The regulatory landscape 2009-2010

John Laker, Chairman - Finsia Financial Services Conference

I am pleased to be participating at the Finsia Financial Services Conference 2009 at a time when the global gloom of the past two years is slowly and, we hope, surely lifting. And I am particularly delighted to be sharing the platform with the Chairman of ASIC as we survey the regulatory landscape for the Australian financial system from the vantage point of our respective peaks.

The focus of my remarks today is Australia's prudential regulation framework. This is the set of ground rules administered by APRA — and made up of legislation, prudential standards and prudential practice guides — that are aimed at promoting prudent business behaviour and risk management by the financial institutions under our watch. Australia's prudential regulation framework has served the community well during the global financial crisis. Don't just take my word for this! In its most recent health check of Australia, the International Monetary Fund noted that 'Australian banks have coped well with the turmoil so far, largely because of robust supervision and regulation.‟ This is but one of a growing number of official and other endorsements of the prudential framework that are, in turn, encouraging considerable interest abroad in Australia's "twin peaks‟ regulatory architecture.

This outcome is not fortuitous. It is the product of a decade of hard work by APRA, together with Government and our regulated institutions, to build a prudential framework in Australia that was industrial strength and beyond. That would ensure the Australian financial system would be resilient to shocks, of whatever origin. The two guiding themes of APRA's prudential reform agenda over the decade have been our commitment to a "principles based‟ approach to regulation that recognises the complexity and diversity of financial institutions and, secondly, our desire to harmonise prudential standards across the regulated industries, where appropriate.

Stepping back from the technicalities involved, APRA's reform agenda, which has embraced all of our regulated industries, has had three high-level objectives. These have been:

• to enhance the calibre and decision-making processes of those charged with running regulated institutions;
• to strengthen the ways in which institutions identify and manage their risks; and
• to better align capital requirements to the risks being borne.

Until the global financial crisis reshaped prudential policy agendas, the hard yards involved in building a robust prudential framework in Australia had largely been secured. The last major initiative was the introduction of the Basel II capital regime for authorised deposit-taking institutions (ADIs) from the beginning of 2008. Operating within Australia's prudential framework, our regulated institutions largely avoided the pitfalls that claimed many of their global counterparts and capital resources have proven more than adequate to withstand the stresses thrown up by the crisis. For all these stresses, there is very little red ink colouring the bottom lines of our regulated institutions.

Not surprisingly, given this experience, APRA does not envisage any fundamental overhaul of Australia's prudential framework in response to the global financial crisis.

The global reform process

However, the story cannot end here. The Australian financial system is global in its ambition, in its reach, and in key aspects of its operations. In particular, Australian banking institutions as a group have a much higher reliance on global funding markets than most other retail banking systems. And the global financial system in which Australia participates is clearly in need of substantial repair.

As the Leaders of the G20 have emphasised, major weaknesses in financial regulation and supervision were fundamental causes of the global financial crisis. In the area of prudential regulation, those weaknesses related to the management of liquidity risk, the capital treatment of securitisation activities and the measurement of traded market risk, particularly in complex structured instruments. More generally, there were insufficient incentives for banks around the globe to build-up enough capital in the good economic times preceding the crisis to enable them to play their traditional "shock absorber‟ role when times turned sour.

The task of addressing weaknesses in the global regulatory framework is being driven by the Leaders of the G20, on what they have called "strict and precise timetables‟. Strict they are and must be, because the forces of amnesia and resistance to change that will inevitably accompany the return to calmer global conditions may soon begin to chip away at fundamental reforms. The blueprint for these reforms is a series of recommendations by the Financial Stability Board, whose goal is "to create a financial system that operates with less leverage, is immune to the set of misaligned incentives at the root of this crisis, where prudential and regulatory oversight is strengthened, and where transparency allows better identification and management of risks".

The global reform process is focussed mostly on banking systems. This is not because insurance and superannuation industries around the globe were immune from the crisis — the experience of AIG and US monoline insurers bears telling witness to the contrary — but because the breakdown of trust that precipitated the traumatic events of September and October last year was a breakdown of trust in global banks. APRA‟s main involvement in the global reform process therefore comes through its membership of the Basel Committee on Banking Supervision, the global standard-setting body for banking regulation, which APRA and the Reserve Bank of Australia joined in mid-year. For many years previously, I might add, APRA had been an active participant in the Basel Committee's working groups.

