How well is the Australian financial system meeting community needs?

John Trowbridge, Executive Member - 5th Financial Services Forum, Institute of Actuaries of Australia, Sydney

How well is the Australian financial services system? What improvements might be made? And from an international perspective, what are regulators thinking about and what are governments thinking about around the world in respect of financial regulation?

Before considering the financial system in Australia, I will review international regulatory reform and systemic risk. I will also explain some regulatory models and outline the theory of prudential supervision.

In dealing with these topics, the paper offers commentary on three questions regarding international regulatory reform –

1. does the work of the Basel Committee, which is concentrated on capital and liquidity, get to the root of the problem?
2. will the group supervision problem and the "too big to fail" problem be solved?
3. are political and cultural conditions around the world conducive to effective regulatory responses?

and on three questions regarding the Australian financial system -

1. superannuation: do we have a retirement system or a savings and investment scheme?
2. investor protection: does Australia's disclosure model work?
3. APRA: how important is supervision as distinct from regulation?

I wish to emphasise, incidentally, that the views expressed in this paper on these questions are my own and do not necessarily with APRA's views.

International regulatory reform

The genesis of most of the regulatory initiatives currently under way is, not surprisingly, the GFC. The source of these initiatives is the G20 meeting of April 2009 in London, which effectively appointed the Financial Stability Board (FSB) as its manager of financial reform. The G20 issued a Declaration on Financial Reform which, in paragraph 13, set the following agenda for global financial reform –

• the FSB and IMF should work together on early warning of systemic problems
• regulatory systems to be reshaped, to identify and deal with macro prudential risks
• regulation and supervision to be extended to significant international financial institutions, contracts and markets, including significant international hedge funds
• remuneration to be reformed to promote prudent risk-taking
• quality, quantity and international consistency of banking system capital to be improved to prevent excessive leverage and to introduce buffers in the good times
• "non-cooperative jurisdictions" to be identified, because "the era of banking secrecy is over"
• accounting standard setters to work to improve valuation and provisioning,
• credit rating agencies to be regulated, including to prevent conflicts of interest.

The emphasis is on strengthening the global financial system, dealing with vulnerabilities in the system and protecting stability in the future.

This list tells you what regulators are thinking about and what governments are expecting about financial sector reform.

The institutional structure beyond the G20 and the FSB comprises the Basel Committee on Banking Supervision, International Association of Insurance Supervisors, International Organisation of Securities Commissions and the Joint Forum, plus numerous committees and working parties of various kinds.

The big change for members of international regulatory bodies (including myself and numerous colleagues at APRA) is the need now to work to tight timelines generated by the G20 in order to deliver timely outcomes. And incidentally, the reformers have a further incentive: the more time that elapses from the height of the GFC, the more that complacency can set in and the stronger will be the opposition in some countries to pursuing financial reform.

From the G20 agenda –

• Remuneration reform is under way in many countries and has already been introduced by APRA. But it will be some time before there are any visible consequences.
• Accounting standards are being pursued by both the IASB (International Accounting Standards Board) and the FASB (Financial Accounting Services Board in the USA) for both banking and insurance. There are many difficult debates and frustrations, both in banking and insurance.
• Credit rating agencies are now subject to greater regulation including higher disclosure and reporting standards, and are again under scrutiny in the European sovereign debt crisis.

I will come back to the questions of systemic risk and the reshaping of regulatory systems.

Regarding the banking system, extensive work is being undertaken through the Basel Committee on levels of capital, quality of capital, liquidity arrangements, a leverage ratio and responding to the pro-cyclical problems that suggest the need for stronger provisioning and for buffers to be built up in the good times to assist in the bad times.

An important question regarding banking reform is whether the reforms being considered respond to the essential sources of the GFC. Undoubtedly they do to some extent but note that improved capital and liquidity rules on their own are not enough: supervisors in each country need to have the skills, the resources and the powers to oblige lenders to maintain proper credit standards and lending practices at all times. In both the US and the UK, sub-prime residential mortgage lending was a critical weakness of the financial system but modifications to banking capital and liquidity requirements are worth little if lending standards are poor.

Regarding Australia, APRA is necessarily part of the international initiatives around the banking system. APRA will participate in and ultimately follow, with care and discretion, the decisions of the Basel Committee. It would be unwise to risk the reputation of the Australian banking system by operating to a different set of standards and requirements from the rest of the international banking community.

