Mutuals after turbulent times

John Laker, Chairman - Abacus, Australian Mutuals Convention, Gold Coast

What a year it has been!

The 2008 Abacus Convention, twelve months ago in Darwin, took place in the immediate aftermath of a period of genuine trauma in global financial markets. That period began with the failure of Lehman Brothers and culminated in a series of emergency measures by central banks and governments around the globe, including the public rescue of some major financial institutions. These emergency measures proved to be an essential short-circuit in restoring market stability and their positive real impacts are still being felt. Despite their scale, however, the measures were not sufficient to prevent a substantial collapse of investor and consumer confidence in major advanced economies, which quickly spilled over to economic activity and trade flows, as well as to equity markets. At the end of 2008, the pall of gloom that had descended over the global economy remained thick.

That pall has been steadily lifting over recent months. In Australia‟s case, the worst of fears that the economy could suffer a significant downturn and a blow-out in unemployment have not materialised. On the contrary, the Australian economy has been the best performing advanced economy over the past year and the unemployment rate is the second lowest amongst our peers. Economic recovery is underway. The resilience of the Australian financial system has been tested, to be sure. The operating environment for financial institutions has been more challenging, more unpredictable, more volatile than for many decades. Nonetheless, our financial system has stood firm. Indeed, it is now the subject of regular favourable mentions in despatches from the Front!

In this more encouraging setting, I have only needed a one-word change in the title of my opening address, from "Mutuals in Turbulent Times" last year to "Mutuals after Turbulent Times". This is no declaration on my part that the global financial crisis is over. It is not. There will be further twists and turns ahead until the global recovery is firmly established and the balance sheets of global financial institutions restored to health. That said, it is now timely for mutuals to lift their heads above the parapet, survey the battlefield and prepare for a more supportive, though perhaps more competitive, environment ahead.

These thoughts fit squarely with the theme chosen for the 2009 Abacus Convention — "Building Our Advantage". This is a more sober and pragmatic theme than the territorially ambitious themes of earlier Conventions, but it is an entirely appropriate one. For the reasons I will explore in this address, mutuals have played to their strengths during the global financial crisis and, as a consequence, have retained their good standing in the eyes of their customers and of their communities more generally. This is a major advantage on which to build.

And, dare I say it, the alternative theme I suggested for your 2008 Convention — namely, "Doing the Basics Well" — still has the right ring to it as the guiding theme for your building task.

Mutuals through the crisis

A number of factors, macroeconomic in nature, have contributed to the performance of the Australian economy during the global financial crisis. These include:

• an aggressive easing of monetary policy, which took the official cash rate to 3.0 per cent and pushed market and mortgage interest rates to historical lows. This easing is now being gradually unwound;
• timely and targeted fiscal stimulus that was substantial in scale by the standards of other advanced economies; and
• an early rebound in Asian export markets that has underpinned continued growth in export volumes, particularly resources.

But there is another contributing factor that I for one am pleased to acknowledge. The Australian banking system — underpinned of course by the Government guarantee arrangements — has been readily able to support economic growth through the crisis because it has had the liquidity, capital resources and confidence to do so. Unlike other banking systems, it has not been forced by financial exigencies to beat an ungainly retreat from its critical role in financial intermediation.

This is not just a story of our largest banking institutions. It is the story, as well, of our credit unions and building societies. Some simple facts confirm this. Over the past two years:

• no credit union or building society has breached APRA's prudential capital requirements or, for that matter, any other key prudential requirements;
• no credit union or building society has left the industry under circumstances of force majeure;
• more positively, credit unions and building societies as a group have continued to grow their balance sheets by pursuing sensible lending opportunities; and
• credit unions and building societies, again as a group, continued to earn solid profits, totalling just over $300 million in 2008/09. This figure is much lower than in previous years — the inevitable outcome of Australia‟s economic slowdown, margin pressures and the tough competitive environment — but a good result in difficult times.

