APRA: The global financial crisis and beyond

John Laker, Chairman - The Australian British Chamber of Commerce, Melbourne

For the second time this year, I have the pleasure of addressing the Australian British Chamber of Commerce. On the first occasion, joining your Sydney members in February, I painted a grim picture of the global environment. Global financial markets were only slowly settling after the turmoil that followed the failure of Lehman Brothers the previous September. Notwithstanding extraordinary levels of public sector support, confidence in many large global financial institutions remained tentative, credit spreads were still well above pre-crisis levels and equity markets continued to deteriorate. Major advanced economies — the United Kingdom prominent among them — were contracting sharply, unemployment was on the rise and domestic banking systems were retreating under stress.

These developments did not bode well for the Australian economy and the Australian financial system. Not immune from the protracted bouts of market turbulence once the global financial crisis began, financial institutions supervised by APRA faced the additional prospect of a domestic economic downturn as the crisis spilled over to the domestic economy. A prolonged downturn would have put strong pressure on asset quality, profitability and capital, and could have  penalized harshly those financial institutions slowest to adapt. In hindsight, the period around February was the proverbial darkest hour before dawn in Australia’s case. Economic activity did contract around the turn of the year but it then regained some moderate momentum. Australia, in fact, is the only advanced economy likely to record positive growth over 2009 and growth forecasts for 2010 and beyond are being revised upwards. Similarly, the unemployment rate increased sharply in early 2009 but it has since steadied, at a rate lower than almost all our peers. The resilience of the Australian economy has reflected in the resilience of our financial system — indeed, the two have been mutually reinforcing.

Alas, the dawn has been slower to arrive in the United Kingdom. Although there are now encouraging signs looking ahead, six successive quarters of negative growth have produced a substantial cumulative fall in output and taken unemployment to its highest level in 13 years. The human cost of the crisis is brought home in the half a million jobs lost. The U.K. banking system remains fragile and the task of strengthening bank balance sheets is unfinished. Some household banking names are still fully or largely in public ownership and have been the recipients of public sector support that the Governor of the Bank of England has described as ‘breathtaking’ in its scale. To repeat his clever paraphrasing, ‘… never in the field of financial endeavour has so much money been owed by so few to so many’!

These contrasting experiences in Australia and the United Kingdom have an immediate echo in ongoing debates about regulatory architectures and the appropriate regulatory responses to the global financial crisis. Australia’s ‘twin peaks’ model has stood up well to scrutiny but there is, as you are well aware, a significant cloud over the future of the U.K. Financial Services Authority, our counterpart agency. In Australia, concerns are being voiced that global reform initiatives will go too far, given how well the Australian financial system has coped through the crisis. Any self-congratulatory tone here, however, needs to be avoided; after all, many hands were involved in the lifting. In the United Kingdom, the concerns in some quarters are that global reforms will not go far enough, particularly in dealing with the issue that some banks might be ‘too big to fail’.

The Governor of the Bank of England has enlivened this particular debate by questioning why the traditional or utility function of banks should not be separated more distinctly from the riskier financial activities that banks undertake. This is the background to my remarks today. As the year draws to a close, it is timely to provide a brief stocktake of APRA’s four supervised industries — deposit-taking, life insurance, general insurance and superannuation — as they position themselves for the prospect of better times. I would then like to offer some insights into how APRA has approached its supervisory responsibilities during the crisis and how Australia’s regulatory architecture has fared. Finally, looking ahead, some comments on the objectives of global regulatory reform are in order, lest these objectives get lost in any ‘Australia versus the world’ discussions. Since the wrappers have just come off APRA’s 2009 Annual Report, you will understand it if I take this opportunity to draw on some of the themes and language of this Report.

APRA’s supervised industries

Let me start on a strong note. APRA’s supervised industries remain in fundamentally sound condition, notwithstanding the most difficult operating environment they have faced in many decades. The global financial crisis has impacted on these industries in three main ways:

• through the higher cost and reduced availability of wholesale funding (including the freezing of securitisation markets);
• through the spillover effects of market turmoil and loss of consumer and investor confidence on the global and domestic economies; and
• through the significant volatility and decline in global and domestic equity markets.

