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Role of the prudential regulator

Friday 21 May 2010

Helen Rowell, General Manager - 2010 National Conference of the Financial Services Accountants Association (FSAA): ‘Life After The Noughties’, Sydney

Good morning ladies and gentlemen. It is a pleasure to participate in today's National Conference of the Financial Services Accountants Association and to provide APRA's perspectives on the decade ahead. It is interesting to note how many of the sessions at this conference address issues that are on APRA's agenda (IFRS, the Cooper review, remuneration and others).

In his book, The Road Ahead, Bill Gates wisely said: "we always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. Don't let yourself be lulled into inaction." The last sentence of that quote leads well into what I‟d like to speak about today. That is, preparing for the unexpected - with a robust and forward-looking regulatory framework.

The Noughties were certainly a journey for APRA. Among the "highlights" were the collapse of HIH, the NAB foreign exchange trading incident and of course, the global financial crisis.

As all of you are well aware, it has been a somewhat turbulent period for the financial sector over the last few years. The financial markets had seemed to have stabilised since the period of late 2008 and early 2009 - when confidence in many large financial institutions was being questioned and market conditions remained volatile. However, as we have witnessed in just the last week as share markets have fallen substantially over concerns about sovereign debt in Greece, some degree of uncertainty remains as to whether the global economy has successfully weathered the GFC.

Australia does seem to have emerged from the GFC relatively unscathed (so far!), and many factors have contributed to that. However a number of commentators have noted that one contributing factor has been the strength of Australia‟s regulatory framework and its proactive implementation by Australia‟s regulators.

I would like you to keep this in mind as I take you through some of the things on APRA's agenda in the coming decade, and how these tie in with the global regulatory agenda.

What I propose to do in the short time that I have this morning is to:

  • provide some brief context on the environment in which we currently find ourselves;
  • comment on the global prudential regulation agenda and what it may mean in the Australian context;
  • outline key aspects of APRA's policy agenda; and
  • close with a few remarks on the interaction of national perspectives and the international reform agenda, the risk of complacency and the need for continuing focus on sound risk and capital management.

The general conclusion I would like to leave you with is that forward-looking regulations and sound institutional frameworks, together with strong prudential supervision, are not only desirable but also necessary to combat the challenges that will undoubtedly arise over the next 10 years.


Up until the last few days, a number of market commentators were suggesting that the global financial crisis was behind us. But is this the case? Can we look forward to a post GFC world that will be more resilient than it was in September 2008, at the time of the failure of Lehman Brothers?

It is true that the global economy has begun to rebound: the recovery in Asia remains strong and output has recently grown strongly in both North and South America. Australia‟s terms of trade have improved and growth in the domestic economy over the past year has been stronger than expected. The Reserve Bank of Australia‟s central forecast for domestic GDP growth in 2010 and 2011 is above its longer-run average rate.

However these positive signs are by no means universal and we need to remain cautious as uncertainties continue to cloud the global economic forecast. Recovery in most advanced economies, as the IMF has noted in its most recent World Economic Outlook, is expected to be relatively sluggish compared with recoveries from previous recessions. Furthermore, the unwinding of substantial public interventions is presenting serious challenges for some governments and regulators. The pressure on the sovereign debt of some European issuers, and its flow on effects to financial markets over the last few days, is another reminder that the global economy and global financial markets remain vulnerable to aftershocks.

Though Australia has shown resilience throughout the crisis, we are not immune. Australia‟s performance through the GFC has been relatively strong, and APRA-regulated institutions remain in a fundamentally sound condition. However, as John Laker noted in his Chairman‟s remarks in APRA's 2009 Annual Report:

"Although it may now seem a case of 'steady as she goes', the operating environment for financial institutions supervised by APRA will remain testing for some time to come… Boards and management will need to be careful not to drop their guard on risk if relief at surviving the most challenging circumstances in many decades gives way, as it may, to excessive confidence that their institutions are now invulnerable."

APRA believes that the architecture of Australia's regulatory system is solid and provides a sure footing as we move forward into the future.

At a broad level, the twin peaks regulatory model (comprising APRA and ASIC), gives APRA a single and clear mandate to focus on promoting prudent behaviour on the part of financial institutions. This model allows APRA to perform its supervisory functions without the distractions, or the resourcing and other conflicts, that can arise where a regulator has multiple objectives. This was by no means the only factor in the resilience of Australia‟s financial sector to the GFC, but in APRA's view, it did contribute.

