be ready to fight the last war: the real question is whether we are ready to fight the next one?

Preparing for the future

The difference between a problem and crisis is often the time you have before it arrives. If Brisbane had had four months notice of its recent flooding, rather than four days, there‟s no doubt the city would have been more prepared and the damage from the floods would have been reduced. Financial crises are, almost by definition, hard to see coming. Obviously, if we saw them coming well in advance, the authorities could act to reduce their likelihood and impact.

So in asking whether we are prepared for the future, we need to ask about what sorts of crises might challenge us. On the one hand, banks conspire to lose money quite regularly the same old way: pursuing growth and market share by lowering credit standards. Unfortunately, they often find new means to do it, so it isn't easy in advance to see the same old habits being repeated. And there is always a cheer-squad telling us "this time it's different".

Keynes noted that a sound banker "is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way with his fellows, so that no one can really blame him".[3] More recently and more succinctly, a now ex-banker famously said that "as long as the music is playing, you have to get up and dance.‟ Unfortunately it is rare, in the bullish environment that often precedes a crisis, to hear too many people saying "thanks, but I‟ll just sit this one out‟. That is where prudential supervisors come in. Central bankers are often said to take away the punch bowl just as the party's getting started. Supervisors have a similar role: reminding, cajoling and badgering institutions to hold firm to sound risk management principles and a long-term perspective, despite the seductive music and attractive opportunities that may be on offer on the dance floor.

APRA has long been of the view that good regulation and good supervision go side by side, and that both are necessary for good outcomes. Good supervision, in my view, involves a high degree of judgement. And exercising good judgement, in turn, relies on two key attributes: foresight and gumption.

A large amount of work is going on to improve the foresight of supervisors. This is occurring in both the traditional field of microprudential supervision (i.e. examining the health and resilience of each individual institution via scenario and stress testing, improved data collections, increased focus on market-based information) and in the emerging field of macroprudential supervision (i.e. a more structured examination of the build-up of vulnerabilities within the financial system as a whole).

All of these initiatives are designed to give supervisors more foresight: to understand the vulnerabilities in individual institutions and in the system as a whole, and to identify from which directions, and in what magnitude, the next problems might emerge.

But it's all very well to spot potential problems – we also need to do something about them. Here is where a healthy dose of gumption is needed. The definition of gumption, to me, sums up what every supervisor needs to possess: shrewd practical common sense, spirited initiative, resourcefulness, fortitude and determination. In the years leading up to the crisis, it is clear these attributes did not exist in sufficient qualities within the world's supervisory community. For example, the US Financial Crisis Commission, which recently issued its majority report, found:

"The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public."[4]

Of greater note was the specific criticism of those tasked with supervising the system:

"we do not accept the view that regulators lacked the power to protect the financial system. They had ample power in many arenas and they chose not to use it. …. And where regulators lacked authority, they could have sought it. Too often, they lacked the political will – in a political and ideological environment that constrained it – as well as the fortitude to critically challenge the institutions and the entire system they were entrusted to oversee."[5]

I make these points not to blame the crisis on the failings of US supervisors. These failings would appear to have existed in many jurisdictions. And I certainly acknowledge that they were, a decade ago, the failings of APRA that were highlighted by the HIH Royal Commission. Rather, I wanted to make the point that successful supervision – heading off problems before they become crises – requires courage and conviction. As the International Monetary Fund noted:

"regulatory reform legislation will not be effective by itself and will require on-going vigilance and „the will to act‟ on the part of those tasked with supervising the …. banking system."[6]

The financial system is weakest precisely when it looks at its strongest: when credit is flowing, liquidity is abundant and asset values are high. Standing against the tide in such an environment is difficult: it is often said, and I think it true, that good supervision is most valuable when it is least valued.