Authorised deposit-taking institutions (banks, building societies and credit unions) have borne the brunt of the crisis, through the first two channels. The third channel has been the major influence on the fate of the life insurance and superannuation industries. In contrast, the general insurance industry has been left largely unscathed by the crisis. Obviously, our supervisory attention has been most sharply focused on ADIs. These institutions had avoided the excessive risk-taking behaviour that precipitated the crisis. They had only minimum direct exposures to U.S. sub-prime mortgages and, some unfortunate dabbling aside, to the complex financial instruments structured around these mortgages. However, ADIs were not able to avoid the initial impact of the crisis on the cost and availability of wholesale funding. Some ADIs also found themselves, early in the piece, with impaired exposures to the so-called ‘bad boys’ whose business models were quickly imperilled by the crisis. Without repeating the chronology, the Australian Government’s guarantee of deposits and wholesale funding has proved pivotal in assuring ADIs’ access to funding, domestically and offshore, enabling the banking system to continue lending. And I note that some welcome signs of life have recently appeared in the domestic securitisation market.

ADIs were also not able to avoid the subsequent impact of the crisis on the real economy. Through 2009, asset growth has slowed considerably and credit quality problems have broadened, particularly in business and commercial property lending. Non-performing loan ratios have doubled in business lending and have risen more sharply again in commercial property lending, but in both cases ratios remain well below their peak in the early 1990s. Housing lending portfolios, on the other hand, continue to perform very well. Non-performing loan ratios have risen only slowly and they remain low by historical and international standards — the comparable figure in the United Kingdom, for example, is four times larger.

APRA’s work ahead of the crisis in stress-testing housing loan portfolios and strengthening the capital requirements for higher-risk loans continues to reap dividends. Throughout the crisis, the profitability of most ADIs has been nderpinned by continued solid growth in core earnings. Profit levels are generally below recent peaks because of bad debt expenses and higher levels of provisioning; even so, returns on equity for the larger ADIs have remained double-digit. This  result would be the envy of many other banking systems. Sustained profitability, in turn, has reinforced the sound capital position of the industry and underpinned strong investor support, which has enabled a number of listed ADIs to bolster their capital base.

APRA’s other supervised industries are traditionally less susceptible to cyclical developments in the economy but, as I have mentioned, they have not been immune from the equity market impacts of the crisis. These made 2008/09 a very challenging year for the life insurance industry (including friendly societies). Industry profitability was significantly lower than in recent years as a result of lower fee revenues, declines in investment premium income and investment losses. Over the year, life insurance assets fell appreciably because of declines in asset values but there was little sign of any material increase in withdrawals or insurance claims as a result of market volatility. In this environment, our supervisory focus on the life insurance industry has naturally been on capital positions. As equity markets continued to deteriorate, we undertook a comprehensive stress-test of the industry in December 2008 to ensure that appropriate contingency  plans were in place to deal with further shocks. With our encouragement, a number of life insurers have taken active steps to protect their capital through capital injections, de-risking of investment portfolios, protection of downside valuation risks through derivatives, revised target surplus policies and deferral of dividend payments.

As a result of these various initiatives, the capital position of life insurers and friendly societies remains generally sound. Obviously, the recovery in domestic and global equity markets over recent months has provided an additional buffer of support, enabling us to ease back on the intensity of our supervision. The superannuation industry has faced similar challenges to the life insurance industry during the crisis. Most superannuation funds experienced negative returns in 2008/09, for the second consecutive year. The solvency position of most defined benefit funds deteriorated, placing considerable responsibility on trustees, employers and professional advisers to manage this position appropriately. The liquidity position of a number of superannuation funds also came under pressure when underlying investments were frozen or had no market. As with life insurance, the recent recovery in equity markets has provided the superannuation industry with greater breathing space.

Our supervisory focus during the crisis has been on how trustees have carried out their duties; contrary to suggestions, it is not about the investment outcomes that have been achieved. We have continued to challenge trustees to demonstrate the effectiveness of their risk management systems and their understanding of the critical factors that impact on their ability to meet their obligations. Our probing has identified liquidity management as an area where trustees need to do more work. We have also been working closely with trustees of defined benefit funds to ensure that rectification plans for the funds most at risk are appropriate.

The general insurance industry has faced a different set of challenges that have been physical in character, not financial — namely, for the second consecutive year, a series of weather-related events, particularly the North Queensland floods and the tragic Victorian bushfires. Recorded claims costs in 2008/09 were markedly higher, but these were largely offset by a noticeable increase in investment income. General insurers have progressively reduced their exposure to equity investments in favour of high-quality fixed interest investments, and enjoyed significant realised and unrealised gains.

As a consequence, profitability was down only marginally over the year and industry capital is almost twice our minimum requirements. This is not cause for complacency, however. Recent adverse claims experience is likely to continue through the current economic downturn and this, together with strong competition in some market sectors, will put pressure on profitability. As in our other industries, our supervisory activities have therefore targeted capital management.