At the next level, APRA's prudential and supervisory frameworks are, broadly speaking, working well.

Nevertheless, APRA is wary of the risk of complacency in both our own activities and on the part of the boards and management of institutions. APRA will be maintaining the intensity of our supervisory activities and our work on maintaining and improving our regulatory frameworks. We expect our regulated entities to maintain a similar focus on maintaining their risk and capital management frameworks.

It has been argued that, given the relative resilience of the Australian financial system, there is less need to implement international reforms or that we should have our own Australian versions of them. Whilst we can all take some pride in the manner in which Australia has emerged from the GFC, our resilience was not without the need for extraordinary Government intervention and a certain amount of luck. It would be naïve to believe that Australia can stand apart from international developments and that some further strengthening of the system is not justified. The challenge is to seek to implement the international reforms in a manner that appropriately addresses particular national perspectives and issues.

This is a theme that I will return to a little later.

Global regulatory agenda

With this context in mind, let me turn now to the global regulatory agenda. APRA is an active participant in the current global regulatory debates and we believe that we are on track with, and in some cases leading, the global regulatory agenda.

Some key themes dominate: the first relates to measures aimed at addressing financial stability and systemic risk and the second relates to the regulation and supervision of groups. A third area of global reform relates to remuneration, which I will speak further about a little later.

Financial stability and systemic risk

The sub-prime crisis in the United States and consequential failures of institutions once thought to be "too big to fail" lead to widespread concern about financial stability. This has, not surprisingly, been accompanied by enormous interest in the causes of the instability and policy initiatives that might be taken to protect the financial system and prevent such instability in the future.

The Financial Stability Board has emerged as the coordinating body for this work, bringing together national authorities, international organisations and standard-setting bodies. The G20 leaders have set out a demanding this program of reform, providing strong commitment to the principles of strengthening transparency and accountability, enhancing sound regulation, promoting integrity in financial markets and reinforcing the need for effective and timely international cooperation.

To date the focus of these financial stability policy developments has, understandably, been on the banking sector, and has been aimed at enhancing the ability of individual banks to keep operating when other banks are failing. In particular it has become clear that global banks had too little high quality capital. The Basel Committee has recently released a wide-ranging set of proposals that will increase both the level and quality of minimum capital. Similarly, the GFC highlighted weaknesses in bank liquidity and funding profiles. As a result the Basel Committee is proposing changes that will lead to a greater focus on the quality of liquid assets, establish a longer survival horizon to be met without the need for central bank support and place more emphasis on longer-term funding. The IAIS, in which APRA participates actively, has established a Financial Stability Task Force that has been exploring the insurance-related aspects of financial stability.

Attention is also on measures that may reduce the inherent pro-cyclicality in prudential frameworks and means to address the "too big to fail" problem and the disincentives for sound risk management that this label may create. These latter two issues are proving to be much harder to deal with and reach consensus on than the changes in capital and liquidity requirements (although these also have their contentious aspects!).

The concept of macro-prudential supervision is also the subject of widespread international attention, including among insurance supervisors. More broadly, national and international regulators are seeking to enhance or develop macro-prudential surveillance tools and activities that may assist to identify systemic risks at an earlier stage and assess their potential for creating financial instability.

Cross-border co-operation is also a keystone of effective ongoing supervision and the management of a cross-border crisis. Indeed, in a world where the links between institutions operating in different jurisdictions are many and far-reaching, cross-border co-operation is not merely useful but essential. As President of the European Commission Jose Manuel Barroso said, "better supervision of cross-border financial markets is crucial for ethical and economic reasons".

Effective cross-border cooperation requires appropriate mechanisms for information exchange and international cooperation between national supervisors and other relevant authorities (such as central banks and government ministers) so it is not easy! However, there is considerable effort internationally being channelled into strengthening cross-border arrangements and ensuring they are maintained.

In Australia, a memorandum of understanding on financial distress management was adopted in 2008 between the members of the Council of Financial Regulators (RBA, APRA, ASIC, Treasury). This MoU sets out the objectives, principles and processes for dealing with stresses in the Australian financial system. It also sets an aim of achieving a satisfactory outcome for all affected jurisdictions - subject to ensuring that the outcome meets the needs of the Australian financial system and depositors, policyholders and fund members in Australia.

More broadly, there has been an increased international focus on enhancing international information sharing and cooperation through a range of means, including supervisory colleges, MoUs and the like. APRA is a strong supporter of these initiatives and has, for example, established supervisory colleges for some of its internationally active groups.