These facts may seem humdrum in a country used to the continuing success of its banking institutions. However, we know from our association with the World Council of Credit Unions (WOCCU) that these outcomes would be the envy of mutual movements in many other countries.

Behind these facts lies the ongoing strength of the simple business model of mutual authorised deposit-taking institutions (ADIs) — a model build on high standards of customer service, conservative lending standards in traditional markets and strong liquidity and capital buffers. "Bread and butter" banking. Some mutual ADI boards and managements, we know, have felt constricted by this business model and have wanted to venture further afield, but simplicity has its virtues. The global financial crisis has highlighted starkly the dangers and costs of excessive financial complexity, whether it be financial instruments, business models or organisational structures. Little wonder the Bank for International Settlements, in its 2009 Annual Report, called for banks to adjust "… by becoming smaller, simpler and safer", a call recently taken up by some key global policymakers. This call needs no echo for mutual ADIs. You are there already.

Let me dissect a little the elements of strength in mutual ADIs and the lessons that can be drawn from the crisis. Later, I will say something about the other group of mutuals under the Abacus banner, namely, the friendly societies.

Firstly, liquidity and funding. Mutual ADIs have long had the advantage of a secure and stable funding base through retail deposits. You have been learning, however, that this strong deposit franchise cannot be taken for granted. In the first place, the retail deposit market in Australia was not spared the spillover effects of the souring of confidence in global financial institutions in the wake of Lehman Brothers‟ failure. We saw a "flight to quality" from unregulated institutions to ADIs and, even within the regulated sector, there was a sense of growing disquiet on the part of some depositors and funds were moved from smaller to larger ADIs. The Reserve Bank of Australia also noted a surge in demand for banknotes around this time as households made large cash withdrawals from financial institutions.

This was the context in which APRA asked credit unions and building societies to increase their minimum liquidity holdings. There was pushback on this move from some quarters but APRA judged that the costs of remaining very liquid through this period were an insurance premium well worth paying. The industry obviously agreed, because liquidity peaked at around 19 per cent at the height of the crisis, well above our expectations.

This was the context, as well, in which the Government introduced its guarantee arrangements for deposits and wholesale funding. In the retail deposit market, these arrangements had an immediate calming influence and they underpinned strong growth in retail deposits in the ADI sector over subsequent months. APRA was able to reduce its expectations for minimum liquidity holdings, on a case-by-case basis, as a consequence.

In the second place, mutual ADIs cannot take their strong deposit franchise for granted because your competitors are also very alert to the benefits of a stable and diversified retail deposit base. Competition for retail deposits is now more fierce than it has been for many years. This has obvious implications for the profitability of mutual ADIs, on which I will comment shortly. Mutual ADIs have no option but to compete on price and service — depositors now are very rate-conscious — but you can do so in the knowledge that you have retained solid customer loyalty through the crisis.

In the calmer conditions of 2009, APRA has redirected its supervisory priorities in this risk area to ADI funding plans. My address to the Convention last year emphasised the importance of strong funding plans, that are realistic and responsive to changing market conditions, and I spent some time outlining APRA's expectations. I can say that the plans we have reviewed this year have improved in quality and have been more detailed than previously. So they should be! You have had a two-year "live" stress test and your experiences should be incorporated into your planning. The plans should address, where relevant:

• the behaviour of traditional retail deposits compared to potentially more volatile deposit sources such as quasi-wholesale deposits or internet-style deposits;
• the continued closure of securitisation markets, at least until very recently, to issuers relying solely on private investors;
• the termination, in due course, of the Government guarantee of large deposits and wholesale funding. In the event, mutual ADIs made very little use of the guarantee of large deposits (and no use of that for wholesale funding) but the availability of the guarantee, if required, has provided a degree of comfort to mutuals and their members. Termination of the guarantee is therefore likely to have little impact but mutuals that have increased their reliance on large wholesale deposits will need to manage rollovers carefully. We have been a little surprised that some mutuals are arguing that large deposits from organisations such as local councils and RSL Clubs should be considered to be routine retail deposits; and
• contingency planning for unexpected liquidity stresses. On this score, the Reserve Bank's initiatives to increase the flexibility of its domestic market operations have been very helpful. The Bank now accepts a wider range of securities for repurchase agreements and most Australian banks and some building societies have put together securities backed by mortgages on their books to meet the Bank‟s criteria. These "self-securitised" instruments have proven an effective liquidity mechanism at times of acute market pressures and APRA would expect all large credit unions and building societies to establish self-securitisation arrangements as a contingency measure.