There is another important international topic, and that is group supervision. During the GFC, AIG and some other financial institutions operating as groups demonstrated that, within such groups, contagion risks often exist.

Group supervision is now the primary regulatory reform initiative of the IAIS and the Joint Forum. In many jurisdictions, prudential regulators struggle with group supervision as a result of inadequate legislative powers. And without such powers, prudential regulation for groups and the associated supervisory interventions cannot occur.

Systemic risk in the financial sector

Now to the financial system itself and systemic risk.

The FSB is pursuing systemic risk questions around how to deal with SIFIs (systemically important financial institutions) and the Basel Committee is investigating SIBs (systemically important banks). The dominant question has become how to handle institutions believed to be "too big to fail".

The SIFI situation is difficult to deal with. Nobody wants to have institutions that are too big to fail or too big to let fail because of the moral hazard involved, with the attendant discriminatory and competitive implications. Nevertheless, in the light of the GFC experience, it is hard to believe that certain institutions would ever be allowed to fail.

Is the answer to ensure that, in adversity or distress, shareholders lose everything and there is a change of control, or should the scale and range of activities of any institutions be restricted, or should the effort concentrate on limiting risks such that distress never occurs?

This is a vexed issue for regulators, central bankers, governments, economists and indeed also for the large institutions themselves. And it leads to the question: what is systemic risk and what is systemically important or systemically relevant?

It is widely agreed that we should rely on the FSB definition of systemic risk, which is –

"the risk of disruption to the flow of financial services that is (i) caused by an impairment of all or parts of the financial system; and (ii) has the potential to have serious negative consequences for the real economy".

Systemic importance is said to revolve around size, interconnectedness and substitutability. That is clearly a good starting point.

Stability of the financial system rests predominantly within the banking system. Insurance and funds management, while having systemic relevance, are not central to financial stability.

Systemic risk is increased not only by the leverage and inter-dependencies within the banking system but also by growing volumes of hedging activities including derivatives, structured financial products and other instruments. There can certainly also be contagion across markets.

Regulation vs supervision

Note that most of the international regulatory initiatives concentrate on matters of regulation as distinct from supervision. At the international level we have been hearing little about supervision, about regulators obliging compliance in both form and substance in order to generate accountability, yet the understanding is dawning.

There is active and growing interest at present in why agencies such as OSFI in Canada and APRA in Australia appear to have performed well during the GFC. The interest is not so much in the regulations themselves – after all, some other countries with poor outcomes had good regulation - but in examining the way that supervision was undertaken in these jurisdictions.

The FSB now has the question of supervisory intensity and effectiveness on its agenda and the stakes have risen since the recent publication of an IMF note on the subject.[1] Its introduction reminds us that the key elements of good supervision are that "it is intrusive, sceptical, proactive, comprehensive, adaptive, and conclusive."

The Australian financial system

Effectiveness of the financial services system depends on capabilities of the financial sector including products, distribution, capital, management, systems, competition, etc, together with the nature of the regulatory and supervisory system. It is this latter I will concentrate on.

One could argue perhaps that our banking and insurance regulatory system is effective because it survived the GFC and we didn't see failures. That is far too simplistic, of course, for there were many other factors at play, in both the financial system itself and the economy.

Other important factors included pre-conditions such as generally prudent home lending in the past by our banks. And then we had -

• the government's economic stimulus package
• the RBA's monetary response – it reduced interest rates by 4.25% in just six month
• liquidity and funding support from the RBA
• a shortselling ban on financial stocks, and
• the government‟s deposit and wholesale funding guarantee.

These initiatives represent unprecedented economic and financial system intervention. And don't forget China and its influence on our economy.

• So is there anything wrong with our financial system in Australia? The short answer is not really. But let us have a look at it. We will start with what is less than ideal: two examples –
  • Firstly, disclosure as a form of financial regulation. No matter what is done about the content of PDSs or prospectuses, whether they are longer or shorter, with more or less disclosures, are simpler or more detailed, we do not get any progress.
  • It is clear that most retail investors cannot evaluate PDSs, prospectuses and other forms of financial information. Therefore they often rely on third parties, some of whom have conflicts of interest, or they simply rely on the advertising.
• Secondly, the adoption of IFRS accounting in the banking system in Australia in 2005. It led to banks lowering their provisions for losses because the accounting standards moved from an expected loss approach to an incurred loss approach. That can hardly improve strength and resilience of our banking system.

