Financial regulation and financial sector evolution: Looking ahead

John Laker, Chairman - Australian Centre for Financial Studies/Finsia Leadership Luncheon Series, Melbourne

I am pleased to join this ‘reunion tour’ — with a slightly different and expanded line-up — and reprise the panel discussion on the future of the financial system that took place at the Australian Conference of Economists last July. As I said then, a prudential supervisor is not in the economic forecasting business. Our role is to ensure that regulated financial institutions and the financial system as a whole are sufficiently strong to cope with any reasonably foreseeable adversity, however that adversity may unfold. Hence, I will leave prognostications to others.

Underpinning the strength of financial institutions, and the effectiveness of a supervisor, must be a robust prudential framework — the ‘rules of the game’, so to speak. As we all know, the global rules had been found wanting in the crisis and an ambitious reform effort driven by the G-20 Leaders has been underway to redress weaknesses. APRA’s involvement in this effort, largely through its membership of the Basel Committee on Banking Supervision, has focussed mainly on the so-called Basel III reforms.

The thrust of the Basel III reforms should be well-known to this audience. It is to improve the resilience of the global banking system by raising the quality, quantity and international consistency of bank capital and liquidity, constraining the build-up of leverage and maturity mismatches, and introducing capital buffers that can be drawn upon in stressed times. The reforms are also aimed at improving the pricing and management of risk as well as strengthening banks’ transparency and disclosure. APRA has spoken extensively about the detail and implementation of these reforms.

In a recent speech, I stated that in the areas of particular interest to APRA ‘… global reforms have now largely moved into the implementation phase. Indeed, I believe we are now over the hump of reforms to the prudential regime in Australia. That is not to say that our policy team will not be very busy for some time to come’.[1] Let me use my introductory remarks to expand on that statement and, hopefully, to placate the coast-watchers staring anxiously out for signs of another ‘tsunami’, to use the colourful language of the organisers of today’s event. I will confine my remarks to the Australian banking system, although my ‘over the hump’ comment applies equally to reforms of domestic origin in insurance and superannuation.

Basel III capital reforms

Starting first with Basel III capital. From 1 January 2013, APRA formally introduced the Basel III definition of regulatory capital, the minimum requirements for the different tiers of capital, and the stricter eligibility criteria for capital instruments. However, for in-principle reasons, APRA did not adopt the concessional treatment available for certain items in calculating regulatory capital. Australia was one of 11 out of 19 Basel Committee jurisdictions that had final Basel III regulations in place by this start date.

1 January 2013 also marked the date of a key milestone in Basel III implementation. From this date, authorised deposit-taking institutions (ADIs) were required to meet a minimum Common Equity Tier 1 requirement of 4.5 per cent of risk-weighted assets, after regulatory adjustments. This was at the early end of the globally agreed timetable, although fully consistent with the Basel Committee’s view that, when they can, banking institutions should comply with the Basel III reforms as soon as possible. Our accelerated timetable provoked comment during consultations that Australia was over-zealous in its Basel III implementation. We were not alone in that zeal. As we understand it, six other jurisdictions did not avail themselves of the phase-in arrangements and some of these jurisdictions — such as Switzerland (10 per cent) and Canada (seven per cent) — set higher minimum common equity requirements for some or all of their banks.

The next key milestone is 1 January 2016, when the capital conservation buffer is introduced. From that date, ADIs will be required to meet a minimum Common Equity Tier 1 requirement of 7.0 per cent, including the buffer.

The larger Australian banks have been providing Basel III capital data to the Basel Committee and ourselves as part of a Basel III monitoring exercise. As at end-September 2012, the weighted average Common Equity Tier 1 capital ratio for the major Australian banks under APRA’s requirements was 7.8 per cent; preliminary data for end-December 2012 suggest a slightly higher figure. Hence, these banks have already passed both milestones. Basel III capital data for other ADIs will not be available until after end-March 2013 but we have no doubt the data will show that passing the first milestone was easy and, in all likelihood, so too will be achieving the second.

In APRA’s 2012 Annual Report, I commented that APRA’s approach to the Basel III capital reforms ‘… reflects its firmly held view that conservatism has served Australia well before and during the crisis, that the milestones are not demanding, and that the impact of higher capital requirements on the overall funding costs of ADIs are likely to be small.’ Developments over recent months, particularly the reductions in risk premia for major banks and investor enthusiasm for hybrid capital instruments issued by ADIs, only confirm us in that view.

