Global regulatory reforms - an update

John Laker, Chairman - FINSIA Financial Services Conference, Sydney

On 10 and 11 November in Seoul, the Leaders of the G‑20 are meeting to finalise the core of the financial sector reform agenda they have been driving hard, and on a tight timetable, since their April 2009 Declaration, Strengthening the Financial System.

The Leaders will have before them a series of reform measures from the Basel Committee on Banking Supervision to strengthen bank capital and liquidity regulation and discourage excessive leverage, and recommendations from the Financial Stability Board to address, amongst other things, problems associated with global systemically important financial institutions. The decisions that are taken at the Seoul Summit will be a crucial milestone in the global reform process. It will not be the end of the road, however. A considerable amount of work lies ahead in implementing the reforms in each country, and generous transition periods have been provided, where needed, to allow banking institutions to adjust to the new global regime without deleterious effects on economic activity.

APRA has been actively involved in the global reform process through its membership of the Basel Committee, alongside the Reserve Bank of Australia, and my remarks today will focus on capital and liquidity reforms. There is much more to the Basel Committee’s initiatives, but my time is short. I will also comment on remuneration incentives, another item in the G-20’s reform agenda and one that has now moved into the implementation phase.

Global capital requirements

The Basel Committee’s comprehensive reform measures are now known as Basel III. The specific proposals to strengthen bank capital regulation are in the public domain and have a number of key elements. The first is an improvement in the risk coverage of the Basel capital framework, to ensure that appropriate capital is held to support the risks arising in trading activities, securitisations, exposures to off-balance sheet vehicles and counterparty credit exposures arising from derivatives. Higher capital requirements in these areas will be introduced at the end of 2011 but the impact on authorised deposit-taking institutions (ADIs) in Australia is expected to be very limited. Our institutions generally gave higher-risk trading activities a wide berth.

The second element is an increase in the quality of capital to ensure banking institutions are better able to absorb losses in life (going concern) and death (gone concern). The Basel Committee has agreed on a new definition of regulatory capital that gives greater weight to common equity, the highest quality form of capital; requires regulatory capital adjustments to be taken from common equity; and strengthens the criteria for inclusion of other instruments in Tier 1 and Tier 2 capital. A stricter approach has also been taken to capital adjustments. These measures were well canvassed at the joint APRA-Finsia conference on International Reform of Bank Regulation in early September.

The third element is an increase in the level of minimum capital requirements. The Basel Committee’s measures on this front were being finalised while the APRA-Finsia conference was underway and were announced shortly thereafter. They involve an increase in the minimum requirement for common equity from the current two per cent level, before the application of regulatory adjustments, to 4.5 per cent after the application of stricter adjustments. The minimum Tier 1 capital requirement was increased from four to six per cent. A capital conservation buffer was set at 2.5 per cent above these new minimum requirements; when capital levels fall within this range, banking institutions will be subject to constraints on capital distribution that increase in severity as losses mount. In addition, the Basel Committee has introduced a macroprudential measure in the form of a countercyclical buffer of 0 to 2.5 per cent, which will apply when excessive credit growth is leading to a system-wide build-up of risk.

The concept of a conservation buffer is yet to be tested in practice. It will be important that supervisors and markets allow the buffer to be drawn down in times of stress; otherwise, banking institutions will feel compelled to operate well above the buffer level, thereby creating a much higher de facto minimum requirement.

Implementation of the second and third elements of the Basel III reforms in member countries will begin on 1 January 2013 and the new minimum capital requirements will be phased in by 1 January 2015; implementation of other aspects is to be completed by 1 January 2019.

The fourth key element in the Basel III capital framework is a non-risk-based leverage ratio playing a backstop role to help contain the build-up of excessive leverage in the banking system and safeguard against model risk and measurement error. A minimum leverage ratio of three per cent based on Tier 1 capital will be tested during a parallel run period from 1 January 2013 to 1 January 2017. At this level, the proposed leverage ratio appears unlikely to act as a binding constraint on ADIs in Australia in normal conditions.