So here are two problems at opposite ends of the spectrum: disclosure, which is about investor awareness, and financial reporting in banks, which relates to financial system strength and stability.

Regulatory models and regulatory agency structures

How do we understand these two topics - disclosure and financial system stability - as part of a total financial regulatory system?

Firstly let us define the financial system (its institutions, not its intermediaries). The financial system is essentially about institutions that supply one or more of –

• banking services
• insurance
• superannuation, and
• investment products and services (retail and wholesale).

The community has an interest in the integrity of all of these institutions.

In Australia, we have through APRA full prudential regulation and supervision of banks and insurers and partial prudential supervision of superannuation. Securities and collective investments do not fall under APRA but are subject to a range of ASIC requirements.

ASIC essentially operates a regime characterised by disclosure and licensing, backed by enforcement powers designed to secure good market conduct.

So what are the regulatory models that exist? What do we know about these models? How do they work?

These questions are relevant to the G20 topic of reshaping regulatory systems.

The models range from disclosure only, with caveat emptor, at one end of the spectrum, often with some form of licensing, and enforcement powers to comprehensive prudential regulation and prudential supervision at the other end that includes obligations around governance and risk management as well as capital.

The regulatory agency structure can be supplemented by, for example, schemes for beneficiary protection. In Australia we have such schemes now for banking, general insurance and superannuation. There are no such schemes for collective investment products.

To illustrate these ideas another way, we can refer to the next chart, which shows how the Australian system operates for the most common sub-divisions of financial regulation.

Note that the RBA, APRA and ASIC are the "players" and there are two empty boxes.

They relate to prudential conduct for collective investments and other kinds of securities.

…and the UK today -

As you can see, the FSA is the regulator for everything outside of the central bank role and pensions.

….and the United States, where regulatory agency structure is more fragmented than in other countries (there are several regulators in the banking system and separate insurance commissioners in every state) -

In some countries, the regulatory agency structure has changed or will change. The new UK government has just announced that the FSA is to be broken in two, with prudential regulation to be transferred to the Bank of England. A similar change has already occurred in France and is also being considered in Belgium and Germany. There are also some significant changes to occur in banking in the United States.

Theory of prudential supervision

A bank acts as custodian for depositors, whose funds are generally at call or on short term deposit. The essential role of the banks is maturity transformation. We need prudential regulation as well as central bank support to protect against losses and to ensure liquidity during the maturity transformation process, which is based on borrowing short and lending long. Prudential regulation aims to minimise the risks of insolvency, contagion in the banking system and the asymmetry of information between depositors and banks.

An insurer collects and holds premiums as the custodian for policyholders until claims have occurred and been paid. Through the peculiarity of its "inverse cycle of production", the insurer receives its revenues (premiums) first and incurs its costs of production (claims costs and operating expenses) afterwards. Hence premium revenue needs to be withheld and retained by the insurer so as to be able to meet the subsequent claims costs and expenses. Regulation is aimed at ensuring that the insurer properly manages its finances in this way.

In effect the government deems that the roles played by banking and insurance in the economy are crucial to the effective functioning of the economy. Given the inherent limitations in the business models of banks and insurers as outlined above, the government chooses to protect beneficiaries from these limitations, hence the need for prudential regulation and supervision. The role of supervision is to make effective the accountability of institutions for complying with regulations.

Not so for the prudentially unregulated sector, where there is more risk, more innovation, more variety, more entrepreneurial activity and therefore more of caveat emptor.

Attitudes to prudential supervision

A comparison between APRA and the FSA in the UK is instructive. The FSA‟s chairman, Adair Turner, made the following statements in a paper presented earlier this year[2]

"the idea that … financial innovation was to be encouraged because it expanded investor and issuer choice, and that regulatory interventions can only be justified if specific market imperfections can be identified, [was] in our institutional DNA in the years ahead of the crisis. We were philosophically inclined to accept that if innovation created new markets and products that must be beneficial and that if regulation stymied innovation that must be bad. We are now more aware of the instability risks which might offset the benefits of such innovation."

