APRA: The year ahead

John Laker, Chairman - The Australian British Chamber of Commerce

I am pleased to have this opportunity today to address the Australian British Chamber of Commerce as part of its Business Executive Network program.  In a previous life, as the Reserve Bank’s Chief Representative in Europe, based in London, I saw at first hand the enthusiasm and commitment of business leaders to enrich the historical links between Australia and the United Kingdom in the commercial and finance areas especially, and the size of today’s gathering confirms that the networks continue to flourish.

These are grim times around the globe.  The heady days over much of this decade, which saw an unprecedented build-up in risk appetites and borrowings (or ‘leverage’), fuelled by low interest rates and an explosion in complex and opaque financial instruments, are gone.  Instead, the global economy is now confronting a deleveraging process and retreat from risk equally extraordinary in its scale and its speed.  Consumer confidence has been severely jolted in the wake of the financial traumas late last year.

Nowhere are the problems more evident than in the United Kingdom itself, which is mired in deep recession.  Economic activity is contracting sharply, housing prices are slumping, unemployment is nudging two million people and the UK banking system has been under considerable stress.  You will forgive me for saying that, nothwithstanding our two countries’ close and affectionate links, this is one experience we in Australia hope not to share.

Nonetheless, 2009 will be a difficult environment for the Australian economy and the financial institutions under APRA’s supervision.  The global financial market turmoil that has buffeted our financial institutions since August 2007 has spilled over to the domestic economy, which is now undergoing a slowdown of uncertain length and severity.  Economic downturns are not a new phenomenon.  What is especially challenging about the current environment is that the global financial system — though showing signs of improvement in some areas — remains under intense strain and, added to this, economies are slowing in lock-step with no obvious engine for recovery in sight.  Little wonder that the International Monetary Fund has described the global economy as in ‘uncharted waters’.

Since the crisis began, APRA has often stated that Australia has a financial system of undoubted underlying strength and that our supervised financial institutions are, on the whole, profitable, soundly managed and well-capitalised.  We have weathered the global financial market turmoil much better than many other financial systems.  The economic slowdown will inevitably put pressure on asset quality, profitability and capital, and some financial institutions will have cause to regret lending and other business decisions taken in more prosperous times. Nonetheless, APRA is confident that the fundamental strength of the Australia financial system will continue to assert itself in this difficult environment.

Today, I would like to outline the basis of this confidence by giving you an overview of our four supervised industries — deposit-taking, life insurance, general insurance and superannuation — and APRA’s supervisory priorities in these industries for 2009.  APRA covers a broad territory so the overview will inevitably be brief.  I will also talk a little about the regulatory response to the global financial crisis with, again, the emphasis on APRA’s priorities.  On both supervisory and regulatory fronts, we are one very busy organisation at this moment!

Firstly, an introduction to APRA for those who may not know us well.

The role of APRA

APRA is Australia’s prudential regulator and our business is risk.  Our mandate, put simply, is to promote prudent behaviour on the part of financial institutions.  We strive to ensure that their risk-taking is conducted within reasonable bounds and that their risks are clearly identified and well-managed.  We act on behalf of specific groups that we call our ‘beneficiaries’ — depositors, policyholders and superannuation fund members — who are generally not well placed themselves to assess the soundness of financial institutions on which they rely for their financial security.  Our work involves regular, and at times intense, dialogue and engagement with each one of our supervised institutions.  We know them well! Unlike the U.K. Financial Services Authority, we do not get involved in shareholder issues or dealings with individual customers.  We have no mandate for market conduct or consumer matters so we can be single-minded in pursuing our prudential objectives.

The tight supervision of individual financial institutions — the ‘micro-prudential’ focus — is the bread-and-butter work of a prudential regulator.

APRA also has a broader mandate to promote the stability of the Australian financial system.  The global financial crisis has brought forcefully home the critical importance of a robust and smoothly functioning financial system that acts as the intermediary between savers and investors.  In the United States and the United Kingdom, to name but two advanced countries, unprecedented government intervention, up to and including bank nationalisation, has been required recently to help rebuild shattered confidence in the domestic banking system and revive bank lending.  To meet its broader mandate, APRA needs to bring a ‘macro-prudential’ focus to its work.  This requires us to identify and counter where we can the build-up of risks in the financial system as a whole and ensure that any actions we take in individual cases are consistent with the promotion of safe and efficient financial intermediation.  This macro-prudential focus, which involves close liaison with the Reserve Bank of Australia, will be increasingly important for APRA in negotiating the economic slowdown.

