Enhancing the competitiveness of financial services - lessons learnt and opportunities for improvement

John Laker, Chairman - IFSA Annual Conference, Gold Coast

Thank you for the opportunity to join this distinguished panel to offer a prudential regulator’s perspective on the lessons learnt from the global financial crisis.

No doubt it was clear foresight on IFSA’s part, and not luck, that led it many months ago to choose this high-octane theme — “Energise 09” — for its Annual Conference.  As it has turned out, this gathering has coincided with a growing sense among financial system participants, certainly in Australia, that the worst of the crisis might be behind us and that sensible planning for better times can begin. The global financial system, standing at the precipice in September and October last year, has indeed stepped back from the edge.  Global credit markets have stabilised.  And the dramatic declines in output in a number of advanced economies have begun to ease.

In Australia, consumer and business confidence has been recovering and, on the latest signs, the economic downturn may not be a serious as had been feared initially.

Without wishing to put a dampener on this gathering — to run a parallel “de-Energise 09”!  — we in APRA are by no means ready to relax.  Testing times still lie ahead for our regulated institutions.  The current phase of the domestic credit cycle has yet to run its course.  Asset quality remains under pressure. Disappointments could easily dent financial market sentiment.  Globally, the balance sheets of major financial institutions are still under repair and the trust on which financial systems depend so crucially is being regained only slowly.

At first blush, it might seem curious to have a prudential regulator on a panel discussing the competitiveness of financial services.  APRA does not have a mandate to promote competition, although competition is one of a number of factors which we must take into account in our prudential activities.  That said, we deal in a commodity that is critical to the strength and competitiveness of the financial system — namely, confidence.  Our role is to promote confidence in the soundness of financial institutions and in the financial system more generally.  We are complemented by ASIC’s role in promoting confidence in the integrity and continuity of markets.  Together, the two regulatory agencies have been working tirelessly through the crisis to maintain confidence in our financial institutions and markets, and very effectively if the international accolades are accepted at face value.  Abroad, the story is different.  In a number of major countries, that confidence has been lost and financial systems have been enfeebled in performing their traditional function of intermediating between savers and investors, and allocating risk.

Not surprisingly, then, the restoration of confidence by rebuilding trust in the global financial system has become a major objective of the Leaders of the G20. This is a task to which the energies of all financial system participants —  institutions and their boards, management and owners; fund managers; credit rating agencies; regulatory agencies and governments —must be harnessed.  After all, the failures that gave rise to the global financial crisis were comprehensive.

Global reform efforts in the area of prudential regulation are aimed at addressing weaknesses in bank capital and liquidity requirements that contributed to the growth of unregulated exposures, excessive risk-taking and leverage, and weak liquidity risk management.  The reforms are being progressed by the Basel Committee on Banking Supervision and are focused particularly on bank capital. Enhancements to capital requirements involve:

• improving the coverage of risks arising from securitisation, off-balance sheet conduits and trading book activities;
• strengthening the quality, consistency and transparency of the highest forms of capital (Tier 1 capital);
• building counter-cyclical buffers into capital frameworks and provisioning practices to help ensure that capital and reserves are built up in good times, so that they can be drawn down in periods of stress; and
• introducing a simple leverage ratio as a backstop to the more complex risk-based rules of the Basel II Framework.

The upshot of these reforms is that global banking systems will, once the crisis has eased, be operating with more capital, and more high quality capital, than they have in the past.

APRA is now a member of the Basel Committee and we support these reform initiatives.  Though Australian banks have largely avoided the excesses to which the reforms are targeted, our banks will be beneficiaries of a more robust global capital regime.  I attended my first meeting of the Committee a month ago and I can attest that the issues are complex and will require careful and pragmatic judgments.  One simple example:  how to design capital buffers that markets will allow to fall, as well as rise.  Nonetheless, the mandate given by the Leaders of the G20 is clear and the Committee’s work has considerable momentum.