We have been reviewing stress-testing and capital management processes to satisfy ourselves that insurers are maintaining adequate buffers to withstand adversity and grow the business.

APRA’s supervisory activities

Naturally, once the global financial crisis began, APRA’s supervisory activity was stepped up in intensity. After the Lehman Brothers’ collapse, we dialled our intensity to its highest level. It is not easy to convey exactly what that means. I could tell you that, over the past 12 months, we have conducted over 570 prudential consultations, carried out over 1,200 reviews of our risk-ratings of institutions and undertaken financial analysis of almost 3,200 quarterly or annual returns. More simply, I could just tell you that I have around 600 tenacious but very tired staff awaiting a Christmas break! Obviously, as a risk-based supervisor, we have targeted our attention and supervisory resources on those institutions we judged likely to be at greater risk during the crisis. As the crisis intensified, we have been interacting more, and more often, with institutions. In doing so, as I have outlined, we have concentrated our efforts on a narrower range of areas — in particular, liquidity and capital — than the broad sweep we take in good times when the source of emerging risks may be less obvious. No institution escapes our gaze, however. We are committed to a ‘baseline’ level of supervisory oversight for all regulated institutions to ensure our risk assessments and supervisory action plans remain up-to-the-mark.

More intense supervision during the crisis has had a number of dimensions. One has involved the dedication of teams of supervisors and specialist risk staff to monitor and coordinate responses to specific risks. In the ADI industry, we brought together a team, now standing at ease, to coordinate our oversight of ADI liquidity management and our frequent contact with treasurers and the Reserve Bank of Australia during periods of acute market volatility. A dedicated team was also set up for life insurance.

Another dimension has been more face-to-face contact with regulated institutions, more frequent discussions with boards and more frequent and/or more comprehensive collections of data. For example, we have been monitoring a wide range of indicators of ADI liquidity and funding as well as of credit quality, including the internal ‘watchlists’ of vulnerable exposures of the larger ADIs. A third dimension has been APRA’s ‘thematic’ or overall industry analysis. For some years, the main thrust of our thematic work was credit standards in housing lending. We have broadened that work to encompass a number of emerging industry-wide risks and we have undertaken comprehensive stress-testing in the ADI, general insurance and life insurance industries. The crisis itself, of course, has been a ‘live’ stress-test but, as it has transpired, not as demanding a test for Australian financial institutions as for many of their overseas counterparts. Our stress-testing is designed to identify and correct any possible complacency and to make sure that boards and management confront and plan for the possibility of ‘near death’ experiences.

More frequent contact with boards is fully consistent with our expectation that boards will act as a critical line of defence against excessive risk-taking. Boards of some major global financial institutions failed in that role, and this is widely acknowledged as a material contributor to the global financial crisis. Generally speaking, the boards of our regulated institutions avoided those shortcomings and they have provided sound leadership to their institutions through the crisis; indeed, strong governance has been one of Australia’s distinguishing features. That is not to say that all lending and investment decisions proved wise in hindsight, that business models were always robust or that some reputations did not take a dent.

Moreover, there are general lessons from the crisis that APRA wishes to keep ‘front of mind’ at board level. One lesson is that boards must ensure they are fully briefed on risks by a risk management function that has authority and independence within the institution. Another lesson is that boards must understand the risks involved in new endeavours and must challenge management on how such endeavours, particularly if complex in nature, support the core business.

The regulatory architecture

As I hinted at the outset, the global financial crisis has shone an unflattering spotlight on the regulatory architecture, coordination arrangements and the performance of the prudential regulator in a number of advanced economies. You would not be surprised that I am a strong supporter of Australia’s ‘twin peaks’ model. Having a single and clear mandate — namely, to promote prudent behaviour on the part of financial institutions — has kept APRA free of the distractions and the resourcing and other conflicts that can arise in attempting to pursue multiple objectives. Our organisation as an integrated regulator has also delivered substantial benefits in identifying cross-sectoral issues (such as housing credit quality and capital requirements for lenders mortgage insurers) and in the supervision of conglomerate groups that straddle more than one supervised industry. The global financial crisis has thrown up some classic counter-examples of ineffectual group supervision.

