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Reform of Global Banking Regulation

Friday 9 April 2010

Wayne Byres, Executive General Manager - Bond University Symposium, Global Financial Crisis: The Way Forward

Most of you in the audience would be at least occasional readers of Ross Gittins, who writes on matters of economic interest for the Sydney Morning Herald. I'd like to begin today by quoting from one of Ross' articles on the subject of prudential supervision:

'To everyone but the supervisors and the supervised, it's a dull subject. That’s because, in 19 years out of 20, nothing of interest happens. We don't give a second thought to the stability of the financial system because we know it’s stable; always has been, always will be ... But you can see where this story is leading: this is the one year in 20.'[1]

What's notable about this statement is that it's quite prophetic: the quote comes from an article he wrote in 1990, the last time financial system problems put prudential supervision in the public spotlight. Twenty years later and, as predicted, once again prudential supervision is the talk of the town.

Today I propose to talk a little about the case for reform, some of the more important items on the reform agenda for banks, and APRA's perspectives and approach to dealing with them in an Australian context. Our objective is straight-forward: to get the reforms "just right" – not too much, not too little. But that, as I will explain later, is not an easy task.

The Case for Reform in Australia

In Australia, there has been debate about the merits of the international reform agenda, and whether, given the relative resilience of the Australian financial system, such reform is necessary. Maybe, some have suggested, we should have our own Australian versions of the international rules, or even perhaps not implement some aspects of the reform proposals at all?

I‟m sure you are familiar with the story of King Canute. Heaped with praise by those around him, and attributed with great powers, Canute attempted to stop the tides. He knew he would fail, but his purpose was to demonstrate to those around him that while he might appear powerful, there were forces in the world far more powerful than he.

In many respects, the Australian regulatory system at present has a number of parallels with King Canute. Over the past couple of years people have lauded its strengths, and it has been lavished with praise by many, but those of us within it are far more humble about our abilities. In practice, regulators like APRA played their part before and during the financial crisis, but as I will point out later it has also needed extraordinary interventions by the various arms of Government, and a certain amount of luck, to enable us to safely negotiate the past couple of years. I don't think anyone should conclude that, by itself, our regulatory system could hold back the heavy seas that were battering our shore during the GFC.

That said, the resilience of the Australian financial system throughout the crisis is something that we should all be proud of, and thankful for. Our regulated institutions were, on the whole, well managed in the years leading up to the crisis. Our largest and most important institutions have maintained very strong credit ratings. Our regulatory regime, after some scrutiny and soul-searching early in the decade, was substantially strengthened and therefore much better equipped to handle a period of extreme stress when it emerged.

But reflecting the global nature of the financial system, we were not immune from some of the trends that occurred throughout the world. As was the case elsewhere, to remain competitive and improve their returns to shareholders our banks did increase their levels of leverage, until implementing a sharp reversal via substantial capital raisings beginning in late 2008. Business lines and transactions were pursued which, with the benefit of hindsight, some institutions now regret pursuing: thankfully, none of these were such that their folly seriously threatened the viability of any individual institution. And their liquidity planning was probably not as robust as first thought. These trends may have been less significant than in other countries, but they were evident here nonetheless.

And while there is no denying our system did prove relatively resilient to the global financial crisis, let's not forget that there was extraordinary support and intervention necessary to ensure that system was kept stable and the wheels of the economy kept turning:

  • there was an unprecedented fiscal response – the stimulus package implemented by the Federal Government was, relative to GDP, one of the largest in the world;
  • there was an unprecedented monetary response – the Reserve Bank of Australia (RBA) cut the official cash rate by 425 basis points in a little over six months;
  • the RBA also substantially extended its market operations, expanding the list of repo-eligible collateral and lengthening the term for which it would provide funding;
  • ASIC imposed a 8-month ban on the short selling of financial stocks; and
  • at the height of the crisis, the Federal Government initiated a guarantee of retail deposits of up to $1 million, and a facility for authorised deposit-taking institutions (ADIs) to purchase guarantees for larger deposits and wholesale funding out to 5 years.

As a result of these initiatives - along with the underlying support from our favourable terms of trade, and the shock absorber provided by an exchange rate which fell from almost parity with the US$ to US60c (and has now rebounded most of the way back again) - the Australian economy has performed remarkably well. We have a banking system that has remained profitable throughout: the return on equity for the largest banks fell into the low teens from historical highs in the twenties before the crisis, but compared to the red ink elsewhere in the world this is a very positive result.