… and -

"I am arguing for a radical reassessment of the too simplistic case in favour of financial liberalisation and financial deepening which strongly influenced official policy in the decades ahead of the crisis,"

… and further –

"we have challenges which cannot be overcome by any silver bullet structural solution. Instead we need to deploy a wide range of regulatory and macro-prudential tools, informed by a philosophy deeply sceptical of past arguments that financial liberalisation, innovation, and deepening is axiomatically beneficial."

This "light touch" attitude, this extraordinary faith in markets, can actually be seen as an incentive for institutions to indulge in the excesses that generated the GFC! In Australia, this attitude or philosophy has never been part of the thinking of APRA or, to the best of my knowledge, the RBA or the government.

Indeed the Australian philosophy could be expressed as follows: in principle, APRA treats boards as undertaking the role of custodian for the depositors and policyholders. If an institution is not doing its job properly, the regulator is justified in moving the board aside and expropriating the custodian role in order to protect the position of depositors or policyholders. Of course we need to be cognisant of competition and contestability, but not at the risk of institutional or systemic failure.

Investor protection

This approach to prudential supervision leads, however, to something of a cliff. At the top of the cliff is the plateau representing the full measure of APRA's pre-emptive supervision supported by prudential regulation. At the bottom of the cliff is the plain representing the ASIC disclosure regime supported by licensing of product providers and intermediaries. At the top of the cliff, APRA is endowed with the resources to practise timely and regular pro-active and pre-emptive supervision. ASIC on the other hand does not have the resources or the mandate to engage in this form of supervision for dealing with impending problems of product providers.

There has been no debate in Australia about changing the agency structure (ASIC, APRA and the RBA) i.e. the government is maintaining the status quo and has shown no inclination to alter the agency structure. After all, there has been no systemic breakdown, only international contagion. Also, to the extent that investor protection is a community issue, ASIC can take some further initiatives within its existing powers to give greater investor protection. My understanding is that this question is under active consideration at ASIC.

To consider further the full scope of investment products and retail investor protection in Australia, we have a mixture of regulatory arrangements -

Life insurers can offer a wide range of investment products and we have full prudential regulation and supervision by APRA. But we see declining use of life companies for investment products because –

• the providers (insurers and their related entities) prefer to avoid the APRA regulatory net,
• most retail investors do not appear to place value on the protection provided by the Life Act and the associated prudential supervision,
• distributors simply follow the line of least resistance and most profit, and
• tax arrangements generally discourage investment products from life companies in favour of unit trusts.
  
  For investment products, being collective investments and various other investment products, we have essentially a disclosure model, as already discussed. Accounting standards, Corporations Act solvency, auditing, licensing of financial advisers, etc are all aimed at more effective outcomes but disclosure is the primary mechanism for compliance, supported by "after the failure" penalties. Accordingly the regime has limited incentives for high quality risk management and governance to protect investors.
  
  In superannuation there is no protection of member balances by regulation. APRA is the prudential supervisor of trustees but does not have standard-setting powers, as it does in banking and insurance, and cannot introduce capital requirements on superannuation funds. APRA has no particular role or responsibility regarding investment performance beyond attempting to ensure that trustees act in the best interests of members. Members otherwise rely largely on disclosure so that defined contribution superannuation is in some respects a caveat emptor regime. APRA's supervision does, however, lead to much greater accountability of trustees in relation to governance and risk management, thereby giving fund members rather more protection than non-superannuation investors.

In summary, we have a degree of trustee accountability in superannuation but limited investor protection for collective investments and other securities. By contrast, there is a full prudential regime for depositors in banks, holders of life insurance investment products and other insurance policyholders. Hence from an investor protection perspective, we have -

• a strong prudential regime through life insurance companies but tax and other disincentives to use it!
• a disclosure regime for collective investments which inherently offers limited protection, and
• for superannuation, prudential supervision with emphasis on trustee performance but disclosure only for investment performance.

Superannuation: a retirement system or a savings and investment scheme?

The Cooper review will be making proposals around efficiency and accountability in the superannuation system. An important question is whether it will recommend standards making powers for APRA. If it does and the government adopts the recommendation, then APRA will be in a rather better position to supervise the industry.

