Deputy Chair John Lonsdale - speech to Customer Owned Banking Association (COBA) 2020 Convention

Working together in challenging times

Thank you for the opportunity to address this year’s COBA conference. APRA appreciates the regular dialogue we have with COBA and recognises the important role COBA members play in the communities they serve.

It’s obvious that 2020 clearly has been a very challenging year for everyone, confronting the Australian community with firstly a health crisis and then testing the financial system with a resulting economic crisis. 

However, as many have noted before me, this crisis has also highlighted the vital role that financial institutions, particularly authorised deposit-taking institutions, play in supporting households, businesses and communities, as well as driving economic growth. 

Clearly the work APRA and the ADI industry have undertaken over the past 10 years or more to build strength and resilience in the system put the Australian financial sector on a sound footing going into the COVID-19 crisis, but we can never say our work on system resilience is complete. It is an ongoing task and must always account for new challenges, and never more so than now when we are looking to work our way out of a severe health and economic crisis. 

The theme of this year’s COBA conference, ‘Forging our path ahead’, is appropriate for the current times. 

In this period of considerable uncertainty, it is more important than ever that COBA members continue to work together to strengthen the foundations for a prosperous and competitive mutual bank sector. 

Today I want to talk about the importance of the industry working together to overcome current challenges and to plan for those challenges that are yet to materialise.

The current environment

Mutual ADIs have grown in significance in the Australian banking sector. Over the past decade, the market share of mutual ADIs has grown across key metrics, including assets, loans and deposits. Although market shares remain modest, the success of mutual ADIs in firming their place within the banking sector is testament to their importance. 

Clearly, mutual ADIs offer a value proposition that is appealing to many banking consumers. Further illustrating the point, mutual ADIs’ collective assets have doubled over the past ten years, which is significant when compared with the major banks, which have expanded just over half as rapidly. Even through COVID-19, mutual ADIs have continued to grow their asset and liability base faster than the banking industry average.

That growth has not been achieved through a reduction in core prudential metrics. In times like these it is especially important to not lose sight of the capacity for banks to withstand periods of stress. Banks require adequate capital and liquidity to provide buffers during episodes that could otherwise threaten their viability. 

Mutual ADIs have in part been able to manage through this period due to the substantial buffers built up through better times. Mutual ADIs’ capital ratios have remained stable at around 16 to 17 per cent for over a decade – an undoubtedly strong position. 

These high levels have been managed and maintained through the pandemic, despite the significant pressure the entire industry has faced on asset quality and earnings over this period. 

Mutual ADIs have also maintained strong liquidity positions, particularly through COVID-19, where the threat of meeting increased deposit outflows was very real. 

With the RBA’s measures providing support to the system as a whole, the average minimum liquidity holdings ratio for mutual ADIs increased from 15.6 per cent prior to COVID-19 to 19.1 per cent at the end of the September quarter. 

As a result, both capital and liquidity ratios for mutual ADIs remain well above regulatory minimums and, together with other financial institutions, mutual ADIs are supporting the economy by continuing to extend credit to households and businesses.

As you may be aware, and as previously flagged, shortly APRA will publish a consultation package on bank capital reforms designed to increase the risk sensitivity, flexibility and transparency of capital, but will not change the current level of capital. The package will include more differentiated risk weights for different types of mortgages and reduced risk weights for small business lending. 

This capital consultation will also include more details on the simplified framework and reduced compliance requirements which will apply to all COBA members, and we welcome your contribution to the consultation. 

In the midst of this challenging environment, the banking industry also provided forbearance to households and businesses struggling to meet their loan repayments. Repayment deferrals soon became an area of considerable scrutiny, with over 10 per cent of all lending subject to repayment deferral at its peak. 

However, compared to the major banks, mutual ADIs have low volumes of loans subject to repayment deferral and so the task ahead to manage loan deferrals down is smaller. This is the case for lending to both housing borrowers and small and medium-sized businesses. 

As at the end of October, repayment deferrals constituted only 2 per cent and 4 per cent of total housing loans and total small and medium-sized enterprise loans, respectively. Smaller mutual ADIs – with total assets less than $5 billion, have even lower shares of loan deferrals. 

While the scale of repayment deferrals on bank balance sheets are by no means the only indicator of credit risk in the current environment, mutual ADIs have managed their impact well to date, which may assist in lessening the impact of the so-called “cliff” effect as support measures are withdrawn.

Challenges and opportunities

Despite this current sound operating state, smaller ADIs have faced a number of challenges in recent years, which could be exacerbated given the current operating/economic environment. 

A large number of the small banks – and not only mutuals – have business models that are challenged. 

High cost-to-income ratios, with a high cost operating model, are likely to continue to constrain the ability of smaller ADIs to generate earnings for further balance sheet growth. Because of this is it is important the industry strives to tackle costs.