APRA’s core task in our supervisory role, in good times and bad, is to look at the downside (we are by nature ‘glass half empty’ people!) and satisfy ourselves that our institutions can survive adversity in any reasonably likely form.  This core task does not change as the economic environment changes.  What does change is the intensity with which we target and review particular issues.  In good times, risks can emerge from a number of directions and APRA’s supervision is appropriately broad in its coverage.  Complacency can be a major threat.  Our goal is not to prepare for every possible contingency but to ensure that our supervised institutions have the general strength and resilience, and quality of governance and risk management, to cope when good times end.

And when they do, our supervisory attention and resources zero in onto the risk issues that are most pressing.  This is standard practice for a risk-based prudential supervisor, as we are.  Over the past 18 months, the dislocation of global financial markets meant that our key focus was on liquidity and funding.  In 2009, it will be on the core strength of our institutions.  That is, on capital, the cornerstone on which a strong and successful financial institution is built.  At present, markets are relentless in identifying and pressuring institutions they perceive as having inadequate capital to survive this difficult environment.  As you would expect, APRA itself has always been relentless on capital adequacy issues.

Let me turn now to APRA’s supervisory priorities for 2009.

APRA’s supervisory priorities

The global financial crisis has had its strongest impact, so far, on our banking institutions — banks, building societies and credit unions — and these institutions (ADIs as we call them) have been, and remain, under intense APRA scrutiny.  These institutions had only minimal direct exposures to U.S. sub-prime mortgages and, with limited exceptions, to the ‘alphabet soup’ of complex financial instruments structured around these mortgages.  What brought the global financial crisis to Australia and our banking institutions was its impact on the cost and availability of wholesale funds, a key funding source.

This is now a well-chronicled story of the vulnerability of any banking institution —  even our highly rated banks — when there is a breakdown of the bonds of trust between investors and banks, and between banks themselves, in global financial markets, and funding dries up.  This breakdown reached its nadir in the traumatic financial events of September and October last year, triggered by the failure of Lehman Brothers, when global interbank funding markets shrank to overnight markets only.  It was in this context that the Australian Government introduced its guarantee of deposits and wholesale funding.  Many other sovereign governments did likewise and, indeed, were forced to provide even more substantial support to their banking systems.  

These interventions are now having a positive impact: global credit market volatility has eased, interest spreads on bank debt — though still well above pre-crisis levels — have fallen and access by banking institutions to longer-term funding has re-opened.  Australian banks have raised a record of over $60 billion of bonds since the start of December under the Government guarantee scheme. Encouragingly, as well, there are early signs that our banks are willing to test wholesale funding markets without reliance on the guarantee.  The Government guarantee also dispelled an increasing disquiet on the part of some depositors, and retail deposits have been growing strongly.  All in all, ADIs have been making good progress in meeting their funding needs for 2009.

Since the global financial crisis began, the most intense focus of APRA’s supervisory activities has been on how ADIs have been managing their liquidity and funding. Early on, we stepped up liquidity reporting and requested forward-looking funding plans from a range of ADIs.  Tracking against these plans is now done via a monthly ‘dashboard’ that compares various funding indicators for ADIs.  We also established a dedicated team of frontline supervisors and specialist treasury risk staff to keep in close contact with the treasurers of ADIs, both large and small, during periods of acute market stress.  This contact was critical to identifying pressure points.  

The improving tone of global credit markets in 2009 has enabled us to stand this team down and to reallocate our priorities to ADI funding plans.  We review these plans to identify concentrations of funding sources and any over-reliance on a single source of funding; growth assumptions for both assets and liabilities; the duration of cash flow mismatches; the spread of funding maturities; contingency planning for sustained market dislocation; and modelling of different stress scenarios.  Funding plans have been improving in quality since our initial requests.