APRA’s policy work, of course, extends beyond the banking system.  The global insurance sector has not been immune from the crisis, as the rescue of AIG and the pressures on U.S. monoline insurers bear witness.  Closer to home, the substantial deterioration in global and domestic equity markets has had its impact on our life insurance and superannuation industries.  Against this background, we are continuing to develop a prudential framework for conglomerate groups, that is, groups that straddle our regulated industries and may include unregulated entities. We have also signalled a review of capital standards for both the life insurance and general insurance industries, with the aim of improving the risk-sensitivity and appropriateness of the standards and their alignment between regulated industries. We have released proposals on remuneration, to which I will refer shortly.  And APRA’s Deputy Chairman, Ross Jones, has outlined our priorities in the superannuation industry to another panel at this Conference. 

All in all, APRA has a full prudential policy agenda and our policy resources are stretched.  Let me emphasise, however, that we are not contemplating a substantial overhaul of Australia’s prudential regulation framework.  That framework has stood us in good stead during the global financial crisis. Nonetheless, there is always room for improvements and the lessons to learn from the crisis continue to unfold.

A focus on regulatory reforms, however, can present too narrow a view of the task of rebuilding confidence and trust in financial services markets.  Within each major economy, regulatory arrangements are uniform and yet some financial institutions have fared much better than others through the crisis.  There is another and major contributing factor at play here — namely, standards of corporate governance. Between major economies, capital requirements for banks are broadly consistent yet some banking systems — Canada and Australia in particular — have fared much better than others.  One of the factors here, I would suggest, is the performance of the prudential regulator itself.

Let me say a few words about these two factors.

By establishing the institution’s tolerance for risk, approving its risk management strategy and ensuring that management has effective risk controls in place, boards are a critical line of defence against excessive risk-taking.  And as chronicled in a succession of reports, the Walker Review in the United Kingdom being the most recent and comprehensive, that line of defence has been found wanting in a number of major financial institutions over recent years.  The Walker Review concluded that

“It is clear that governance failures contributed materially to excessive risk taking in the lead up to the financial crisis.  Weaknesses in risk management, board quality and practice, control of remuneration, and in the exercise of ownership rights needs to be addressed in the UK and internationally to minimise the risk of a recurrence.”

The weaknesses in risk management highlighted in the various reports include:

• failure to identify and understand risks on new complex products;
• weak controls over balance sheet growth and over off-balance sheet risks;
• inadequate authority and independence of the risk management function;
• inadequate communication and aggregation across business lines and functions; and
• defective due diligence on strategic acquisitions.

Standards of corporate governance were also undermined by an undue focus on short-term horizons, such as the weight put on quarterly revenue and market share performance.

The Walker Review makes 39 ‘best practice’ recommendations designed to improve governance in key UK banking institutions.  Relevant to this audience, some of the recommendations are addressed to institutional investors, which the Review complains were slow to act where issues of concern were identified in banks in which they were investors.  This is not APRA’s territory, but our sense is that institutional investors in Australia are more vigorous and persistent than in the United States and Europe.

Generally speaking, the boards of the institutions APRA regulates have avoided the failings of many of their overseas counterparts and have performed sensibly up to and through the crisis.  Inevitably, the harsh spotlight of the crisis has shown some lending and investment decisions to have been made on over-optimistic assumptions; reporting to the board has been revealed as insufficiently detailed in some cases; and business models reliant on securitisation have had to be hastily redrawn.  Some reputations have taken a dent.  However, APRA does not have a parallel list of 39 recommendations and it does not see a need to revamp its governance standards, other than to deal with remuneration.  These standards were subject to considerable industry debate when they were enhanced in 2006, and our emphasis on independence, board renewal and board performance continues to bear fruit.  Our message is that Boards will need to be relentless in pursuing effective governance of risk as the crisis continues and, equally, when heads are finally lifted above the trenches and the battlefield looks benign.

Our boards may have some harder thinking to do in a couple of areas, at least. The first is remuneration.  A global consensus that remuneration arrangements in financial institutions encouraged excessive risk-taking, with insufficient regard to longer-term risks, prompted the development of the Financial Stability Forum’s Principles of Sound Compensation Practices. APRA intends to give effect to these principles through proposed changes to its governance standards, which have been out for public consultation since late May.

APRA’s approach to remuneration has two main objectives:

• to empower and embolden boards to determine sound remuneration arrangements for all staff who can materially affect the performance of their institution; and
• 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.