In APRA, we view strengthening supervision as just as important as strengthening the regulatory framework. Maintaining an interventionist supervisory culture does not come easily: it requires the right resources, as well as hard work and diligence by the supervisor, a clear and unconflicted mandate, an acceptance by industry of the role good regulation plays, and political support for the job being done. In the post-HIH world, those are things that APRA, thankfully, has not lacked. The G20 Leaders have now endorsed this sentiment.[7]

This is important because, notwithstanding the strengthened regulatory environment, our supervisory mettle will continue to be tested. The likely operating environment at least for the next few years will likely be different to that which existed for more than a decade pre-crisis. The danger will be that not everyone will adapt, or that some will seek to recreate the past, since this will only be able to be done via increasing risk levels. In Australia, we still see instances of ambitious return targets and growth aspirations that don't seem to match the underlying environment. We see instances of banks with business plans founded on market share targets rather than risk-return trade-offs. We see instances of credit standards reduced because to not do so would cede business to a competitor. These are, of course, the workings of a vibrant and competitive market place, but taken too far they are also symptomatic of Keynes' sound banker – if we are ruined, we won‟t be alone. So the supervisor's job goes on, notwithstanding the significant regulatory change.

But in examining the global response to the crisis, and the capacity for the system to respond better next time around, it is important to ask what exactly has been done to strengthen the hand of supervisors more broadly? If they failed to act, or felt unable to act, last time, why will they be able to do so next time around? What has been done to give supervisors a clear mandate, and strong powers? Is there political support for the supervisor's role as chaperone on the dance floor? And even if there is now, what ensures it survives once the music starts up again? There are lots of rule changes being debated and implemented, but it is less easy to see how the role of supervisors is being supported and strengthened. This is something that needs on-going attention in the global debate.

Concluding remarks

Global leaders and international regulatory institutions have spent much of the post-crisis period devising a new regulatory framework to respond to the shortcomings identified by the GFC. But strengthening the rules will not be enough to prevent another crisis. We know that in something as complex and potentially unstable as a modern financial system, no set of rules – no matter how well designed – will be sufficient to contain risk to prudent levels at all times. The mistakes of the past are quite often repeated by the banking industry, but in new ways and in new forms that rule-makers cannot predict. Supervisory oversight – an independent pair of eyes focused on long-term institutional soundness – is also necessary to apply the rules and make judgements about whether risk levels are within community tolerances.

Efforts are being made within the community of prudential supervisors to improve the quality of supervision. At its heart, this needs to support two key attributes that supervisors need to have: foresight and gumption. At this stage, most work is occurring in areas that will improve the ability of supervisors to see crises coming and understand their impact, e.g. the emerging field of macroprudential supervision, and in improved microprudential techniques (e.g. increased focus on stress testing, better data, and a broader focus on market-based information). However, while this will take extra resources and skills to put into effect, the lessons of the crisis are as much about culture and attitude: the key question remains as to whether supervisors have the gumption to do their job as the community expects? If not, then not only will we not be prepared for whatever the future may hold, but we are also destined to repeat the mistakes of the past.

Thank you.



  1. The G20 Toronto Summit Leaders‟ Declaration said "We agreed that new, stronger rules must be complemented with more effective oversight and supervision" (paragraph 20). This led to the issuance of the Financial Stability Board‟s "Intensity and Effectiveness of SIFI Supervision: Recommendations for Enhanced Supervision" in November 2010. That is not to say rule-making is necessarily more cost-effective than employing more supervisors. For example, the Basel Committee‟s Quantitative Impact Study estimated that the world‟s largest banks would need an additional €577 billion of equity, over and above that which they held in 2009, to meet the new Basel III capital requirements. Assuming a cost of capital of 12 per cent, this imposes an additional annual cost on the global industry the equivalent of asking it to fund an extra 800 APRAs!
  2. Keynes (1931) "Consequences to the Banks of a Collapse in Money Values", Essays in Persuasion, Macmillan, London
  3. Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (January 2011), p. vii
  4. Ibid, p. xviii
  5. International Monetary Fund (2010), „United States: Publication of Financial Sector Assessment Program Documentation - Detailed Assessment of Observance of Basel Core Principles for Effective Banking Supervision’, Country Report No. 10/121 , p6.
  6. " … we endorsed the policy recommendations … on increasing supervisory intensity and effectiveness. We reaffirmed that the new financial regulatory framework must be complemented with more effective oversight and supervision. We agreed that supervisors should have strong and unambiguous mandates, sufficient independence to act, appropriate resources, and a full suite of tools and powers to proactively identify and address risks, including regular stress testing and early intervention.", paragraph 33 of the G20 Seoul Summit Leaders‟ Declaration, November 11-12, 2010.

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.