Australia’s economic slowdown is now directing heightened attention to issues of credit quality in ADIs.  In APRA’s case, these issues have in fact been at the forefront of our supervisory work for some years, and particularly since credit standards in housing lending came under pressure during Australia’s housing market boom in the early years of this decade.  A portent of the difficulties ahead is the rise in the level of problem loans over the course of 2008.  Most of that rise can be attributed to a small number of exposures to high-profile domestic corporations struggling under the weight of short-term borrowings or their involvement in commercial property.  However, a more broadly based increase in problem loans and provisioning levels is becoming apparent.

APRA will be closely monitoring a range of indicators of credit quality during 2009, including internal ‘watchlists’ from the larger institutions — that is, exposures which the institutions themselves consider to be most vulnerable to problems.  We have emphasised to ADIs the importance of applying appropriate risk grading, valuation and provisioning against problem assets.  We are giving particular attention to ADIs’ commercial property lending, historically a high risk area as the collapse of the office property boom of the late 1980s reminds us.  Over recent years, commercial property lending by ADIs has gained momentum but the prospects for this sector are now clouded by uncertainties about asset quality and valuations.

Let me make two general points about the possible evolution of credit quality during the slowdown.

Firstly, although hindsight will be unkind to some individual lending decisions, housing lending — around half of the total ADI loan portfolio — is expected to remain a sound asset class.  Whether it be earlier warnings by the Reserve Bank of Australia and ourselves about credit risk, APRA’s tighter prudential requirements for housing lending, or the ‘wake-up call’ from the bursting of Australia’s housing boom, ADI boards and management have had ‘pause for thought’ about aggressive lending strategies in this area and have maintained generally good discipline in credit risk assessment and new product development.  True, problem housing loans have been rising, but this is off a very low base and recent interest rate reductions have eased debt-servicing burdens on households.  The performance of housing loan portfolios in the period ahead will, of course, depend critically on what happens to unemployment.  

Secondly, although conditions in the business sector have soured recently, the sound financial health of this sector until that point will help to support business loan portfolios.  Gearing levels in this sector are only a little above their medium-term average and, in this sector too, recent declines in interest rates will help to lighten debt-servicing burdens.

Recent increases in provisioning levels have meant that for many ADIs, though by no means all, the long run of record profitability in our banking system has come to an end.  Nonetheless, core earnings have remained generally strong and even current levels of profitability would be the envy of many other banking systems. This sustained profitability has helped to underpin the sound capital position of the industry.  Recent capital raisings by our largest institutions of around $16 billion —  some of the issues oversubscribed — were a confirming vote of investor confidence.

Even so, as I mentioned at the outset, capital will be the key focus of APRA’s supervisory activities in the ADI industry in 2009.  Capital has become a very scarce commodity in banking systems globally and ADIs will need to husband capital carefully in this difficult environment.  Our focus on capital involves much more than simply looking at capital ratios or how far above its minimum capital requirements an institution sits.  Our reviews of capital management plans are more probing and comprehensive.  We need to understand an institution’s risk appetite, the quality of loan portfolios, the strength of systems for identifying and managing problem loans, and how conservatively it provides for potential losses. We also need to understand the potential sources of additional capital and their reliability.  Some of our banking institutions, in the interests of preserving capital, have signalled that they are reviewing their dividend policies, and this is a sensible development.  Dividend payout ratios established in good times should not be seen as sacrosanct and it is important that dividend expectations be set at a sustainable level.

At present, our large banking institutions are targeting ratios for Tier 1 capital (the highest quality capital) of around eight per cent.  To be clear, this is a response to market pressures, not to APRA’s prudential requirements.  Indeed, some market pressures are building for even higher capital ratios.  In APRA’s view, ADIs need to be careful getting caught in a macho ‘race to the top’ simply in reaction to market sentiment.  How times have changed!  Not that long ago, banking institutions were being berated for ‘lazy’ capital, concepts of capital efficiency were dominant and every bank share buy-back was cheered!  

Don’t get me wrong — APRA wants well-capitalised ADIs and at current levels, measured under APRA’s conservative rules, ADIs meet that test.  However, capital ratios driven too high in the current environment run the serious risk of inhibiting normal financial intermediation and setting in train a credit contraction — with its attendant flow-on to the real economy — that could ultimately weaken the banking system.  This is one example where seemingly prudent behaviour by individual institutions, looking only at their own circumstances, can produce adverse outcomes at the macro level.