Meeting minimum Basel III capital requirements, however, is only part of a prudent approach to capital planning and management. There are other critical elements:

• ADIs may be subject to a Prudential Capital Requirement that is higher than the Basel III minimum, based on APRA’s assessment of the risk profile of the institution;
• institutions designated by APRA as domestic systemically important banks (D-SIBs) will, from 1 January 2016 onwards, also be subject to a so-called D-SIB capital surcharge, that will take the form of Common Equity Tier 1. I will say a little more about D-SIBs in a moment; and
• ADIs also need to hold a sufficient buffer above minimum prudential requirements to ensure that they can absorb losses in stressed situations.

The setting of these buffers is an essential part of the Internal Capital Adequacy Assessment Process (ICAAP) for ADIs (and insurers). We published guidance on this process earlier in the month. In the case of ADIs, APRA expects a board to satisfy itself that capital buffers and capital targets are set in line with the risk appetite of the institution and take into account the impacts of severe but plausible stresses identified in robust and conservative stress-testing. A prudent board will also consider other factors, such as growth expectations, capital volatility, dividend policy and credit ratings where relevant. Peer comparisons, whether domestic or international, are not sufficient, a lesson learned in the crisis.

In short, the appropriate level of capital that an ADI targets and seeks to maintain is a more nuanced and forward-looking assessment than a focus on minimum prudential requirements would suggest. This needs to be kept front of mind when siren calls for share buy-backs, special dividends or higher dividend payout ratios get louder. And they surely will!

The Basel Committee has developed a standardised disclosure template that is intended to address concerns about the international comparability of regulatory capital ratios. APRA will be consulting on this template shortly. We have expanded the template so that users will readily be able to reconcile the capital position of ADIs under APRA’s requirements and under the so-called ‘harmonised’ Basel III requirements.

The disclosure template focuses on the numerator of the capital ratio. The Basel Committee is currently undertaking a substantial exercise on the denominator — the measurement of risk-weighted assets — aimed at ensuring consistent implementation of the full Basel capital framework, including Basel II and Basel II.5, so as to maintain market confidence in regulatory ratios and provide a level playing field. The exercise includes hypothetical test portfolio analysis designed to identify areas and sources of material inconsistencies, on both the banking book and the trading book, across banks and jurisdictions. Preliminary findings for the trading book were published in January this year.

The remaining component of the Basel III capital reforms is the leverage ratio. This is a simple, transparent ratio that is intended to help contain the build-up of leverage in the banking system and to provide additional safeguards against model risk and measurement error. The Basel Committee is currently finalising the specification of the leverage ratio and associated disclosure requirements; when it has done so, we will begin our consultations. We have time on our side here. Under Basel III, the leverage ratio is not scheduled to migrate to a Pillar I requirement until 1 January 2018, but disclosure requirements will come into effect from 1 January 2015. We are now in a parallel run period.

Basel III liquidity reforms

Let me turn now to the Basel III liquidity reforms. The centrepiece of these reforms is two new global standards, which seek to promote stronger liquidity buffers and a more sustainable maturity structure of assets and liabilities. Most attention has been directed to the Liquidity Coverage Ratio. This aims to promote a bank’s short-term resilience by ensuring that it has an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted into cash easily and immediately in private markets to meet its liquidity needs under a 30-day liquidity stress. The LCR rules text was first published by the Basel Committee in December 2010 and, following further assessment of the LCR’s calibration, was revised in January 2013.

The revisions include an expansion in the range of assets eligible as HQLA and some refinements to the assumed inflow and outflow rates. They also include a revised timetable allowing a phase-in of the LCR.

Our consultations on the revised LCR will commence shortly. We have already been offered advice that APRA should adopt the revisions without demur, although it is not always clear that commentators have fully understood the Basel III rules. There is devil — deliberate devil — in the detail!

Take the expansion in the definition of HQLA. The revised Basel III rules give national authorities the discretion to include certain additional assets in a new Level 2B category, provided they fully comply with the qualifying criteria. These assets are residential mortgage-backed securities (RMBS) with a long-term credit rating of AA or higher; corporate debt securities with a long-term credit rating between A+ and BBB-; and a selection of listed non-financial equities. But note the qualifying criteria, which are fundamental and tight: these assets should be liquid in markets during a time of stress and, ideally, be eligible for use in central bank repo operations.