The crisis has highlighted the crucial need for effective coordination and communication between the prudential regulator and the central bank. On this score, as well, Australia’s arrangements have been exemplary. During the dramatic events of September and October 2008 particularly, APRA remained in very close contact with the Reserve Bank of Australia. Maintaining strong personal and professional links between these two agencies will, over time, be as important as formal protocols, memoranda of understanding and crisis management plans.

Broader cooperation between regulatory agencies in Australia, under the aegis of the Council of Financial Regulators, also proved very effective during those events. The spotlight on the prudential regulator itself reflects the reality that, across advanced economies, the prudential regime for banks is broadly consistent yet some banking systems have fared much better than others during the crisis. Calls have been made abroad that supervisors need to take a tougher,  more challenging and more intrusive approach, be less trusting of boards and senior management and exercise more supervisory judgment. We had our clarion call a few years earlier and the risk-based approach we have developed, applied constructively but firmly, has in APRA’s view proven its worth in battlefield conditions. This assessment is supported by the results of APRA’s first stakeholder survey, which we published recently. That survey gave a strong endorsement of our prudential framework and approach to supervision, and of our positive impact on the industries we supervise.

Global regulatory initiatives

The global regulatory response to the crisis has now moved from the emergency rescue phase to the hard grind of strengthening the foundations of the global financial system and addressing underlying weaknesses in the regulatory framework. The blueprint for this work is a series of recommendations by the Financial Stability Board, a coordinating body bringing together national authorities (including Australia’s), international organisations and standard-setting bodies.

This blueprint has the endorsement of the Leaders of the G20, who have given their strong commitment to the principles of strengthening transparency and accountability, enhancing sound regulation, promoting integrity in financial markets and reinforcing international cooperation. Australia’s prudential framework has performed well during the crisis and, as I have said in our 2009 Annual Report, a ‘root and branch’ review is neither necessary nor contemplated. Nonetheless, global reform initiatives will have implications for this framework. For this reason, it is critical that APRA be actively engaged in the reform process to ensure that Australian financial institutions do not bear the unnecessary brunt of global solutions to problems they were sufficiently prudent to avoid. APRA’s engagement has gathered momentum as a consequence of joining the Basel Committee on Banking Supervision, the global standard-setting body for banking regulation. This was a welcome development, ensuring that we now have a seat at each of the major international fora for prudential regulation.

Three particular global reform initiatives are now shaping APRA’s prudential policy agenda. The first involves a program of measures, under development by the Basel Committee, to raise the quality and quantity of capital in the global banking system and introduce a framework for countercyclical capital buffers. These measures involve an enhancement of the Basel II Framework, the new global capital regime for banking institutions. The Framework was introduced in Australia from 1 January 2008 and we believe it has been a positive factor in the prudential soundness of ADIs, not only in establishing more risk-sensitive and comprehensive capital requirements but also in promoting more rigorous risk management.

The second global initiative concerns the management of liquidity risk, an area where serious weaknesses were exposed by the global financial crisis. Lulled by years of ample global liquidity, many major global banking institutions failed to contemplate how suddenly liquidity risks can materialise and funding sources dry up. The Basel Committee has released revised principles for sound liquidity risk management and supervision and APRA is now translating these principles into its prudential framework for ADIs, with a series of proposals currently out for consultation. I will say more about these proposals shortly.

The third global initiative concerns remuneration. APRA has been at the forefront of work to address poorly designed incentives in remuneration, another of the key factors contributing to the crisis. Within the next few days, we will be releasing our prudential requirements for remuneration for ADIs and insurers. Our principles-based approach puts the onus on boards to do two things. One is to determine sound remuneration arrangements for all staff who can materially affect the performance of their institution. The other is to inject a longer-term horizon into remuneration arrangements by requiring that they be aligned with the long-term financial soundness of the institution and its risk-management framework.

These global reform initiatives are comprehensive, and serious. Reforms will happen; they are happening now. At this stage, however, the increasing media and other ‘chatter’ about the burden of the reforms on our regulated institutions must be taken with a grain of salt. Obviously, where Australia’s prudential framework is already consistent with emerging global norms, or where our institutions were not enticed into the excessive risk-taking to which some of the specific reforms are targeted, the reform burden is likely to be muted.

Take the issue of the quality of bank capital, for example. The Basel Committee is proposing to raise the quality of the Tier 1 capital base (the highest quality capital) by limiting the predominant form of Tier 1 capital to common equity and retained earnings. APRA’s decision several years ago to tighten its predominance test positions Australia well on this issue. Take the tougher Basel II capital requirements for securitisation and trading book activities, released a few months ago, as another example. These are likely to have only a modest impact in Australia because our ADIs have only limited reliance on the income streams from these activities compared to many of their overseas counterparts.