Moving to other industries, the global financial crisis has also had an appreciable impact on the life insurance industry (including friendly societies) in Australia, mainly through the sharp deterioration in domestic and global equity markets. (Having said that, the life insurance industry in Australia is by its nature less exposed to the crisis than life industries in other countries, including the United Kingdom, because it has a preponderance of investment-linked and short-term risk business.)  Over recent years, the industry has been reducing risk in its investment portfolios and it entered the crisis well-capitalised and structurally well-placed to withstand falling asset values; the average asset allocation to equities for non-investment-linked business was only around 20 per cent but some insurers did have much higher allocations.

Since the crisis began, APRA’s supervisory focus on the life insurance industry has been on its capital strength.  In the early part of last year, we sought detailed information from life insurers on the sensitivity of their capital positions to adverse movements in equity markets and interest rates.  We used that information to identify more vulnerable insurers that required closer supervisory attention.  Over the next few months, a number of insurers took active steps to fortify their businesses through capital injections, reductions in holdings of potentially volatile assets, protection of downside valuation risks through derivatives, and revised capital management plans and trigger points for Board action.  These initiatives have enabled the industry to absorb substantial reductions in equity prices and property values, as well as the impact of much lower interest rates and wider credit spreads, without putting their capital positions under threat.

Markets have subsequently plumbed lower depths.  In response, we have established a team to closely monitor life insurance capital and to coordinate any supervisory responses.  Late last year, as well, we asked insurers to carry out additional detailed stress tests to ensure that the impacts of any further significant market deterioration were well understood and appropriate contingency plans put in place.  The results of that stress testing are still being assessed but all indications are that the life insurance industry remains in a generally sound position.  We commend the industry for the actions it has taken, thusfar, to protect the interests of policyholders and for the level of involvement of Boards and senior management in these actions.

The deterioration in domestic and global equity markets has also had a pronounced impact on the superannuation industry, with nearly all superannuation funds experiencing negative returns for the first time since 2002/03.  Superannuation poses a particular set of challenges for a prudential regulator.  Unlike our other supervised industries, capital does not play a significant role as a buffer against losses and, because the Australian superannuation system is predominantly defined contribution, the major risks on investments are borne directly by fund members. What underpins our system is the trustee structure.  Trustees have strict fiduciary obligations but substantial freedom in managing funds, especially in regard to investment allocation.

This system has served Australia well to date and has, since the new licensing regime was introduced in 2006, shown a growing sense of maturity and professionalism.

APRA’s focus through the global financial crisis has been on trustee processes, rather than investment outcomes.  Superannuation trustees are subject to prudential requirements on governance, risk management, fitness and propriety, outsourcing arrangements and resourcing.  Three particular risk issues thrown up by the crisis are worth highlighting.

The first is liquidity risk.  Traditionally, superannuation funds have enjoyed excess liquidity relative to their needs, driven by the inflow of compulsory superannuation guarantee contributions, voluntary contributions and concessionally taxed earnings in the accumulation phase.  Choice of fund and other policy changes to make the system more flexible have put greater demands on liquidity risk management, and these demands have been accentuated during the crisis by the freezing of a number of managed funds and mortgage trusts.  As we did in other industries, APRA has exhorted trustees to undertake rigorous stress-testing of their liquidity needs under a range of extreme but plausible scenarios.  We have also undertaken a questionnaire of superannuation funds to gain a better understanding of liquidity management practices.  Our general finding is that these practices have improved but there is more work to do.

A second issue is the valuation of unlisted assets.  Under accounting standards, superannuation funds are required to report all assets at net market value. Although valuation is relatively easy for listed assets, it is as we know more complicated for assets where there is no ready market mechanism to validate values.  The valuation approaches that are used have implications for performance measurement, decisions on portfolio rebalancing and for the allocation of investment returns to members.  Risks magnify where assets that are infrequently traded and revalued are included in portfolios that must be valued much more frequently — for example, for unit pricing or crediting rate calculations.  

It is not APRA’s role to prescribe specific valuation methodologies.  However, we have been emphasising to trustees that they have a responsibility to ensure reliable valuations of assets, to take the difficulties and costs of valuing unlisted assets into account in determining investment strategies and menu choices, and to give due consideration to the equity aspects of valuation between existing, exiting and prospective members.