Taken together, these Basel III measures represent a substantial toughening of global bank capital regulation, which will pose challenges for banks in a number of jurisdictions. Not so for ADIs in Australia, which are well used to demanding capital requirements. Nonetheless, we are still being counselled that Australia should somehow distance itself from these global reforms and avoid so-called ‘one-size-fits-all’ solutions. Perhaps these reactions are just a fading echo of earlier concerns that the global reform process would produce draconian solutions to problems that had not been experienced in Australia. The solutions are substantial, but they are not draconian and it perhaps best to let these echoes fade completely. The days when the Australian banking system can operate in splendid isolation are long gone. Our largest banking institutions trade actively in global financial markets; they make considerable use of global wholesale funding markets; they raise equity from global investors. These banks are global citizens, and investors and market analysts judge them accordingly. It is entirely appropriate, therefore, that they at least meet minimum global capital standards.

There is a little more to this point. Our banking institutions have acknowledged that their relative success in negotiating the global financial crisis has been due, in part, to APRA’s regulatory framework and close supervisory oversight. And, of course, one of the major features of our regulatory framework is our more conservative approach to the definition and composition of capital compared to many of our counterparts. Well before the global financial crisis struck, we had tightened our ‘predominance test’ for common equity as a share of Tier 1 capital; we had also taken a stricter approach to Tier 1 capital deductions to remove intangible assets with uncertain values in liquidation. Surely we are not being encouraged to relax this conservatism just after our approach has been vindicated through the crisis? Global minimum standards may have moved much closer to APRA’s capital framework but that is, in itself, no reason for us to retreat. Pursuit of the lowest common denominator has never been an objective for APRA. Our enduring objective must be a robust capital framework that protects the interests of Australian depositors and the stability of the Australian banking system.

APRA will consult extensively with industry and other interested parties over the Basel III capital reforms, once all the details have been finalised. As we said at the APRA-Finsia conference, there is no scope for national discretion to fall short of the proposed minimum global capital standards. In some areas, APRA’s current requirements are less onerous than the new standards and we will need to tighten. These areas include:

• the criteria for the inclusion of instruments in Tier 1 and Tier 2 capital;
• the treatment of deductions from capital; and
• the treatment of minority interests.

In other areas, APRA’s current requirements are more onerous than what Basel III proposes to allow and here, we have said that we will consider whether there are valid reasons to change prudential policy. These areas include:

• the recognition of certain additional reserves;
• the treatment of deferred tax assets; and
• the treatment of equity interests in non-consolidated financial institutions.

Let me comment briefly on these last two items. These form a not-insignificant part of the balance sheets of banks in some other jurisdictions and requiring these items to be fully deducted from capital may, as the Basel Committee has acknowledged, have a potentially adverse impact in these jurisdictions. Hence, Basel III allows but does not require limited recognition of these items when calculating the common equity component of Tier 1 — the operative word is that the items ‘may’ receive limited recognition. Circumstances are entirely different in Australia. These items have been fully deducted from capital since the early 1990s, for ‘in principle’ reasons taken by the Reserve Bank at the time and endorsed by APRA in subsequent reviews of the capital framework. Deferred tax assets are deducted because such assets rely on the future profitability of the banking institution to be realised and are not available to absorb losses on a gone concern basis. Investments in non-consolidated financial institutions are deducted so as to avoid double-counting of capital in the financial system. Capital cannot be used more than once and our deduction rule ensures that when capital absorbs a loss at one financial institution, this does not immediately result in a loss of regulatory capital in an ADI that has invested that capital. Given these long-standing arrangements, APRA will need to be convinced to depart from principle simply to align its capital requirements with one or other country that may choose to recognise these items.

Our industry and individual ADI consultations on the capital reform will also address transition arrangements. Though some have work to do, ADIs are generally well-positioned to meet the Basel III capital framework and extended transition relief is unlikely to be needed. On the contrary, we would envisage that ADIs will aim for early compliance as further confirmation of their well-capitalised positions.

Global liquidity requirements

Arguments that Australian banking institutions should only have to meet global minimum standards hit an impasse when it comes to global liquidity standards. The Basel Committee is seeking to promote stronger liquidity buffers and more stable sources of funding to ensure that banking systems are more resilient to the sort of liquidity stresses that emerged, often very sharply, during the global financial crisis. To this end, it has introduced, for the first time, two internationally consistent regulatory standards for liquidity risk supervision:

• a Liquidity Coverage Ratio (LCR), which aims to promote short-term resilience by ensuring that banking institutions have sufficient high-quality liquid assets to survive an acute stress scenario lasting for one month; and
• a Net Stable Funding Ratio (NSFR), which aims to promote longer-term resilience by creating additional incentives for banking institutions to fund their activities with more stable sources of funding on an ongoing structural basis.