The Basel Committee has confirmed that the level and quality of capital in the global banking system needs to be strengthened to raise its resilience to future episodes of economic and financial stress. A program of enhancements to the Basel II Framework, the new global capital regime for banking institutions, is underway to achieve this. The enhancements involve improved coverage of risk, introduction of capital buffers that can be drawn down in periods of stress, strengthening the quality of bank capital and introduction of a non-risk-based supplementary measure, or "leverage ratio‟, to put a floor under the potential build-up of leverage. The Basel Committee has also been promoting the development of stronger liquidity buffers to ensure greater resilience of banking institutions to liquidity stresses.

The Committee has already taken steps to toughen the Basel II capital requirements for securitisation and trading book activities. These steps have closed off loopholes in the prudential framework that distorted incentives for off-balance sheet securitisation activity; they also ensure that the statistical modelling used in calculating traded market risk must now incorporate data from periods of significant stress.

These new capital requirements will come into effect globally from the end of 2010. We expect them to have only a modest impact in Australia because our ADIs have only limited reliance on the income streams from these particular activities. This will not be the case in other jurisdictions. The Basel Committee has just released the results of an impact study showing that its higher capital requirements for traded market risk will, on 2008 data, result in an average increase of over 11 per cent in overall capital requirements for the banks surveyed (none of which was Australian) and over 220 per cent in market risk capital requirements. Tougher does mean tougher.

The Basel Committee is now finalising a broader package of measures to strengthen the regulatory capital framework. One set of measures will raise the quality, consistency and transparency of the Tier 1 capital base (the highest quality capital) by limiting the predominant form of Tier 1 capital to common equity and retained earnings, harmonising deductions from capital and requiring full disclosure of all components of the capital base. APRA fully supports this initiative. We have taken a conservative approach to the definition of capital and to the predominance test, an approach clearly vindicated by the events of the past two years. Nonetheless, major Australian banks have expressed concerns that our approach generates "headline‟ capital ratios that appear lower than those of banks in other jurisdictions. Details of the Basel Committee's measures are still to be finalised but APRA‟s conservative approach is likely to be keeping broader company.

Other measures will include a framework for countercyclical capital buffers, the build-up and release of which could be conditional on particular indicators, such as earnings or credit-related variables. This particular task is not an easy one — if it were, prudential regulators could be rightly criticised for not having completed it earlier. The issues being explored include what indicators of the build-up of risk during an economic upturn would be appropriate; whether the capital buffers would be made public and, if they were, what signal would changes in buffers convey to markets; and whether capital buffers should be determined in some mechanical way or left to regulator discretion. The global financial crisis has also shown that markets are reluctant to allow banks to run capital buffers down in times of stress, which could turn buffers into hard floors.

The Basel Committee will issue concrete proposals on its broader reform package by the end of 2009. The intention is to finalise the package by the end of 2010 and to phase-in the new measures in a way that does not impede the global recovery.

Complicating the Basel Committee's task in dealing with procyclicality have been accounting standards applying to provisioning for loan losses. International Financial Reporting Standards had emphasised a backward-looking or incurred loss approach to provisioning, one concern being profit manipulation. In contrast, prudential regulators have favoured a forward-looking approach under which provisioning levels would reflect credit losses inherent in loan portfolios, even if the losses have not yet been incurred. There is now an active dialogue between the Basel Committee and the accounting standard-setters to develop an approach to loan loss provisioning that would recognise credit losses earlier, and hence mitigate procyclicality.

Other APRA involvement

In addition to the work on capital standards, there are two other aspects of the global reform process in which APRA is actively engaged at this moment. The first is the management of liquidity risk. A salient lesson from the crisis was that many major banking institutions, even with adequate capital levels, came under significant pressure because their risk management frameworks failed to contemplate how suddenly liquidity risks can materialise and funding sources dry up. As a consequence, central banks had to provide unprecedented levels of liquidity support to sustain banking systems but a number of banks failed or were forced into mergers or public sector rescues nonetheless.

In September 2008, the Basel Committee released its revised Principles of Sound Liquidity Risk Management and Supervision, as a step towards promoting stronger liquidity buffers in financial institutions. The Committee has now been charged with introducing a minimum global standard for funding liquidity that includes a stressed liquidity coverage requirement and a longer-term structural liquidity ratio.

APRA had begun a review of our prudential framework for liquidity risk management before the crisis erupted but we had to suspend this work while we and other prudential regulators learned, through the "live‟ stress test of the crisis, what constituted good and bad practice in this area. Our review, now completed, has concluded that Australia's prudential framework remains appropriate but there are areas for improvement. Last month, we released a consultation package on our proposed improvements. Very briefly, our proposals will require ADIs to confront more searching stress scenarios, including the possibility of a protracted period of market disruption, and to be able to provide information on their liquidity position to us at short notice in times of stress.