On a related point, APRA is well aware of market initiatives to assist mutual ADIs in tapping alternative sources of longer-term funding. In principle, we are supportive of initiatives that strengthen the financial position of mutual ADIs, whether it be in liquidity, funding or capital, provided they do not compromise legislative or prudential requirements. One critical requirement that is not open for negotiation is the depositor priority provisions of the Banking Act 1959.

Next, let me turn to the asset quality of credit unions and building societies, another source of strength. That strength has derived from sticking to the principles of Credit Assessment 101 — knowing well your customer and their capacity to service debt, maintaining conservative lending standards and concentrating on lending markets in which you have honed your skills. Housing lending now comprises around 85 per cent of your lending activities and it has proven a good place to be.

Despite Australia's economic slowdown, ADI housing lending portfolios continue to perform soundly. Non-performing loan ratios have been rising, but only slowly, and they remain low from an historical perspective. At the end of June 2009, the non-performing loan ratio for the ADI industry as a whole stood at around 0.6 per cent. For credit unions and building societies, the ratios were 0.15 per cent and 0.35 per cent, respectively, around the same levels as four years ago! To put the strength of ADI housing lending portfolios into an international perspective, the comparable non-performing loan ratios were around 2.4 per cent in the United Kingdom and 5.7 per cent in the United States.

Still, there is no reason for complacency. The quality of housing lending portfolios will be tested if, as is forecast, unemployment were to rise some way above current levels and as mortgage interest rates increase from their generation-low levels. And any mutuals that continued to write lending business aggressively in the early days of the crisis on the misapprehension that this was an opportunity to capture market share may have their nervous moments.

More stresses are evident in other ADI lending portfolios. Aggregate arrears rates in personal lending have been rising, and although this trend is not apparent in the personal lending portfolios of mutual ADIs, this lending bears close watching. Arrears rates can be affected as much as cut-backs in working hours as by increases in unemployment. Commercial lending portfolios, especially commercial property, have performed least well during the global financial crisis, relatively speaking. Though only a small share of mutual ADI lending portfolios, some credit unions and building societies have significant exposures in this area. Again, these exposures require close monitoring with commercial property values still under pressure.

The third source of strength for mutual ADIs is their capital position. This is a straight-forward story. Capital ratios for credit unions are sitting just a little above 16 per cent and those for building societies a little below. For some years now, mutual ADIs have maintained sound capital buffers in excess of APRA's prudential requirements. This careful capital management remains essential to mutual institutions that must rely on retained earnings as their primary means of growing capital.

This brings me to profitability, the fourth source of strength for mutual ADIs though the one most tested during the global financial crisis. As I mentioned earlier, credit unions and building societies have recorded solid profits over 2008/09, but well below recent peaks measured either in absolute terms or as a return on assets. This is the clearest indication that many mutual ADIs have found the going tough. Robust competition for retail deposits has put significant pressure on interest margins and, unlike their major competitors with more diversified lending portfolios, mutual ADIs have had only limited scope to reprice their books to compensate. Nothwithstanding the effective closure of securitisation markets, most mutual ADIs have been able to offset margin pressure, though not fully, through reasonable growth in lending volumes as households responded to low mortgage interest rates and Government incentives to first-home buyers. In a strongly competitive environment, however, mutual ADIs have had to work hard to maintain their market share in housing lending and they have had limited success to date in capturing the territory vacated by wholesale lenders denied funding during the crisis.