Group supervision

This leads into the second key global regulatory theme: the regulation and supervision of groups. The GFC has highlighted clear examples of the impact of weaknesses in the risk management frameworks of groups and the supervision of these groups.

As you are all aware, in 2008 an unregulated subsidiary of AIG in the US needed financial support from its parent. This support was only forthcoming because of support given by the US government. Without this government intervention, it is likely that the AIG group would have collapsed, leading to potentially significant financial and economic consequences despite the generally strong position of the regulated insurance subsidiaries in the group. There are other examples: also in 2008, some bancassurance groups, notably ING and Fortis in Europe, discovered problems in their banking arms that risked the failure of their insurance arms. This lead to the dismemberment of these groups.

These examples highlight the importance of group-wide regulation and supervision, as a supplement to the regulation and supervision of solo insurers or banks. The financial crisis also highlighted the need to review the perimeter of group-wide supervision beyond accounting consolidations to capture a broader range of issues such as risk management and reputational risks.

One of the key challenges for the world‟s regulators over the next few years will be to ensure that:

  • they have the legislative powers for effective group supervision;
  • they have designed and implemented suitable regulatory frameworks; and
  • they have the supervisory capability and resources to oversee such groups effectively.

What has become evident as a result of the GFC is the importance of not just having a sound regulatory framework but also of ensuring that the framework is well implemented through effective supervision.

APRA is a little ahead of the game in its implementation of group regulation and supervision, but others are working in the same direction. We nonetheless have considerable work ahead of us, as you will see now that I turn to outline APRA's policy agenda.

APRA’s policy agenda

As many of you will be aware, APRA has a substantial policy agenda throughout the next few years. Indeed, many of the projects have implementation timelines which reach beyond 2011 (although hopefully not out to 2020!).

Many of the items on our agenda relate to the implementation of the Basel Committee proposals for banks and other deposit-taking institutions in the areas of capital and liquidity which I commented on earlier. Timetables for these proposals are often not entirely under APRA's control.

There are also a range of other items on our agenda that will impact on the broader APRA-regulated financial services industry over the coming decade.

One of these is the issue of group regulation and supervision that I have already touched on in the context of the global reform agenda. The other two items that I would also like to mention today are:

  • implementation of APRA's remuneration requirements; and
  • the review of the life and general insurance capital requirements.

I will also briefly comment on the policy work for APRA that may emerge from the Cooper review and some of our other policy activities.

Some of these policy reforms flow from the need for APRA to keep step with the global regulatory reform agenda, but in many cases (such as liquidity and group supervision) APRA's work was in train well before the GFC, reflecting APRA's desire to ensure that our regulatory regime remains forward-looking, risk-based and at the forefront of regulatory best practice.


Let me start with remuneration, which is an important area of global policy reform where APRA has been at the forefront of developments. The aim of the global remuneration reforms is to address poorly designed incentives in remuneration which are regarded as having contributed to the crisis. Last November, APRA finalised its prudential requirements for remuneration that apply to ADIs and insurers, releasing revised governance prudential standards and a prudential practice guide.

The industry broadly supported APRA‟s principles-based approach, which is focused on pay structures rather than levels and avoids some of the potential prescription evident in parts of the Financial Stability Board‟s guidelines. APRA‟s requirements put the onus on boards to:

  • firstly, have in place a board remuneration committee with appropriate composition and charter, and
  • secondly, determine a sound remuneration policy, particularly for all staff who can materially affect the performance of the institution. The policy should include a longer time horizon for remuneration arrangements to enable them to be aligned with the long-term financial soundness of the institution and its risk-management framework.

APRA‟s requirements apply from 1 April and APRA is continuing to work with industry to ensure their effective implementation. We are currently undertaking a review of remuneration policies across peer groups to assess better practice in a range of key areas. This will enable APRA to provide feedback to industry on the areas where further focus or enhancement may be needed.

Group supervision

Another key area of current focus for APRA is group supervision. The primary purpose of group supervision is to address the potential contagion risk that can exist across different entities within group structures.

APRA has had group supervision requirements in place for ADI groups for a number of years and introduced group supervision requirements for general insurers from 31 March 2009. These requirements are limited to groups that operate primarily within a single industry and rely on applying the rules of that industry to the group. APRA has also recently been given powers to regulate non-operating holding companies (NOHCs) in the life insurance sphere.