However, it is impossible to argue this outcome, or indeed anything like it, could have been achieved without substantial public sector support to both the broader economy and the banking system itself. Had we had to deal six consecutive quarters of negative GDP (as occurred in the UK) or unemployment around 10 per cent (as has been the case in the US), the picture for our financial system would have obviously been far less attractive. Indeed, despite its evident strength, we are still dealing today with a banking system in which around one-third of its entire liabilities are subject to a Commonwealth Government guarantee. If all that I have mentioned was needed to keep the system stable and operational, then it is difficult to argue that some further strengthening of the system is not justified.

APRA's position is that it is both pointless and unhelpful to try to stand against the tide of international reform. We are a small, open economy participating in a global financial system, and any attempt to declare independence from the rest of the world will inevitably be counter-productive. Whilstever our banking system is so reliant on offshore funding, it is vital that we are seen to be playing by the international rules of the game. Whatever the merits of the Australian banking system and its regulatory framework, in the midst of the crisis the rest of the world did not distinguish a great deal between our banks and those elsewhere.

In late 2007, during the first wave of the crisis, I recall one bank CFO telling me "it's quite scary when no one will lend to you for more than a few days." The bank concerned was perfectly healthy, and without apparent problems. So we cannot be complacent. While we hope it is some time off before the next crisis emerges, we need to be better prepared. Our task was summed up quite nicely in another quote from the same Ross Gittins article I referred to earlier:

"[Prudential supervisors] are like a student who face one examination every 20 years, but doesn’t know which year it will be. Now they – and we – are face-to-face with the occupational hazard of supervisors: how do you maintain your enthusiasm – your vigilance – for a job which everyone regards as an irrelevance (apart from the supervised who regard it as a pain in the neck)."[2]

The Reform Agenda

So, before prudential supervisors become an irrelevance again, let me turn now to the key components of the reform agenda itself. The key objectives of the proposals are to:

  • strengthen both the quantum and quality of bank capital;
  • supplement this with a non-risk based measure designed to limit absolute levels of leverage;
  • require banks to do more self-insurance against a liquidity shock (either specific to the bank itself, or the system as a whole);
  • work with accounting standard setters to develop a more forward-looking approach to provisioning;
  • develop additional counter-cyclical prudential measures to promote a longer-term perspective and some "saving for a rainy day";
  • consistent with this theme, promote remunerations arrangements which better align reward with risk over a longer time horizon; and
  • establish, notwithstanding all of the above, better mechanisms for dealing with the risks from systemically–important institutions.

I will discuss some of these in more detail shortly, but I might start by saying what the reforms will not deliver: they will not replace the Basel II capital adequacy framework. There has been a lot of finger pointing at Basel II as a contributor to the crisis. But Basel II was introduced in most countries around the world at the beginning of 2008, long after the seeds of destruction had been sown. The US – the epicentre of the crisis – is still to implement Basel II. Basel II has its shortcomings, but it was not a cause of the crisis. Furthermore, Basel II was all about making the measurement of a bank‟s risk profile more sensitive to its true risks. It is strange to suggest – as some have done – that it should be scrapped in favour of some less risk-sensitive measures. The need for better risk measurement by banks and their supervisors must surely be one of the important lessons of the crisis: indeed, the G20 Leaders have urged its implementation for this very reason.[3]

That said, some criticism can justifiably be levelled at the Basel Framework more broadly.[4] Global banks had too little high quality capital. The Basel Framework, at its minimum, only required banks to have the equivalent of 2 per cent of risk-weighted assets in the form of shareholders funds - or to put it another way, each dollar of equity could be geared 50 times. And even then, some of this equity could be potentially represented by intangible assets of limited value.

Clearly this will need to change, and the Basel Committee has recently released a wide-ranging set of proposals to this effect. In Australia, of course, we have had considerably tougher rules on the composition of capital for some time. This has stood our banks in good stead, and means the impact of the reform proposals will be less material for our banks than many others around the world. Australian banks, who have long been arguing for greater harmonisation between APRA's rules and those of foreign regulators, will presumably also be pleased with this development.