All in all, though, a positive report card for mutual ADIs in a challenging marketplace. Mutuals are not created equal, of course, and some have performed more strongly through the crisis than others. From APRA's vantage point, the qualities of the stronger performers are clear.

Firstly, they have good governance frameworks. They have been active in setting and adjusting their risk tolerance, in revising their strategies and business model to cope with emerging problems, and in embedding a robust risk management framework throughout their institution. Secondly, they have been raising the quality of their boards, through the recruitment of directors who can bring general business acumen and skills in retail banking and risk management to board deliberations. Thirdly, they have maintained a sharp focus on liquidity and have been quick over the ground in managing the pricing and maturity profile of their assets and liabilities. And finally, they have resisted the pursuit of market share through lowering their lending standards, waving through regular exceptions to established lending policies or writing business outside their skill sets. Certainly, they did not have the odd "dabble" in complex structured instruments.

The friendly society industry

At this juncture, I want to acknowledge a group in our midst who have faced a different, though no less challenging, experience during the global financial crisis. This group is the friendly societies. For these societies, which are natural holders of equities and debt securities, the crisis had its impact not through cyclical developments or funding costs but through the significant volatility and decline in domestic and global equity markets in 2008/09. Total friendly society assets fell by around eight per cent overall last financial year, due principally to net withdrawals and net losses, but assets were growing again towards year-end as equity and debt securities markets recovered. And, of course, that recovery has continued.

In this volatile investment environment, friendly societies have had to monitor very closely the impact of market movements on benefit fund solvency and capital adequacy positions, particularly in respect of capital guaranteed products. A small number of societies needed to inject seed capital from the management fund to the benefit fund. This, in turn, raised questions about the financial strength of the management fund itself — whether it had the capacity to support a benefit fund, if needed, and to meet its own capital requirements. Again, a few societies needed to focus on improving surplus capital levels, particularly under certain stress-test scenarios.

Since the crisis began, APRA has also been closely monitoring the sensitivity of friendly society capital positions (and of life insurance companies generally) to adverse movements in equity markets and interest rates. A formal stress-test was conducted in December 2008. The results of this stress-test, and some subsequent initiatives to build capital buffers, have confirmed that the capital position of the friendly society industry is generally sound. That said, the industry will need to pay close attention to its capital management planning and the appropriateness of target surplus levels to ensure that it is well-positioned to absorb any further major shocks.

Industry consolidation

The global financial crisis, beyond its immediate challenges, has no doubt brought forward the day of reckoning for some mutuals. In 2008/09, 18 credit unions and one building society left the industry, continuing a trend that has seen the number of credit unions fall by one-third over the past five years and the number of building societies by over one-quarter. One consequence of industry rationalisation is that only a handful of very small mutual ADIs remain in the game but a number have bulked up to balance sheets of over $1 billion. Though scale brings its obvious advantages, there is still a place for smaller mutuals clearly focussed on their bond or their niche markets.

Further industry consolidation seems inevitable. More mutuals can be expected to look for merger partners in the pursuit of economies of scale, because they have reached a strategic dead-end or because they no longer have a sustainable business model. APRA will continue to do what it can to facilitate orderly rationalisation, and you know our preferences — marriages of strong partners or where a strong partner takes a weaker partner under its wing.

The story is no different in the friendly society industry. Numbers are now down to 19, and have fallen 40 per cent over the past five years. Faced with increasing competition from wealth management groups and falling levels of funds under management, which in turn affects profitability, some friendly societies must also be weighing up their future. Many societies are considering new benefit fund products to maintain their market presence and improve their long-term survival prospects. New products must be appropriately priced and adequately supported by capital. Take care here! Societies should not be committing surplus management funds to ventures with limited chances of commercial success where there is an alternative that may be in the better interest of members — namely, a distribution of funds.

The regulatory landscape after the crisis

In my remaining time, I would like to give you a sketch of the regulatory landscape in Australia in which mutual ADIs can expect to operate over coming years. A sketch only, because many of the details are still to be filled in. Let me allay your fears, though, that there will be wholesale changes to the landscape. There won't be. Australia's prudential framework has performed well during the global financial crisis and does not need substantial overhaul. Nonetheless, there is a comprehensive global reform effort underway to address the flaws and weaknesses in the global financial system so clearly exposed by the crisis, and Australia is actively involved.