In other areas, however, Australia is not an exemplar and our prudential framework will emerge strengthened by global reform initiatives. I am referring here, in particular, to initiatives to improve the shock absorbers in the financial system that are so vital to preserving financial stability — namely, capital, provisioning and liquidity buffers.

I mentioned the Basel Committee’s proposed framework for countercyclical capital buffers. What global policymakers want are resilient banks that build up capital buffers in good times, when it is easier and cheaper to do so, and use these buffers at times of stress to absorb losses and enable lending activities to continue. This is simply the ‘rainy day’ principle. Global policymakers also want to build countercyclical buffers into loan loss provisioning practices to ensure that banks take a forward-looking or ‘expected loss’ approach to provisioning.

It is difficult to see that the ‘rainy day’ principle was at work in Australia. Our banks did not take advantage of Australia’s sustained economic expansion to build up their capital bases; the total capital ratio when the global financial crisis struck was little different to the ratio a decade earlier. Over this decade, of course, listed banks were under constant market pressure to demonstrate capital efficiency and to return so-called ‘lazy’ capital to investors through share buy-backs. Banks in fact funded the necessary growth of their capital bases through extensive use of hybrid and innovative instruments, significantly reducing the share of the highest quality forms of capital in their total capital. The introduction in 2005 of International Financial Reporting Standards, which take a backward-looking approach to loan losses, also resulted in an immediate and substantial reduction in the level of provisions held by banks.

Let me emphasise that banks and other ADIs in Australia have been well capitalised before and during the global financial crisis. My point is simply that we are in no position to lecture the rest of the world on countercyclical capital management.

The Basel Committee is also promoting the development of stronger liquidity buffers in the global financial system. And for obvious reasons! As I have noted, years of apparently abundant liquidity in global funding markets lulled banks and prudential supervisors alike into a false sense of security. The speed with which that supposed liquidity evaporated during the traumatic events of September and October last year was the rudest of awakenings. Central bank support, unprecedented in its scale and the creativeness of some of the support mechanisms, was required to restore liquidity to domestic financial systems, and those actions were reinforced by governments in over a dozen countries providing guarantees of wholesale funding. Australia’s experience over this period was no exception, although the Reserve bank did not need to resort to unconventional monetary measures.

As a matter of principle, liquidity buffers would be made up of high-quality assets that are liquid in private markets during a time of stress. That is, a liquid asset must be liquid when it is needed. Hardly a controversial proposition! Almost any financial asset is liquid during a boom; the test is whether assets are reliably liquid — without large fire-sale discounts or haircuts — under conditions of severe market stress. Sovereign bonds most clearly meet this test and this reality is shaping the thinking of global policymakers.

Some would argue, however, that liquidity buffers need only include assets that can be used (repoed) to obtain liquidity from the central bank. That brings me to the matter of principle. Global policymakers are concerned about ‘moral hazard’ – the incentive that banks would have to take excessive liquidity risks if they know that central banks are standing ready to provide insurance. Market discipline would be much stronger if, on the contrary, banks hold strong cushions of high-quality liquid assets as the first line of insurance against severe liquidity stress and do not turn to the central bank at the first whiff of gun-smoke.

APRA shares this concern about ‘moral hazard’. At the same time, we are able to perform simple arithmetic. We are well aware of the need for an operational definition of high-quality liquid assets that make sense for Australia. We are currently working with the industry and the Reserve Bank to find a pragmatic solution that reconciles the concern with the realities of Australia’s relatively small Government bond market.

Summing up

It would be hard to imagine when I spoke to your Sydney members that, only nine months later, I would be ending this address on a cautionary note. No, not about the testing operating environment that lies ahead — that should go without saying, although I take every opportunity to say it. Rather, about the dangers of complacency creeping back into the psyche of our financial institutions. I warned at the outset about a self-congratulatory tone and we sense it stirring. The risk ahead is that boards and management will drop their guard 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.

When I was putting the finishing touches to our 2009 Annual Report, an APRA colleague mentioned to me the 1951 movie Quo Vadis, starring Robert Taylor. It featured the role of a slave who stood behind his Roman general as he paraded through the streets during a victory triumph, reminding the general that though he was at his peak today, tomorrow he could fall or be brought down. In Latin, the reminder was ‘memento mori’ (remember you are mortal). APRA is no slave, but we will not be averse to uttering similar words, loudly, if we identify hubris emerging in any of our institutions.