Nonetheless the clear message is that, as far as minimum capital requirements for banks are concerned, the only way is up (even from Australia‟s more conservative starting position). Capital requirements – and in particular, equity requirements – for banks will be higher in future. That will be achieved via a range of measures, including higher minimum requirements, tighter eligibility definitions, capital conservation measures and counter-cyclical capital adjustments. And, since the G20 Leaders asked for it, we'll also have a (non-risk based) leverage ratio as part of the supervisory armoury.

It‟s a similar story on liquidity. Globally, the crisis showed up some weaknesses in bank liquidity and funding profiles, many of which were founded on an assumption that apparently deep and liquid markets would not close completely. Australian banks, for example, typically had contingency funding plans that assumed that if they had trouble obtaining funding, they could securitise assets – but, of course, the securitisation market was one of the first to close and is yet to recover. So in the future there will be greater focus on the quality of liquid assets, establishing a longer survival horizon without the need for central bank support, and a greater emphasis on longer-term funding.

Since the introduction of IFRS, provisioning for loan losses has been the source of some angst between prudential supervisors and the accounting standard-setters. The incurred loss approach favoured under IFRS saw banks in Australia substantially run down their stock of provisions during the good times, only to need to substantially rebuild them over the pat couple of years. The Basel Committee is now working closely with the IASB to attempt to develop an approach to provisioning which meets the needs of the accounting standard-setters (current, consistent, objective) and the prudential supervisors (prudent, forward-looking) – this will hopefully produce an accounting regime which eliminates some of the procyclicality inherent in the current accounting approach (which many countries, although not Australia, are obliged to adopt within their prudential framework).

Remuneration is, as many of you well know, also a topic of great regulatory interest at present. The financial crisis highlighted clear deficiencies in remuneration practices within the financial sector. Some incentive structures have delivered substantial riches to managers that have not reflected returns to shareholders. In some cases, the disconnect has been so great that taxpayers are finding themselves footing the bill. As a result, almost the first regulatory cab off the rank from the G20 Leaders reform plan has been new standards on remuneration. The Financial Stability Board (FSB) has produced its Principles for Sound Compensation Practices to guide the debate internationally. APRA was quite heavily involved in drafting the Principles, and as a result our own standard follows them quite closely.[5]

Both the FSB and APRA have tried very hard to make sure we are focussed on the principles of pay structures rather than pay levels. But do not see this as indicating any lack of desire amongst the regulatory world to enforce change. There is considerable regulatory momentum in this area, and I suspect it will continue to be an area of intense scrutiny for the foreseeable future.

Finally, one of the greatest conundrums facing policy-makers around the globe at present is what to do about the "too big to fail" problem. Recent actions by governments around the world, although entirely justified and appropriate for the circumstances, have solidified the perception that the largest and most important financial institutions (and even some non-financial institutions) will not be allowed to fail. This has created major incentive problems.

It is difficult to see where this debate will go from here, other than the status quo is unlikely to remain. In my view, the most likely long-term outcome will be an expectation that, as banks grow in both size and interconnectedness (Lehman was not actually that large in terms of total assets relative to the world's financial giants), tougher prudential standards will be imposed.

In the past, regulators have always given some credit for the stability and diversity that scale can bring to an institution. Under the Basel Framework, for example, the lowest capital requirements were always expected to apply to well-diversified, internationally-operating banks – others would generally need to meet higher requirements. That may no longer be the case. In this new way of thinking, once scale becomes sufficiently large as to be seen as a threat to the stability of the system as a whole, it will increasingly be viewed as a negative rather than a positive, and bring additional regulatory burdens and oversight. In others words, disincentives to scale may be introduced. Compared to taxes and forced break-ups, that might seem relatively modest, but it will mark a fundamental change in regulatory thinking.

Adding National Perspectives to International Reforms

As I noted earlier, when faced with the global reform agenda, some Australian stakeholders have asked "do we need all this?" (and in some cases "do we need any of this?"). In essence, they are questioning whether we have the capacity to stand apart from the rest of the world: can we indeed outdo King Canute?