The objectives of this reform effort, being driven by the Leaders of the G20, are to create a more resilient global financial system that operates with less leverage, has the right incentives for prudent risk management, promotes transparency and is underpinned by better — not necessarily more — prudential regulation and supervisory oversight.

This is a very broad agenda. APRA is participating mainly through its membership, at long last, of the Basel Committee on Banking Supervision. Our reform priorities cover the areas of capital, liquidity and remuneration.

The Basel Committee has confirmed that the level and quality of capital in the global banking system needs to be strengthened and it is developing a package of enhancements to the Basel II Framework. One initiative is to raise the quality, consistency and transparency of the Tier 1 capital base by limiting the predominant form of Tier 1 capital to highest quality capital, namely, common equity and retained earnings. APRA fully supports this initiative and we already have a more conservative test of predominance — our "75 per cent" rule — than many other jurisdictions. Mutual ADIs have nothing to fear from these measures; your holdings of highest quality capital easily surpass this test. We are aware of plans abroad to develop new capital instruments that would enable mutuals to raise Tier 1 capital and we would be happy to discuss these instruments with Abacus as more becomes known about them.

Another initiative is a framework for countercyclical capital buffers to ensure that capital is built-up as risks rise during an economic upturn so that it can be used as a "shock absorber" in the downturn. This framework is still work-in-progress. Mutual ADIs could hardly be accused of running skinny on capital during Australia‟s long economic expansion — the industry is, as I have said, very well capitalised — but in the post-crisis world APRA will be paying particular attention to the management of capital buffers and provisioning through the economic cycle.

The Basel Committee will issue concrete proposals on its broad reform package, which will also include a non-risk-based "leverage ratio", by the end of this year. An impact assessment will be carried out in the first half of next year. APRA will be participating fully in this exercise to ensure that we understand the potential impacts for Australia and we hope to involve some of your institutions. As you would expect, we will also be consulting extensively with the ADI industry before any measures are introduced.

Those mutuals that were active in the securitisation market will know that there is movement at this station. Around the globe, there is clearly a wish to see the traditional "originate-to-distribute" securitisation model resume the contribution it made to credit availability and risk management but a recognition, as well, that regulation and oversight of this market needs improvement. The Basel Committee has tightened the Basel II capital requirements for securitisation and we will be releasing a discussion paper soon on implementation in Australia. One new requirement is that ADIs must look through to and understand the underlying pool to any securitisation exposures they hold. This "due diligence" requirement should not pose problems for ADIs that simply hold exposures in their own originated structure — after all, these assets were once on their balance sheet — but it may prove more difficult where an ADI buys paper from a securitisation vehicle it has not originated itself. Failure to satisfy the requirement will mean a capital deduction for the securitisation exposures, regardless of the credit rating assigned. We would also remind you that ADIs holding securitisation paper must treat them as a securitisation exposure and not, as we have been learning lately, as rated fixed-interest securities.

The International Organisation of Securities Commission (IOSCO) has also recently recommended that originators and/or sponsors of a securitisation retain a long-term economic exposure to the securitisation — "skin in the game", as they call it. This is aimed at restoring investor confidence and improving market quality; it is not a prudential measure. Clearly, however, it has prudential implications, particularly for our "clean sale" requirements. For that reason, we have been consulting closely with the Australian Securities and Investments Commission (ASIC) as it considers how this and other IOSCO recommendations on securitisation might be implemented in Australia.

The Basel Committee has been promoting the development of stronger liquidity buffers to ensure greater resilience of banking institutions to liquidity stresses. APRA supports this objective. Our own proposals to enhance ADI liquidity risk management, which have been some time in gestation and have benefited from two years of "learning by doing", were released in September and have been attracting some media interest. The Basel Committee has now been charged with introducing a minimum global standard for funding liquidity and our proposals naturally need to be finalised in that context.