In addition, the current low interest rate environment has contributed to declining net income margins, with the mutual sector particularly vulnerable given its funding model which has a high dependency on low rate transactional accounts. The low interest rate environment is set to stay for a while and margins across the industry are likely to continue to be squeezed. 

While capital ratios in the sector are generally in excess of minimum prudential requirements, with low profitability and limited capital raising options, small ADIs may be challenged to generate enough income to offset potential asset write downs and provisions in a downside scenario. 

Changes in consumer behaviours and expectations also pose challenges. In the broader ADI sector, customers increasingly expect a quality digital offering, so it’s important that small ADIs refocus on digital offerings and invest in technology in order to stay relevant to members and compete with innovation in the financial sector industry. 

The increased digitisation in the sector highlights another significant risk, which is the increasing possibility of cyber attacks. 

As you would be aware, APRA’s new prudential standard on information security standard CPS 234 came into effect nearly 18 months ago for all APRA-regulated industries. 

The requirements and guidance are aimed at helping regulated entities to manage risks around cyber security, recognising that as technological developments continue to expand, the scope and sophistication of potential malicious activity against financial institutions will increase. 

When it comes to cyber security risks, our financial system is only as resilient to cyber attacks as the weakest link in the chain. ADIs need to continue invest and maintain good cyber hygiene to minimise the risks of attacks in the future.

Mutuals face a particular set of risks due to size and scale. The shift to digital services of the financial services organisations and increasing customer expectations means that mutuals are having to adopt cloud-based solutions to remain competitive and relevant. However, the transition to Cloud also presents challenges, particularly concerning whether they have the skills to manage an outsourced environment. Accordingly, a cautious and measured approach is warranted.

The challenge for mutuals in considering third party arrangements has been evident in the number of relief requests we have received. Over 25 percent of all extension requests received and approved for regulatory relief until January 2021 were from COBA members. These were provided in respect of the third-party arrangements transition provision in CPS 234 Information Security.

By working together, we can hopefully use increased connectivity to strengthen the system’s resilience to attacks.

Clearly with all of these challenges, the importance of contingency planning has increased and there is much more to do. 

Recovery Planning

Recovery plans are entities’ own contingency plans to avoid failure in the event of a severe financial stress. Having an effective recovery plan is part of an entity’s financial resilience, as it will improve an entity’s ability to withstand a stress and reduce the likelihood of failure - and so improve the resilience of APRA’s regulated industries. This process should not be a compliance exercise, rather it is part of good corporate governance for every entity to have a well thought out plan for managing stress. Through this planning, entities can improve their ability to remain in control of their own destiny in a crisis, reducing the risk of having to take reactive measures which adversely impact beneficiaries.    

Recent events have re-iterated why improving entity recovery planning will continue to be a focus for APRA across its regulated industries. To make the point, we have now made recoverability part of our new Supervision Risk and Intensity model, SRI.

A few months ago, APRA completed a thematic review of small to mid-sized ADI recovery plans, including COBA members, as part of APRA’s ongoing work to improve recovery planning capability across the ADI industry and to ensure that institutions are prepared as much as they can be to recover from severe stress.

The review included the benchmarking of peer group recovery plans to identify areas for further improvement. APRA observed that the general quality of recovery plans amongst smaller ADIs was weaker than we would like it to be, and that there was a lack of understanding of APRA’s expectations.  

APRA supervisors are working with ADIs to ensure improvements to recovery plans are delivered, including through review of updated plans and ongoing supervision of recoverability as part of SRI. 

As many of you would be aware, APRA has made clear that we expect the Boards and senior management of ADIs to understand and promote the benefits of strong recovery planning practices within institutions, to ensure that:

• Firstly, credible recovery options are developed and ready to be implemented if needed, 
  
   
• Secondly, that the trigger framework is effective so that a need to deploy the recovery plan is identified early enough, and 
  
   
• Thirdly, that governance arrangements are effective, bought into by senior management, and integrated into the risk management framework.

While there may be a range of recovery options available to ADIs, APRA recognises that for smaller ADIs with simple businesses the range of recovery options may be more limited, and that a merger or transfer of business may be the most effective recovery option. Therefore it is prudent that such ADIs consider the preparatory steps required for a merger or transfer of business, including criteria to identify potential partners, at an early stage rather than wait for a deterioration in financial position. 

Hopefully recovery plans never need to be enacted, but it is important for all APRA regulated entities, even smaller ones, to ensure they have an effective plan in place if needed - and it is APRA’s role to supervise that.

Conclusion

The composition of the mutual sector has changed over the last couple of decades, with increased consolidation in the industry, which is expected to continue to play a part as mutuals seek to gain scale and remain competitive. 

It’s clear that as a cohort of mutuals/small ADIs there is much COBA can do to continue to thrive and deliver an important service to your communities. 

The need to be working together to continue to build strength and resilience has never been more important.