As I said earlier, APRA does not see any case for implementing a framework which the rest of the world would judge to be weak, or less robust than the international norms – this will involve considerable cost to the banking system and, through it, the Australian community. Australian banks cannot simultaneously rely more than many of their international peers on cross-border funding, and seek to be exempted from some or all of the regulatory reforms applicable to the rest of the world's banks. Our starting point is that our regulatory system needs to be seen to be at least as strong as the international standards provide for. And we expect that, even if we attempted to implement a weaker set of rules, international markets and counterparties would hold Australian banks to the international standards and measures in any event. So we see little value in trying to stand apart from the rest of the world, claiming we know better.

Another concern raised by the banking industry has the possibility of uneven application of the reforms in different countries: if Australia rigorously implements and enforces the reforms, while others pay them only lip service, there will be an uneven playing field. This is a problem with any set of rules, be they remuneration, capital, liquidity or any other. But another of the initiatives to emerge from the G20 Leaders is a greater commitment by countries to submit themselves to peer review.[6] This is designed to make sure that, as much as possible, a level playing field exists between jurisdictions, and to provide additional incentives to countries to implement international standards. In the current environment, I doubt any country will want to be reported as having a weak regulatory framework or to be operating outside internationally accepted norms.

So our first objective is to see effective international standards developed that we can sensibly implement in Australia. We are actively engaged in the Basel Committee's hectic work program.[7] Our objective is to add our insights and ideas into the policy development process, and influence global standards in such a way as to ensure they do not unfairly hinder Australian institutions.

But regardless of the success of that influence, we also acknowledge that no international framework is likely to be perfectly suitable to every single country to which it will apply. History tells us that, whatever the final form of the agreed reforms, some tailoring will inevitably be necessary around the globe. So it is worth saying some words about how APRA might go about applying any national discretion in Australia.

In addressing this issue, there are three types of national discretion available to us:

  • The first is common in international standards: a choice, usually on narrow technical issues, that the standard-setting body deliberately and explicitly leaves to the national authority. In these cases, each national authority makes whatever decision it thinks best for its circumstances and, regardless of the decision taken and the options chosen, the country concerned will be seen as in compliance with the international standard.
  • A second form of national discretion is where a national authority seeks to strengthen an international standard to reflect its specific needs.[8] Typically, this might be where additional requirements are added to the „base level‟ international standard, designed to take account of local circumstances. Provided these do not water down the spirit or intent of the global agreement and are intended to strengthen it, the country concerned should still be seen to be in compliance with the international standard.
  • The third form of national discretion needs to be used with much more caution. This is where a country deliberately modifies an international standard in a manner which is not clearly superior (and may possibly be weaker). For a country such as Australia, such an approach is one we use rarely, as we consider the cost of Australia being seen to be materially non-compliant with international standards to be significant.

APRA has in the past utilised all three types of national discretion:

  • Most obviously, the Basel II Framework contained more than 80 explicit national discretions, which APRA had to take a view on as we worked through the domestic implementation phase in Australia. After consultation with industry, we decided which of the available choices made sense in an Australian context and implemented them accordingly.
  • We have also sought to strengthen international standards. APRA has elected, over time, to take a tougher stance on the definition of regulatory capital than the "baseline" Basel Committee requirement implemented in many other jurisdictions, recognising it just as important to pay attention to the quality of capital as to the quantity. Pleasingly, this is a stance the international standard-setters are now adopting too.
  • And, occasionally, we have also diverged from international standards. For example, in our remuneration requirements, we have elected not to adopt some of the more prescriptive limits and caps that have been recommended by the FSB, sticking instead to a principles-based approach.

In all these cases, the decision process involves the same basic question: what makes most sense for Australia, given the costs and benefits involved?

Where Might the Balance be Hardest to Find?

Within the current round of reforms, where do we see the biggest challenges in making sure what is proposed internationally works in Australia?