Nevertheless, superannuation is a conundrum because of its fundamental design -

• In principle our superannuation system exists to promote self-funded retirement, but
• when one retires at age 60 or beyond, there is no tax and members can take as little or as much as they like of the accumulated balance at any time. If it is all spent, there is the age pension to fall back on, the ultimate safety net funded by taxpayers.

Under APRA's supervision there is an incentive for trustees to practise good governance. There is no real accountability of trustees for investor performance, simply disclosure of performance and access for members to the market value of their own funds. This philosophy is emphasised by investment choice and also by the terms of reference of the Cooper enquiry. Choice is essentially about selecting funds and investment options and Cooper is about streamlining the system. But there is no real debate about the fundamentals of the system, whether it be the suitability of market-linked pre-retirement accumulation or how to operate the post-retirement phase.

By operating superannuation as a defined contribution system, there is no risk to the taxpayer and no risk to the employer. While survival of one's employer poses no risk to the individual member (as it does in defined benefit schemes), the member is obliged to accept the risks of:

• investment markets and their performance
• inflation
• longevity
• employment and employability, and
• state of health.

Additionally, the system is not integrated with the age pension, has no post-retirement structure and is supported by a combination of compulsion and tax incentives. On this basis, it is more a savings and investment scheme, albeit a substantial one where benefits cannot normally be taken before retirement age, than a retirement system.

There is an opportunity to create a coherent retirement incomes system through a structured connection between the age pension and superannuation, in the longer term interests of both the retired community and the economy as a whole. The Henry tax review clearly recognises this post-retirement problem and makes some very good proposals. In particular, Recommendation 21 is –

"The government should support the development of a longevity insurance market within the private sector and

a) … should issue long-term securities … to help product providers manage the investment risk associated with longevity insurance.

b) … should make available the data [for] … a longevity index that would assist product providers to hedge longevity risk.

c) … should remove the rules in the [SIS] Regulations 1994 relating to income streams that restrict product innovation"

and recommendation 22 is –

"The government should consider offering an immediate annuity and deferred annuity product that would allow a person to purchase a lifetime income. …"

I understand that these recommendations are yet to be considered by the government.

Summary

To summarise, we consider firstly international regulatory reform. It is a formidable undertaking that has a long way to go because, as I read the situation -

• one of the fundamental problems in the banking system in some countries, namely a propensity to engage in sub-prime lending, can be resolved only by effective prudential supervision practices, not by the Basel Committee‟s regulatory reform agenda
• effective supervision of corporate financial groups and systemic control over institutions „too big to fail‟ are tough challenges not yet mastered, and
• the longer it takes to achieve reform and the faster the international economic recovery, the more that complacency, resistance from the financial sector itself and declining political support will defer and diminish the reform effort.

Nevertheless, Australia has a well functioning financial system, with generally effective prudential and market conduct oversight and, as far as we can tell, as good a handle as any other country on systemic risk.

APRA has played its part in limiting systemic risk, during and since the GFC. Bank depositors and insurance policyholders are well protected through APRA at more than one level (by sound standards for capital,risk management and governance, backed by pre-emptive prudential supervision). APRA has done this in conjunction with the other key government agencies in the game, namely the RBA, ASIC, the Treasury and indeed the government itself.

There are, however, some known inadequacies, the most important of which are -

• for investor protection, reliance predominantly on disclosure, which does not work well – this is a significant gap in our present financial system because it gives minimal assistance to investors; at the same time we are neglecting the potential of the life insurance regulatory regime to lift that protection to a high level.
• for superannuation, a system which, in placing virtually all the risks on members and having no form of integration with the age pension system and no post-retirement structure, is not meeting the longer term needs of the community or the economy. As it stands today, superannuation is more a savings and investment scheme than a retirement system.

Finally a couple of predictions. The first is that our regulatory agency structure will endure as is for the foreseeable future, serving us well generally but with investor protection under-done and an incomplete superannuation system that would benefit greatly from adoption of the Henry tax recommendations for retirement incomes . The second is that APRA's pre-emptive approach to supervision of regulated institutions will continue to underpin the stability, safety and competitiveness of the Australian financial system.

Footnotes

1. International Monetary Fund, The Making of Good Supervision: Learning to Say "No", IMF Staff Position Note, May 18, 2010.
2. What do banks do, what should they do and what public policies are needed to ensure best results for the real economy? Cass Business School – 17 March 2010.