Our proposals will toughen stress-testing scenarios, and will improve our ability to monitor and assess ADI liquidity risk profiles. Important parts of the enhanced framework, however, will not apply to credit unions and building societies. The minimum liquidity holdings (MLH) regime under which they operate has, through the crisis, delivered an appropriate degree of resilience for ADIs with relatively straight-forward, retail-based business models. That regime will remain, and credit unions and building societies will not be subject to our requirements for stress-testing or for an internal liquidity pricing mechanism. However, we will continue to take a risk-based approach in determining whether any credit union or building society with a more complex business model should remain exempt from the stress-testing regime.

There is work for you to do, though. Our proposals will require boards of all ADIs to articulate their tolerance for liquidity risk and to have a formal, documented funding strategy. This will build on the progress you have already made in developing robust and detailed funding plans. All ADIs will be required to provide a "going concern" cash flow projection for a minimum timeframe of 12 months. The crisis has taught that all ADIs should be able to forecast their funding needs accurately and develop appropriate strategies and actions to meet them. This requirement should not be onerous for mutual ADIs, irrespective of your size or nature, because you should already be thinking, planning and operating your business with that forward-looking perspective. Finally, all ADIs will be subject to standardised reporting requirements. Again, this should not be a significant burden for the majority of mutual ADIs which will simply put a "zero" against most of the data items.

APRA's approach to remuneration will be released in the next few weeks, after two very useful rounds of consultation. Our approach will be set out in an expanded governance standard and in a prudential practice guide. Though some of the details have changed, our key principle stands — namely, that boards of ADIs and insurers are responsible for the remuneration policies of their institutions. Our two key requirements also stand:

• boards must establish a Remuneration Committee made up of non-executive directors of the institution, with a majority being independent; and
• boards must establish and maintain a written Remuneration Policy that aligns remuneration arrangements with the long-term financial soundness of the institution and its risk management framework. The interplay between remuneration, performance and risk management must be explicit.

By and large, mutuals have simple remuneration structures notwithstanding performance-based aspects in some contracts. No significant prudential issues have arisen, although we have intervened on occasion where remuneration incentives driven by asset growth targets alone have struck us as imprudent. Our assessment of your remuneration arrangements will feed into our overall risk assessment, via the PAIRS rating, and where necessary into our prudential capital requirements.

As you know, our governance standard gives us the flexibility, in exceptional circumstances, to approve alternative arrangements that achieve our prudential objectives. We have used that flexibility before and will do so again. But there can be no exception to the principle that, on remuneration policies, the buck stops with the board!

Concluding comments

Nothing in the performance of mutuals over the past two years, or in the likely regulatory landscape ahead, suggests that the mutual movement is at a strategic cross-roads. On the contrary, your resilience through the global financial crisis is evidence that game plans were generally up to the challenge. And like any game plan that is working, boards should have compelling reasons before they make a change.

Obviously, though, there are lessons to be learnt. Now is the time for mutual boards and management to take an honest and hard look at what has worked well for their institution and what hasn't, at what elements of their business model needed adapting, at what skills and competencies were stretched, and at whether the warning signals on risk flashed early and clearly. We would expect that a critical self-analysis would form part of your strategic planning process, and APRA will be pushing you to make that process a robust one.

This is the last occasion, I hope, on which I will be addressing this Convention with the words "turbulent times" in the title. Next time we meet, I expect to be warning you about the dangers of complacency — the dangers from that heady rush of adrenalin that survivors feel after escaping adversity. Don't succumb to that rush. Even with better economic times ahead, it will be hard grind in the marketplace and mutuals will need to remain sharply focussed. That said, the Australian community, perhaps more than ever, wants genuine choice in its financial services but an assurance, at the same time, that its financial institutions can stay the course. Mutuals know now, after two years in battlefield conditions, that they can provide that assurance and offer that choice. These are solid foundations on which to build!