A third issue is solvency risk for defined benefit (and hybrid) funds.  Under defined benefit schemes, a legacy in Australia of older employment arrangements, the employer sponsor bears the residual risk of the fund being able to pay the defined benefits.  Australia’s economic slowdown will obviously affect employer fortunes and increase the possibility of earlier exits from funds through redundancies and early retirements.  Taken together with the recent sharp falls in asset values, the solvency of some defined benefit funds will be tested.  We are closely monitoring solvency and emphasising to the trustees, auditors and actuaries of funds with unsatisfactory solvency positions the need for credible remediation plans within an acceptable time-frame, and well within the legal limit of five years.  

Amongst our supervised industries, the general insurance industry has to this point been touched least by the global financial crisis.  A major reason has been its conservative approach to investments.  Less than 10 per cent of the industry’s assets are exposed to equities and there are no material exposures to U.S. sub-prime mortgages or complex financial instruments.  The industry’s recent fortunes, rather, have been tied to domestic developments, in the form of adverse natural events and strong market competition.  In particular, the severe storms and floods in late 2007/early 2008 have eroded underwriting profit as will the recent North Queensland floods and the tragic Victorian bushfires.  Nonetheless, the industry remains very well capitalised.

APRA’s supervisory priorities for the general insurance industry in 2009 are being shaped by the economic slowdown and by recent industry experience, here and globally.  Slowing economic activity and lower interest rates are likely to be associated, on the revenue side, with reduced premium revenue and investment returns and, on the costs side, with increased claims frequency in a number of insurance classes, such as professional indemnity and directors and officers (D&O) insurance.  In this context, one of our priorities is, and has been, underwriting and pricing disciplines in the industry.  We note signs that the premium cycle is turning.  

Another priority is reinsurance management.  The apparent increase in weather-related events has led some insurers to buy reinsurance in ways that better deal not only with large-scale catastrophes but also the increased frequency of ‘mid-sized’ events.  This is a reversal of the previous trend for insurers to reduce reinsurance costs by retaining more risk themselves; it can also be a prudent response to changing claims patterns.  Nonetheless, insurers need to ensure that credit exposures associated with this reinsurance are managed carefully.

A third supervisory priority is group supervision.  A telling lesson from the AIG experience — the largest global insurer, undone by its involvement in complex financial instruments — is the importance of supervising insurers on a consolidated basis, covering all the risks that may directly or indirectly impact on the insurer. After a long consultation process, APRA is introducing consolidated supervision of insurance groups from end-March this year, with the aim of reducing the potential for group activities and interrelationships to adversely affect the financial soundness of individual insurers within the group.

One sector of the industry that has been attracting close scrutiny from APRA has been lenders mortgage insurers (LMIs), which have significant exposures to credit risk in mortgage lending in Australia.  As I noted, the level of problem housing loans has been rising; in response, LMIs are tightening underwriting criteria and higher risk mortgage products are being de-emphasised or priced accordingly.  Although recent claims experience has been readily manageable, a more conservative approach to reserving has put downward pressure on underwriting results. Nonetheless, operating profits have been boosted by good investment returns and the capital base of the LMI sector remains strong.  Rating agencies, while maintaining a negative outlook on the sector locally, have recognized the independent strength of Australian LMIs and their growing distance from the risks in the U.S. mortgage market.  The agencies have also acknowledged the robustness of APRA’s prudential framework for this sector.

APRA’s regulatory priorities

As you would expect, the global financial crisis has prompted a comprehensive and — as best it can be — coordinated public policy response aimed at restoring confidence and stability to financial markets and institutions.  In addition to tackling immediate issues of liquidity and capital, that response also involves detailed work to address weaknesses in the global regulatory framework.   This takes us into APRA’s territory.  The work is being pursued under the auspices of the G20 and the Financial Stability Forum, which in April last year made a series of recommendations — some 67 in total — aimed at enhancing the resilience of the international financial system.  The guiding principles are “to create a financial system that operates with less leverage, is immune to the set of misaligned incentives at the root of this crisis, where prudential and regulatory oversight is strengthened, and where transparency allows better identification and management of risks”.

The recommendations of the Forum are informing APRA’s prudential policy agenda in a number of areas, three of which I would like to mention briefly.  

