Opening Statement - June 2010

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

At the time of our February appearance before this Committee, the operating environment for Australian financial institutions was clearly on the improve. Recovery in the global economy — though uneven — was beginning to gain traction, the Australian economy had resumed its forward momentum after a mild downturn and conditions in global funding markets had become more settled. Nonetheless, we noted that uncertainties continued to cloud the global economic outlook and global financial markets remained vulnerable to aftershocks.

For that reason, we advised the Committee that APRA was not ready to dial down the level of its supervisory intensity. That caution on our part has been vindicated by recent events.

Since February, prospects for the global economy have continued to firm. The IMF is now forecasting global growth over the next couple of years to be a little above trend, but with very different outcomes across regions. Recovery in Asia has been particularly robust and this is generating a significant terms of trade boost for Australia. As a consequence, forecasts for GDP growth in Australia are also being ratcheted up. These developments augur well for Australian financial institutions.

Over recent weeks, however, this positive global growth story has been obscured by the financial „ash cloud‟ over Europe. Concerns about the public finances of Greece and other European countries, about the exposures of European banks and about Europe becoming a dragging anchor on global recovery have led to a renewed bout of turbulence in global financial markets, particularly foreign exchange and equity markets. Australian banks have only very small exposures to countries in the Euro area and, although spreads have been widening, global funding markets — to date at least — have been more discerning about the fundamental strength of our banks. In contrast, the Committee will recall that investor retreat from risk in October 2008 was so rapid and pervasive that all internationally active banks were, so to speak, tarred with the same brush.

We are continuing to liaise closely with Australian banks that tap offshore wholesale markets, and we are satisfied that these banks are much better placed than they were in October 2008 to deal with potential disruptions to these markets. We are also monitoring the impacts of recent global and domestic equity market volatility on the life insurance and superannuation industries; these impacts are being well managed.

At the same time, APRA remains fully engaged in G20 global reform initiatives designed to promote a more resilient global banking system and strengthen prudential and regulatory oversight of that system. For us, the main aspects of the reforms are the level and quality of capital held by banking institutions, the management of liquidity risk, and remuneration incentives.

As I mentioned in February, the Basel Committee on Banking Supervision, the global standard-setting body for banking institutions, has released proposals to strengthen global capital and liquidity regulations. The objective is to improve the banking system‟s ability to act as a shock absorber rather than, as we saw in the global financial crisis, as a transmitter of shocks to the real economy. The proposals are wide-ranging, and a global quantitative impact study is being undertaken to assess their impact and to ensure that they are calibrated appropriately. APRA has been an active participant in this study and has collected data from a number of authorised deposit-taking institutions (ADIs). The results from the study are now being analysed by the Basel Committee, ahead of what will be critical deliberations at its next meeting in July, at which APRA and the Reserve Bank of Australia will be present. The Basel Committee has also been consulting with interested parties and has received submissions from some Australian banks and from the Australian Bankers‟ Association.

The final shape of this reform package will be clearer at our next appearance. The Basel Committee‟s intention is to develop a fully calibrated set of standards by the end of 2010 to be phased in, as global economy recovery is assured, by the end of 2012, with appropriate phase-in and grandfathering arrangements. As I have said before, APRA will not implement the reforms in Australia without extensive consultation.

APRA‟s work on remuneration incentives is much further advanced. Prudential requirements on remuneration for ADIs and general and life insurance companies came into effect on 1 April this year. They were implemented through our existing prudential standards on governance; we see remuneration incentives as an important issue of risk management that boards must „own‟, consistent with their responsibilities for good stewardship.

Before our prudential 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. Some institutions are well advanced in adopting risk-adjusted remuneration practices, while others have some way to go. Our current supervisory focus is ensuring that institutions have appropriate governance structures to deal with remuneration, and undertaking our own initial assessments of remuneration structures so that we have a good understanding of how institutions incorporate an adjustment for risk in their performance-based compensation schemes.

In March this year, the Financial Stability Board (FSB) undertook its own peer review on progress in applying its Principles for Sound Compensation Practices and Implementation Standards. Australia was one of 24 countries covered by the review and was identified as having made significant progress in this area. APRA has eschewed some of the more prescriptive limits and caps that have been recommended by the FSB, but we are confident that our principles-based approach will achieve the substantive outcomes sought by this global reform initiative.

In addition to its international engagement, APRA has been active on other prudential policy fronts that are more home-grown in origin. Since February, we have released:

• enhancements to the prudential framework for life insurers, dealing with governance, audit and actuarial matters;
• a comprehensive set of proposals for supervising conglomerate groups, aimed at ensuring that such groups hold adequate capital to protect APRA-regulated entities from potential contagion and other risks within the group. APRA is at the forefront of global policy developments in this area; and
• a set of proposals to update our capital requirements for general insurers and life insurers, aimed at making these requirements more risk-sensitive and improving the alignment of our capital standards across regulated industries. Naturally, as an integrated regulator, we have a strong commitment to harmonisation where it is appropriate. The proposed changes to capital requirements are more fundamental for life insurers than general insurers.

The various policy initiatives I have just described, global and home-grown, are intended to improve the regulation of financial systems. Focussing attention on regulation alone, however, downplays another key issue to emerge from the global financial crisis -  namely, the quality of prudential supervision. By supervision, I mean the direct oversight of financial institutions to ensure that they are operating soundly and prudently, not just complying with the regulations. This is APRA‟s „bread and butter‟ activity. As many now acknowledge, some advanced countries with similar financial systems, operating more or less under the same set of global regulations, were less affected than others in the crisis. Australia is one such country. While there may be a number of reasons for this, the IMF has recently highlighted one explanation ? that supervision in some countries had not proved to be as effective as it should have. I would commend the IMF‟s paper, The Making of Good Supervision: Learning to Say "No", to this Committee. The IMF identifies the key elements of good supervision as being „intensive, sceptical, proactive, comprehensive, adaptive, and conclusive.‟ The IMF goes on to say that

'To achieve these elements, the "ability" to supervise, which requires appropriate resources, authority, organisation and constructive working relationships with other agencies must be complemented by the "will" to act.'

We in APRA, not surprisingly, are in broad agreement with the themes of the IMF paper. Certainly, the key elements of good supervision espoused by the IMF have been fundamental to our approach to supervision before and during the crisis, and will continue to shape our approach when the dust from the crisis finally settles.

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