APRA has, since its establishment, been conscious of the need to understand and assess the financial and operational aspects of conglomerate groups, as well as the individual APRA-regulated entities within them.

APRA's current industry-based approach to group supervision has served us reasonably well to date. However, as I noted earlier, international experience through the GFC has shown that the failure of one entity (regulated or not) within a conglomerate group may damage or even cause the failure of related entities. Hence, a narrow, stand-alone view of regulated entities is insufficient to obtain a full picture of the financial risks to which depositors and policyholders may be exposed. Hence APRA is proposing to extend its group supervision framework to capture a broader view of conglomerate groups.

Although membership of a conglomerate group often provides benefits to APRA-regulated entities, it will also invariably increase and change the risks they face. The more material a group‟s activities outside its primary industry, the greater the risk that an industry-focused supervisory regime will not appropriately detect or respond to risks associated with these activities, and the greater the danger of a supervisory „blind spot‟ that may result in risks building up without adequate remediation.

In March this year, APRA released its discussion paper on the supervision of conglomerate groups. This consultation paper considers the extension of capital, governance and risk management standards to groups which include entities operating in more than one regulated industry or with material unregulated entities. It proposes specific standards aimed at promoting a consolidated view of a group‟s capital position and risks, in a manner which is appropriate regardless of the underlying companies within the group.

APRA's proposed Level 3 supervision framework aims to ensure that prudential supervision adequately captures the risks to which APRA-regulated entities within a conglomerate group are exposed and which, because of the operations or structures of the group, are not adequately captured by the existing solo or industry-based prudential frameworks.

The conglomerate proposals would put in place a complementary layer of regulation, which harmonises existing standards and industry specific supervision frameworks at the group level to provide a group view.

The proposals build on APRA's existing capital requirements, to ensure that a conglomerate group holds adequate capital to protect the APRA-regulated entities from potential contagion and other risks within the group. The framework also contains proposals on a range of principles–based risk management and governance standards that would apply to the parent company of the conglomerate group, again built on the requirements already applying to the prudentially regulated entities within the group.

The project is ambitious, particularly in light of the range of legal and financial structures APRA supervisors must get to know. Though, we have seen some groups simplify their structures, to the benefit not only of APRA but also of their own boards and management. We hope this trend toward increasing transparency within groups and reducing risks associated with structural complexity will continue.

Life and general insurance capital review

Let me turn now to our review of the general insurance and life insurance capital standards. Our discussion paper was released last week and describes APRA's key proposals. The objectives of the review are to:

  • improve the risk-sensitivity of the standards; and
  • where appropriate, improve the alignment of the standards between industries.

APRA is also taking into account industry and other developments, including international regulatory developments, since the existing standards were set.

The proposals introduce a common framework for required capital and eligible capital for general and life insurers. This broadly corresponds to the existing capital framework for general insurers but represents a more substantial change for life insurers. The proposed structure is conceptually simple but allows for industry-specific differences to be recognised in the assessment of required capital. It also provides a clearer view of the financial position of a life insurer than the current capital structure and will facilitate implementation of APRA's conglomerate proposals. This simplification will also be of benefit to the boards and management of life insurers as well as to external analysts and other industry observers.

Capital adequacy depends not only on an insurer‟s capital position but also on the way it monitors and manages its capital and risks. APRA is proposing the introduction of a three pillar supervisory approach for general insurers and life insurers similar to that in place for ADIs.

The three pillars would comprise:

  • Pillar 1 – quantitative requirements in relation to required capital, eligible capital and liability valuation;
  • Pillar 2 – the supervisory review process, which includes the supervision of the practices of insurers‟ risk management and capital management and may include a supervisory adjustment to capital; and
  • Pillar 3 – disclosure requirements designed to encourage market discipline.

Some of the key changes that are proposed include:

  • a more risk sensitive asset risk capital charge that appropriately addresses asset-liability mismatch;
  • some tightening of asset concentration risk limits and review of insurance concentration risk requirements; and
  • inclusion of an explicit operational risk capital charge.

The discussion paper is the first major outcome of the capital review process.

APRA will release three supplementary technical papers in June 2010, covering the capital base and insurance risk capital charge for life insurers, the insurance concentration risk capital charge for general insurers and the asset risk capital charge for both general insurers and life insurers.

APRA intends to evaluate its capital proposals by assessing the results of a quantitative impact study (QIS) in which all insurers will be invited to participate. The QIS is expected to be issued in July and insurers will be given three months to complete it.