The first concerns strengthened prudential oversight of risk management.  The global financial crisis revealed, at its heart, significant and even fatal shortcomings in risk management at major global financial institutions — not our supervised institutions I might add — in credit standards for housing lending, in the assessment of risks in complex financial instruments, in the identification of risk concentrations and in the management of liquidity.  It remains the responsibility of financial institutions themselves to take the lead in strengthening governance and risk management frameworks.  What supervisors globally are aiming to do is enhance their supervisory tools and standards to promote improvements in these frameworks and encourage better practices.  In this context, liquidity risk management is now one of APRA’s highest policy priorities.  We had begun a review of our prudential framework for liquidity risk management before the crisis struck, but this process had to be suspended while we and other regulators learned at first hand what constituted good and bad practice in this area.  We are now finalising this work.

The second area relates to prudential capital requirements and their relationship to the economic cycle.  Banking is inherently a cyclical business but there are aspects of global capital requirements, even in the much improved Basel IIFramework now being implemented, that can be procyclical in their impact — that is, they may amplify an economic cycle rather than counteract it.  The key international body here, the Basel Committee on Banking Supervision, has confirmed that it does not propose to raise global minimum capital ratios for banks during the global financial crisis — that would indeed be procyclical — though capital requirements for the taking of market risk will increase.  The Basel Committee, however, is exploring how to promote strong capital buffers above minimum requirements that can be used during a downturn to dampen shocks and encourage continued lending.  The Basel Committee is also exploring the need for simple, transparent gross measures of risk — so-called ‘leverage ratios’ — to supplement risk-based prudential approaches and provide a further check on the build-up of leverage.  APRA is not a member of the Basel Committee but we are committed to a harmonised global approach to capital requirements for banking institutions.

The third area, also critical to concerns about procyclicality, is executive remuneration and its alignment to long-term risk management.  In response to the Prime Minister’s request, APRA is developing a principles-based framework that is focused on the structure of executive remuneration in supervised institutions and the incentives, explicit or otherwise, that are built in to act against excessive risk-taking.  We have always seen the setting of remuneration levels as the responsibility of boards and shareholders.

APRA’s proposed framework is still under development internally and will, of course, be subject to broad consultation.  It would be an extension of the governance, risk management and capital requirements to which our supervised institutions are already subject.  Without prejudging outcomes, let me illustrate two of the principles which would be expected to be the centerpiece of sound remuneration structures.

The first, and obvious, principle is that boards are responsible for remuneration arrangements.  This is a simple extension of APRA’s key governance principle that boards are responsible for the sound and prudent management of their institution. The board need not understand or approve the remuneration arrangements for every employee, but it should understand and approve the overall remuneration structure.  The board will typically apply this principle through a board remuneration committee of independent directors, but the entire board remains responsible.

The second principle is that boards should extend their stewardship of remuneration matters to all groups of personnel whose performance and activities can materially affect the institution’s overall performance.  Generally, the relevant groups would include the senior executives of the institution, risk management staff, commissioned sales employees and agents, and traders and other operators where incentive remuneration can be material.  The larger and more complex the institution, the more the board will need to consider remuneration arrangements beyond the senior executive group.

….and further reforms?

Beyond the current global regulatory effort, recent speeches and reports by senior policymakers and global think-tanks are suggesting that an even more fundamental overhaul of the global financial system is needed if financial crises of the current severity are to be prevented.  The questions being asked include:

• Should large and complex financial institutions that are critical to financial stability be subject to more rigorous standards of prudential regulation than others?
• Should hitherto unregulated financial institutions that undertake banking-like activities, which collectively can have an impact on financial stability, be subject to some form of prudential regulation?
• What is the appropriate balance between the public sector in its role of safeguarding stability and the private sector in spurring competition and innovation?

The answers to these complex questions, which are slowly emerging, will have a major bearing on the future shape of the global financial system, even if they have no immediate implications for Australia, or for APRA.

The best-laid plans of regulators to promote prudent risk management will not succeed, however, if the private sector’s approach to risk-taking is not squarely grounded in the highest standards of personal accountability.  Multi-million dollar payouts to executives of failed banking institutions show where these standards have slipped abroad.  In Australia’s case, though, we as a prudential regulator take considerable comfort from the fact that personal accountability still has considerable moral force within our supervised institutions.