We have received a significant number of submissions on our proposals, which we are now assessing.  Overall, the proposals have been well received.  Some submissions say that our high-level principles are too prescriptive and others that our guidance is not prescriptive enough.  On that basis, we have probably got the balance about right!

A second area that will challenge board thinking is that of complexity.  One dimension of this issue has been a discussion point between APRA and the life insurance (and superannuation) industries for some time — namely, legacy products.  In that context, we welcome the Minister’s announcement on product rationalisation at the Conference yesterday.  But I have in mind some much broader dimensions.  The global financial crisis has thrown into stark relief the dangers and costs of excessive financial complexity.  Complex and opaque financial instruments such as CDOs and CDO2s have proven difficult to understand, value and trade.  Complex financial institutions involving a range of subsidiaries operating with various degrees of independence have proven difficult to corral into effective enterprise-wide risk management.  Financial complexity is putting increasing demands on risk management, on the prudential regulation of financial institutions and on the oversight of systemic risk.

Little wonder, then, that there is a yearning for a simple life.  The Walker Review has suggested that boards of large and complex financial groups in the United Kingdom should consider “… whether the interests of their shareholders would be better served by a less complex product array, a more dependably manageable business model and more limited geographic reach”.  Policymakers, questioning the value to the real economy of the surge in trading of complex instruments, share similar sentiments.  In its 2009 Annual Report, the Bank for International Settlements argued that “…[t]he banks must resume lending, but they must also adjust by becoming smaller, simpler and safer”.

And what of the prudential regulators themselves?

There is now a growing understanding of the distinction between prudential regulation and supervision.  Prudential regulation is the set of rules — in APRA’s case, legislation, prudential standards and prudential practice guides — aimed at promoting prudent business behaviour and risk management by financial institutions.  Supervision refers to the direct oversight of financial institutions to ensure that the rules are being properly applied and the institutions are operating soundly.  A distinction, simply put, between the rules of the game and how they are refereed.

As I mentioned earlier, the prudential framework for banking is a largely global one.  Yet as the events of the past two years have shown, some referees have used the whistle very differently from others.

A former senior executive of the UK Financial Services Authority has recently called for supervisors to take a tougher and more challenging approach to the institutions they regulate, be less trusting of boards and senior management, and exercise more supervisory judgment.  This would involve:

• being more intensive and intrusive;
• testing outcomes rather than relying on an institution’s internal systems and controls;
• being more challenging of institutions’ business models and their ability to survive stresses; and
• shifting the ‘burden of proof’ on how well an institution is run so that this falls more on the institution than on the supervisor.

And his list goes on.

We in APRA do not feel the need to respond to this clarion call.  It is an echo of the call made by the HIH Royal Commission in 2003 that APRA develop “… a more skeptical, questioning and, where necessary, aggressive approach to its prudential supervision”, and we took that call to heart then.  There is no shortage of financial institutions, large and small, that have experienced APRA’s ‘tough love’ in the lead-up to, and during, the global financial crisis.

Our risk-based supervisory approach underpinning this ‘tough love’ has a number of key elements:

• a comprehensive supervisory action plan for each regulated institution that takes a consolidated view of the institution’s risk profile;
• robust risk assessment and supervisory response tools;
• continuous off-site analysis backed up by a program of on-site visits, drawing where appropriate on our specialist risk teams;
• regular engagement with boards and senior management.  An excellent discipline is to have boards or responsible risk managers explain to us the risks involved in new or key lines of business; and
• finally, a strong preference for early and targeted intervention over late, rare and drastic intervention.

I would not want to leave you, however, with the impression that the effectiveness of our supervisory approach to date means that it must be an adversarial one.  It is not.  For the most part, we have a constructive, co-operative and highly professional relationship with our institutions and that relationship has withstood the obvious strains created during the crisis.  Neither APRA nor any board or management group has any interest in seeing a regulated institution fail.  Where we do have differences of view with an institution, we will bring in additional expertise as appropriate to consider the issue, and we remain open to be convinced by sound argument.  Where we are unpersuaded, however, we do not resile from taking necessary action.  Generally, a simple but clear “NO” from APRA has been sufficient.