Opening Statement

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

At our appearances earlier this year before this Committee, my opening remarks assessed the impact of a series of physical shocks — in the form of a spate of natural disasters — on the general insurance and deposit taking industries regulated by APRA.

Today, Mr Chairman, my opening remarks will focus on financial shocks, in the form of the renewed turbulence we are witnessing in global financial markets. This turbulence is telling evidence that the global financial crisis that erupted over four years ago has further to run.

The origins of the current market turbulence, as is well known, lie in weaknesses in the public finances of the United States and a number of European countries, and in the large sovereign debt exposures of European banks. These weaknesses are legacies, in many ways, of the substantial public policy interventions to address the earlier financial and real impacts of the crisis. Markets are losing confidence that policymakers in the countries concerned have the capacity to restore their economies and financial systems to a surer, more sustainable footing within a reasonable timeframe. The loss of market confidence has reflected in bouts of severe turbulence in global equity markets, a retreat from bank risk in global funding markets and increasing pessimism about global growth prospects.

APRA is, of course, monitoring this situation closely. As the Committee knows, we remained on ‘heightened alert’ status even after the worst of the crisis appeared to be behind us — we are by nature sceptical! — and it would seem we will not be able to relax that status for some time to come.

Our assessment is that the Australian banking system is well placed to deal with the current market turbulence. Its financial condition is very sound. Authorised deposit-taking institutions (ADIs) in Australia are recording relatively strong levels of profitability, aided by a continuing gradual decline in bad debt expenses. ADIs are also holding historically high levels of capital. At end June 2011, the Tier 1 capital ratio of Australian banks reached a record 10 per cent, having operated between seven and eight per cent for the decade prior to the crisis; the comparable ratio for credit unions and building societies is higher again.

The Australian banking system has only a limited direct exposure to the European countries currently under the most severe financial pressure — Greece, Portugal, Ireland, Italy and Spain (the so-called PIIGS countries). Exposure to the broader euro area is larger, although still less than two per cent of banking system assets. The relatively small size of these European exposures suggests that any direct impact from pressures on one of the troubled European countries would be minimal. However, ADIs will not be completely insulated from broader market turbulence, particularly if it persists for some time. The larger Australian banks are well aware of the potential for indirect impacts via the disruption or closure of global funding markets caused by a widespread investor retreat from risk. They have been there before. As it stands, global short-term funding markets remain open and accessible to Australian banks, which seem to be beneficiaries of ‘safe haven’ status, though pricing is higher than earlier in the year. However, global markets for unsecured longer-term debt are regarded as effectively closed. Spreads are sufficiently wide that no bank wishes to issue unsecured debt for fear of being perceived as desperate for funds.

This is not causing the larger Australian banks any immediate stress. Low lending growth, coupled with ongoing solid deposit growth and wholesale funding activities that are ahead of targets, mean that the larger banks have built up liquidity and can operate without access to global term funding markets in the immediate period ahead. Compared to their position in 2008, Australian banks have a substantially more robust funding profile because they have significantly reduced their reliance on short-term wholesale funding, which has fallen over this period from around one-third of total funding to one-fifth.

The strengthened liquidity positions, coupled with unused self-securitisations that can be used in repurchase transactions with the Reserve Bank of Australia, provide comfort that ADIs could survive a period of months without access to global term debt markets, provided short-term and domestic markets continued to operate relatively normally. That said, should the disruption to markets extend well into 2012, it will start to coincide with wholesale debt maturities. ADIs will then be seeking to raise funds in markets likely to be crowded by sovereigns and offshore banks. The larger Australian banks are therefore preparing to tap covered bond markets now that the legislation has been enacted, and to pursue funding securitisations (another form of secured funding) to assist in alleviating any future pressures.

APRA is also monitoring the exposure of the insurance and superannuation industries to the volatility in global financial markets. These industries are exposed both to falls in share markets and any blow-out in credit spreads.

The life insurance industry is exposed to falls in share markets, given its sizeable portfolios of equities. However, stress-testing by APRA, as well as regular liaison with individual life insurers, indicates that the industry is capable of absorbing further substantial market declines and/or adverse credit spread movements before minimum regulatory requirements would come under pressure.

The general insurance industry is much less exposed to equity markets than life insurance but has a larger exposure to credit spreads, given its substantial fixed-interest portfolios. The industry is operating with strong levels of capital and, at this stage, APRA does not foresee major strains being created if financial market conditions were to worsen.

As with life insurance, the superannuation sector is heavily exposed to share markets and credit spreads. Investment returns will therefore be buffeted by current volatility although, since superannuation is a long-term investment, members should be encouraged to focus on returns over a longer period of time. APRA has been encouraging superannuation funds to hold sufficient liquidity to ensure that benefit payments can be met regardless of market circumstances. APRA is also closely monitoring the funding positions of defined benefit funds to ensure trustees are well on top of the situation.

One final point, on prudential policy matters. Last month, APRA released its proposals for implementing the Basel III capital reforms in Australia. These reforms, which respond to the clarion call of the G-20 Leaders for a more resilient global banking system, are part of a comprehensive package of measures, developed by the Basel Committee on Banking Supervision, that are centred on raising the quality, quantity and international consistency of bank capital and liquidity. In APRA’s view, ADIs in Australia are well placed to meet the higher Basel III minimum capital requirements and APRA is therefore proposing to accelerate aspects of the Basel Committee’s timetable. APRA’s proposals for implementing the Basel III liquidity reforms will be released shortly.

Also last month, APRA released a Discussion Paper introducing its proposals for prudential standards for the superannuation industry. This follows the Government’s announcement, in the context of its Stronger Super reforms, that it will release draft legislation to enable APRA to make prudential standards for superannuation. If approved by Parliament, a standards-making power will be important in strengthening the protection of the interests of fund members.

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