Broadly, we are supportive of the objectives of the initiatives, but can see plenty of challenges:

  • In the area of capital adequacy, many of the changes being proposed to improve the quality of capital are consistent with the philosophy already adopted in Australia, so the impact will be relatively less here than in many other parts of the world. Higher minimum levels of equity capital are inevitable, but we already have a profitable banking system which is operating with strong capital levels. We therefore expect the new rules will reduce banks' reported capital ratios, but at this point we do not expect the Australian banking system to be found to be short of capital under the new risk-based measures.
  • The leverage ratio will be an interesting development for Australian banks. Our banks tend to operate with relatively high levels of leverage, but this is mitigated by the relatively low risk profile of their balance sheets (driven by large mortgage portfolios). We see limited benefit from a leverage ratio if the risk-based ratio is correctly implemented and policed. Nonetheless, if it is to be introduced, we will need to work with our international counterparts to calibrate the minimum leverage ratio so that it does not act as the binding constraint on normal banks in normal times.
  • In the area of liquidity, there are a number of challenges. It will be difficult to both raise the size of the liquid asset buffer and simultaneously require that buffer to be comprised of the most reliably liquid assets (e.g. sovereign bonds), when those assets are less abundant in Australia than in most other jurisdictions. And the proposed structural funding measure may be more difficult to meet for banks which hold customer assets on their balance sheet rather than originate assets for onward distribution to non-bank financial agents.
  • In the area of remuneration, we have not adopted the prescription evident in some parts of the FSB's guidelines. We are confident that we can achieve sensible outcomes without this level of prescription, although there is a considerable amount of work to do to bed down the new requirements and some institutions will need some time to revise their practices.
  • And we are watching with interest the international work on dealing with systemically important institutions. APRA‟s supervisory framework[9] may be ahead of the game here, as it already directs its greatest intensity to the largest and most complex institutions, by factoring scale into its risk assessment and supervisory response processes. But at this stage we do not have mechanical formulas or prescriptive rules which dictate how increasing systemic importance should be dealt with, allowing instead the exercise of supervisory judgement.

Finally, the biggest of challenge of all will be to assess all of the proposals as a single package, to understand the inter-linkages between the various components, and to assess the overall impact. This challenge cannot be underestimated, given the complexity of what is proposed. Inevitably, a large amount of judgement will be necessary to try to get the reforms "just right".

Concluding Remarks

Let me conclude by returning once more to the Ross Gittins article that I've quoted from a couple of times today:

"Taking an interest in prudential supervision is like watching paint dry. The only audience it gets is the people who take ten minutes to realise that they’re in the wrong room." [10]

The large audience here today presumably reflects something else: a strong interest in the global reform agenda, and an understanding of the impact that it may have on the Australian financial sector, and through it the community as a whole.

The reform agenda set by the G20 Leaders is substantial. From the perspective of the banking industry, APRA and the RBA are at the table of the Basel Committee seeking to influence these reforms, and make sure they address issues of importance to this country. Inevitably, however, there will be aspects of the international standards that are not what we would have created if the task of producing the reforms was left entirely to us. This difference between national and international rules are a cost of doing business in a global system, but there are also costs to a country like Australia if it decides it does not want to play by those international rules.

The latest round of international reforms, given their breadth, will undoubtedly throw up many difficult challenges for APRA in balancing international initiatives with domestic perspectives. Ultimately we will need to balance up the pros and cons, and decide what we think is in Australia‟s best interests. No doubt we'll get lots of helpful advice along the way. But like King Canute, we know we can't stand against the tide, even if we wished to do so.

Thank you.



  1. Gittins, Ross (1990), "Was the Reserve Awake While the Rest of us were Asleep?", Sydney Morning Herald, 25 August 1990.
  2. Ibid.
  3. The G20 Leaders Statement, issued at the conclusion of the Pittsburgh Summit in September 2009, included a statement that "All major G-20 financial centers commit to have adopted the Basel II Capital Framework by 2011"
  4. In its simplest form, there are three components to the Basel Framework: a measure of capital, a measure of risk, and a minimum ratio of the former to the latter. The Basel II reforms which came into force in Australia at the beginning of 2008 dealt essentially with the measure of risk.
  5. Although, as I will note later, APRA has not followed them blindly, and there are some areas where we diverge from the international principles.
  6. This will build additional external review mechanisms on top of that already provided by the Financial Sector Assessment Program, conducted jointly by the International Monetary Fund and World Bank.
  7. APRA is represented on the Basel Committee‟s Policy Development Group, the Accounting Task Force, the Definition of Capital Group, the Working Group on Liquidity and the Top-Down Calibration Group, amongst others.
  8. In some jurisdictions, this would be referred to as 'gold-plating', or adopting a standard that is 'super-equivalent'.
  9. Risk assessment and supervisory response tools
  10. Gittins (1990), op cit.

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.