The argument is being put that if APRA were to designate particular types of assets as eligible HQLA, this would encourage depth and liquidity in the markets for these assets. The designation would be self-reinforcing, so to speak. That may well be the case over time. However, the Basel III rules do not reward wishful thinking; they require national authorities to acknowledge the facts. Australia has been through the ‘live’ stress of the global financial crisis — when financial markets were severally disrupted at times — and the behaviour of financial assets during this period will be a critical factor in our assessment of HQLA eligibility.

There is more to this story, of course. Some types of debt securities in the list of potential Level 2 assets are eligible collateral for the Committed Liquidity Facility that will be provided by the Reserve Bank of Australia as part of Australia’s rather unique LCR arrangements. These include RMBS rated AAA or higher and some corporate debt securities. ADIs with access to the Facility will no doubt hold these debt securities as part of a well-diversified liquid assets portfolio, even if the assets do not qualify as HQLA, and that may in itself encourage market depth.

Next, take the revised timetable allowing for a phase-in of the LCR. The LCR will be introduced as planned on 1 January 2015, but the minimum global requirement has now been set at 60 per cent and will rise to 100 per cent over the following few years. Note, this is a minimum requirement and national authorities have the discretion to accelerate the timetable. No doubt, we will again be accused of being over-zealous if we do not adopt the graduated approach. However, this approach was introduced, in the words of the Chairman of the Basel Committee, ‘… in light of the considerable stress facing banking systems in some regions.’[2] Australia is not one of those regions. And Australia would not be in the lead here. On end-June 2012 data, the Basel Committee has estimated that the weighted average LCR for a sample of around 200 of the world’s largest banks, on the revised calibration, is around 125 per cent. Only around one-quarter of that sample could still be below 100 per cent. This convoy has already sailed, and it would hardly be wise to be seen at the back!

The Basel Committee will be refining the Net Stable Funding Ratio, which addresses the longer-term structure of bank debt, between now and the end of 2014.

Other major policy initiatives

Very briefly, let me run through the other major initiatives in banking that are keeping our policy team busy.

Firstly, we are finalising our proposed prudential framework for conglomerate (Level 3) groups. These are groups that have material operations in more than one APRA-regulated industry and/or have one or more material entities operating in non-APRA-regulated industries. The proposed Level 3 framework consists of four components: requirements for group governance, risk exposures, risk management and capital adequacy. Draft prudential standards for group governance and risk exposures were released in December last year and draft standards for the other two components will be released within the next couple of months. This has proven a complex exercise with little global precedent to draw on, but the benefits to Australia of avoiding a so-called ‘AIG problem’ are very real.

Secondly, we are currently reviewing our prudential standard on securitisation, with a discussion paper outlining our proposed reforms planned for mid-year. As we have foreshadowed, these reforms will include:

• an explicit framework within which ADIs may engage in securitisation for funding purposes, without any capital benefit. This will be a simple and straightforward framework; and
• a somewhat less simple method — though simpler than current arrangements — under which ADIs can also achieve capital relief through securitisation.

We want to ensure that the unduly complex and obscure securitisation structures that proved so toxic in securitisation markets abroad do not emerge in Australia and that Australian securitisations are seen as amongst the simplest and safest structures in the world. Our approach, which focuses on the issuer, will naturally take into account the work of the Basel Committee, which is focussed on the holder of securitised assets and is seeking to make capital requirements for securitisation products simpler, better reflective of risk, less reliant on credit ratings and without significant cliff effects.

Thirdly, but well back in the policy queue at this point, we are beginning work on implementing the framework for dealing with D-SIBs, as endorsed by the G-20 Leaders late last year. Under the principles-based approach, APRA is required to establish a methodology for assessing the degree to which banks are systemically important in Australia, publically disclose information that provides an outline of the methodology employed and ensure that any D-SIB has higher loss absorbency, fully met by Common Equity Tier 1. We think it important to develop a methodology that will not only help us to identify current D-SIBs but also help us identify banks that are gaining in systemic importance, and why that is so. The D-SIB framework does not come into effect until 1 January 2016 so, in that area too, we have time on our side.

Footnotes

1. J.F.Laker, The Importance of Good Governance, Speech at Australian British Chamber of Commerce, Melbourne, 27 February 2013.
2. S. Ingves, From Ideas to Implementation, Speech to BCBS/FSI High Level Meeting, Cape Town, 24 January 2013.