After an observation period beginning in 2011, the LCR will come into effect on 1 January 2015, later than had been foreshadowed originally. The NSFR will move to a minimum standard by 1 January 2018 — a long monitoring period indeed. As we know, Australia simply cannot meet the LCR standard as originally proposed. But for reasons other countries envy — fiscal prudence by a succession of Australian governments. As a consequence of that prudence, the supply of Commonwealth Government Securities to meet so-called ‘Level 1’ liquid asset requirements is relatively limited and eligible ‘Level 2’ liquid assets, in the form of certain non-bank corporate debt, are also in short supply in Australia. These circumstances have been recognised by the Basel Committee, and APRA and the Reserve Bank have been working closely with fellow Committee members on this issue. However, there are no unique circumstances to justify a departure from the NSFR global standard in Australia and that standard, once finalised, is intended to be implemented here in its globally agreed form.

Once the details of the global liquidity standards are released in December, we will outline how the LCR standard is intended to be implemented in Australia. We will also resume our industry consultations on ADI liquidity risk management.

Remuneration incentives

For APRA, the G-20’s goal of improved remuneration incentives has now been incorporated into the regulatory framework and our task is to secure improvements in practice. In contrast to capital and liquidity reforms with their quantitative precision and set transition periods, reforms in this area are better described as a journey, as market practices are brought into closer alignment with the expectations of prudential supervisors, in Australia and globally. As is now well recognised, inappropriate remuneration practices contributed to significant losses at some major global financial institutions and, in turn, to the severity and duration of the global financial crisis.

APRA’s prudential requirements on remuneration came into effect from 1 April this year, in the form of extensions to our prudential standards on governance. This was entirely appropriate. Remuneration incentives are an issue of prudent risk management that boards must ‘own’, consistent with their responsibilities for the good stewardship of their institution. It is boards that must set the tone that fosters the right risk-taking behaviour, rather than supervisors through quantitative restrictions. In this spirit, APRA’s principles-based approach allows boards to design remuneration arrangements that suit their institution’s structure and risk profile, provided our requirements are met. APRA does not prescribe a single or preferred set of arrangements. Nor do we focus on the issue of ‘how much’. Our focus is on ‘why’. What are the ex ante mechanisms used by regulated institutions to determine amounts of incentive-based pay? Do these mechanisms promote prudent risk management? How do institutions make ex post risk adjustments to deferred bonus amounts?

Before our remuneration requirements came into effect, we asked a number of our largest regulated institutions to prepare self-assessments of their current remuneration practices against these requirements. Our initial aim was to ensure that institutions had an appropriate structure in place for the governance of remuneration arrangements. More recently, we have been undertaking a series of ‘peer reviews’ to examine in more depth how institutions have been implementing our requirements.

These reviews confirm good progress is being made in improving remuneration structures and policies but further improvements are required. This is the journey. The area we are now focussing on is the alignment between risk and remuneration, particularly ex post risk adjustments to deferred remuneration entitlements. Many institutions have quite robust deferral structures for variable remuneration but risk adjustments are generally based on the current year’s performance, rather than a reassessment of performance based on the year of the original award. This is not quite what prudential supervisors had in mind. We want to ensure that deferral structures, as they evolve, do not reward performance found wanting if risks later come home to roost.

The issue of risk adjustment is not unique to Australia but is one that financial institutions and prudential supervisors around the global are seeking to resolve. The Basel Committee has just released guidance in this area that confirms there is no one superior method or approach. You should not be surprised to hear that APRA has had a significant involvement in the preparation of this guidance.

These various global initiatives that I have canvassed only briefly today do not, of course, exhaust our prudential policy agenda. We are currently consulting on two other major APRA initiatives. One is a proposed prudential framework for conglomerate groups. The other is an updating and, where possible, harmonisation of capital requirements for general and life insurers. You will be hearing a lot from us over the next year and beyond!