APRA expects to release draft capital standards by the end of 2010 and final capital standards in mid-2011, to take effect in 2012.

We encourage you to look out for the technical papers and the QIS. An industry seminar is also planned for the end of June, in conjunction with IFSA and the Insurance Council.

Other policy projects

I have briefly touched on the major policy initiatives that APRA has underway. However APRA is also working on a range of other policy projects.

These include:

  • finalisation of changes to reporting for general insurers;
  • product rationalisation proposals, in consultation with Treasury; and
  • implementation of the Financial Claims Scheme for ADIs and general insurers.

And there are other developments on the horizon that are likely to add to APRA's policy agenda.

For example, the Cooper Report is likely to have implications for APRA's supervision of superannuation trustees and funds. These range from the possibility of additional powers and/or responsibilities for APRA, to scope for some legislative reforms. APRA looks forward to working with Treasury and industry on this once the Government has responded to the recommendations in the Report.

Prudential supervision 2010 – 2020

Before I close let me make just a few comments on the prudential supervision landscape for the next ten years.

APRA‟s approach over its first ten years has been to refine and enhance the regulatory framework in each industry with a view to driving industry practice to where we felt it should be. In some cases this involved step change (such as the major general insurance reforms introduced in 2002) and in other cases it has been more incremental change (such as the enhancements to the general insurance framework in 2006 and 2008).

We have seen an evolution in risk and capital management across APRA's regulated industries over the past decade which has been driven, at least in part, by APRA's requirements in these areas. For example, prior to APRA introducing requirements for companies to regularly review their risk management frameworks and the introduction of financial condition reports, including capital projections for insurers, these practices were not exactly in vogue. Yet few would question their importance today.

While industry practice in this area has evolved considerably over the last ten years, there remains room for continued enhancement. Risk and capital management will therefore continue to be a key focus for prudential regulators over the next ten years.

The GFC has highlighted weaknesses in both the implementation of risk management frameworks and in the capital management processes of some institutions. The aim of APRA, and also of international regulators, in the coming years will be to reduce the likelihood that either we or the institutions which we supervise are caught out by unanticipated risks, or by capital stresses for which mitigating strategies have not been developed. Improvements in the capital stress and scenario testing that is undertaken by all entities will be a key area of focus in this regard. The Internal Capital Adequacy Assessment Process that is currently a requirement for ADIs and being proposed for insurers reflects this focus.

Concluding Remarks

As you can gather from my comments this morning, 2010 and 2011 will continue to be very busy for APRA. Engagement with industry is a key plank of our policy development process and I'd like to encourage everyone here to continue effective dialogue with us to help carry forward our mutual interest in maintaining the strength of our financial services sector.

Let me close by emphasising some key points.

Firstly, as I indicated earlier, APRA's position is that it is both pointless and unhelpful to try to stand against the tide of international reform. We are participating in a global financial system and it is vital that we are seen to be playing by the international rules of the game. The challenge for Australia is to try and influence, to the extent we are able, the development of these international rules to ensure that they make sense for our financial institutions. No international framework will be perfectly suitable to every single country and so APRA will want to ensure, where it can, that our particular national perspectives are taken into account.

This brings me to the second point that I'd like emphasise. APRA's supervisory approach is forward-looking, primarily risk-based, consultative, consistent and in line with international best practice. At times this means that APRA is at the forefront of international developments and that our regulatory framework is ahead of international regulatory practice in some areas. We make no apology for that. We believe it is in the best interests of our financial services sector for Australia‟s regulatory framework to be very well-regarded internationally.

A key focus of supervisory attention will remain on risk and capital management frameworks, so that the lessons learned from the GFC are applied to improve the ability of industry and regulators to respond to changing risks.

The final point with which I'd like to leave you is on the need to be alert to the risk of complacency. As I indicated earlier, it is important that APRA and the institutions we supervise remain focused on the challenges that remain ahead. There are signs that some of the urgency for reform that was created by the GFC has dissipated in what appears to be a more benign environment than has been experienced over the last few years. APRA is by no means ready to relax its guard, and we will continue to remind industry of the need to maintain their focus on sound risk and capital management in order to be better prepared for the next crisis – whatever form it takes.

Returning to the words of Bill Gates, don't underestimate the change that can occur over the next ten years or be lulled into inaction through complacency.

Thank you

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.