Opening Statement

John Laker, Chairman - Senate Standing Committee on Economics, Canberra

When we appeared before this Committee last October, the world was bracing for a major aftershock from the global financial crisis that had erupted four years earlier.

To recall, global financial markets were rapidly losing confidence that policymakers in the United States and a number of European countries had the capacity to restore their public finances and, in the European case, their banking systems to a surer, more sustainable footing within a reasonable timeframe. There was increasing pessimism about global growth prospects, accentuated by fears of a ‘hard landing’ by the Chinese economy. The loss of market confidence was reflected in bouts of severe turbulence in global equity markets, falls in commodity prices and dislocation in wholesale bank funding markets, particularly for unsecured longer-term debt.

These developments were the background against which the IMF in January downgraded its forecasts for global growth and the IMF Managing Director warned dramatically of the dangers of easily sliding into a ‘1930s moment’ — a moment where trust and cooperation break down and the global economy faces a downward spiral.

These developments were the background, as well, for my confirmation to the Committee that APRA remained on ‘heightened alert’ status. As I outlined, our particular focus was the potential funding pressures on Australian banks via any continued dislocation of global funding markets, and the exposure of the insurance and superannuation industries to the volatility in global and domestic equity markets.

Fortunately, the extremes of pessimism have begun to lift since the New Year. Global financial markets have had some positive news to absorb. In particular:

• The US economy is showing firmer signs of recovery;
• The Chinese economy appears headed for a ‘soft landing’ from earlier overheating pressures, while still recording strong growth; and
• European governments, individually and collectively, have taken further steps in shoring up support mechanisms for the euro, improving fiscal discipline and tackling fiscal deficits.

In addition, large-scale market operations by the European Central Bank have been instrumental in improving liquidity in the European banking system and bolstering market confidence.

The lift in market sentiment has had two immediate benefits for APRA-regulated industries. Firstly, improved conditions in global bank funding markets have enabled the larger Australian banks to step up bond issuance, and all four major banks have now commenced their covered bond programs. As the Reserve Bank of Australia has noted, however, spreads on bank debt are significantly higher than they were in the middle of last year. Secondly, global and domestic equity markets have firmed and volatility has returned to average levels or below. These are positive developments for the capital position of the insurance industry and for investment returns in the superannuation industry, although returns for 2011/12 for most superannuation funds will still be in the red.

All that said, there have been earlier false dawns during this protracted global crisis. Market sentiment is fragile and will remain so, certainly until European governments can demonstrate tangible progress in dealing with their sovereign debt crisis.

Looking through these market gyrations, as a prudential regulator must do, the current operating environment presents a more general challenge for the Australian banking industry. This was highlighted in our 2011 Annual Report, which was tabled shortly after our last appearance before the Committee. Our message bears repeating.

The challenge is coming to terms with ‘life in the slow lane’. The Australian economy is expected to grow at around its trend pace over the next couple of years. However, if the current cautious approach of households and businesses towards taking on additional debt persists, authorised deposit-taking institutions are very likely to be denied the strong balance sheet growth that supported a sustained period of profit increases before the crisis. In these circumstances, boards and management may be tempted to chase unrealistic expectations for returns on equity by assuming more risk — through lowering credit standards or seeking new and unfamiliar markets where they may have little comparative advantage — or by aggressive cost-cutting that may weaken risk management capacities. These temptations must be resisted in favour of more measured strategic ambitions.

A quick update, finally, on prudential policy matters. Since we last appeared before the Committee:

• APRA has released its proposals for implementing the Basel III liquidity reforms. These global reforms address a number of weaknesses in liquidity risk management that came to light during the global financial crisis. We are currently consulting on our Basel III capital and liquidity proposals and they were the subject of a major industry workshop in November;
• APRA has also begun a third — and, we hope, final — round of consultations on its review of capital standards for the general and life insurance industries; and
• APRA has been consulting on its proposals for prudential standards for the superannuation industry. We plan to release draft standards once legislation to enable APRA to make prudential standards for superannuation is being considered by the Parliament.

We are now happy to take the Committee’s questions.