Our proposals also enhance the qualitative requirements for liquidity risk management, in line with the Basel Committee's Principles. In particular, we are proposing that the board of an ADI articulate its tolerance for liquidity risk in a way that is comprehensive, meaningful and reflective of the particular vulnerabilities of the ADI. We are also proposing that ADIs have a liquidity risk management function that is operationally independent and has the skills and seniority to challenge treasury and other profit-making businesses.

A greater role for boards is the centrepiece of the other aspect of global reform in which APRA is actively engaged. This is the issue of remuneration. I mentioned earlier the Financial Stability Board's goal of removing "misaligned incentives" from the global financial system. Remuneration incentives were key sources of misalignment: as we have learned, remuneration arrangements in many financial institutions encouraged excessive risk-taking with insufficient regard to longer-term risks. In response, the Board developed its Principles for Sound Compensation Practices, to which APRA was a significant contributor. These Principles, which were endorsed by the Leaders of the G20 in April this year, have been followed up by the Board's recently released Implementation Standards, which are aimed at facilitating adherence to the Principles.

APRA is currently in a second round of consultations on its proposals on remuneration for ADIs and general and life insurance companies. These proposals are designed to align remuneration incentives with good stewardship of institutions. They put the onus on boards to have an independent Remuneration Committee and to inject a longer-term horizon into their remuneration policies. This principles-based approach, which will be implemented through extensions to APRA‟s governance standards, has broad industry support and we are now down to finalising details. Our intention is to finalise our remuneration requirements by the end of 2009, to come into effect from April 2010.

APRA's engagement in the global reform process has added considerable impetus to a prudential policy agenda that, before the global financial crisis erupted, we had hoped was well over the hump. And our agenda is not confined to the banking system. Drawing particularly on the AIG experience, we are developing a prudential framework for conglomerate groups. In addition, a review of capital standards in the life and general insurance industries is looking at the scope to harmonise these standards and improve their risk-sensitivity.

The challenges of global reform

Already we hear the cries, however, that APRA should somehow stand aloof from the global reform process. We are being counselled not to "blindly‟ adopt global standards that are being designed, it is claimed, to deal with regulatory shortcomings in other jurisdictions, not ours. These are understandable sentiments, given how well the Australian financial system has coped through the global financial crisis — underpinned, though, by the Government guarantee arrangements. Nonetheless, there are clearly limits to how far these sentiments can and should be taken when Australia is inextricably linked to the global financial system. Let me put the particular global reforms in which APRA is involved into a wider context.

Although Australia has been spared the worst, the fallout from the global financial crisis has been pronounced: a substantial loss of confidence in financial institutions and markets, sharp contractions in output and strongly rising unemployment in many advanced economies, a slump in trade flows and a significant loss of wealth by savers. The global financial system stood at the brink twelve months ago and has only been brought back by a series of unprecedented public policy responses by central banks and governments which, in many countries, have exposed taxpayers to considerable risk. Understandably, then, the Leaders of the G20 want no return to the status quo ante. Their determination to rebuild the bonds of trust in the global financial system through a stronger global regulatory framework should not be underestimated.

And Australian banking institutions were not immune from the breakdown of trust. Notwithstanding their strong financial position and high credit ratings, our banks were not given a "free pass‟ in those dramatic days of September and October last year when global funding markets almost fully seized. They faced the same acute anxieties about the price of wholesale funding, and whether such funding would be available at all, as their global competitors. In that context, the Government guarantee was essential and very timely. Global reforms that provide more assured access to wholesale funding markets will obviously benefit our banking institutions.

We also need to recognise that in a world of greater transparency, investors, analysts and others will judge our financial institutions against any global standards, whether we or the institutions like it or not. It would be curious indeed for our financial institutions to promote their strengths to the marketplace while at the same time shying away from global benchmarks. Investors will not allow that to happen.

There can be no unilateral declaration of independence from global reform. What I can confirm, however, is that APRA will be working very hard, through our membership of the Basel Committee and other international fora, to ensure that our financial institutions do not bear the unnecessary brunt of global solutions to problems they themselves had avoided. We will be consulting fully before any changes to our prudential framework are implemented and we will make sure that any unique characteristics of our financial system are taken into account. It is for this reason, for example, that we are currently consulting with ADIs on the definition of a high quality liquid asset in a country where, for the best of reasons, the government bond market is small.

Global reforms to capital and liquidity will not be finalised until a comprehensive impact assessment of the various measures is completed, by the end of 2010. This work is essential to get the calibration of the various measures right. APRA will be participating fully, supplementing the global effort with a very close look at the impacts on Australia. From my own participation in the Basel Committee, I can assure you that prudential regulators around the globe are very mindful of the unintended consequences that would follow if, so to speak, the whole proves greater than the sum-of-the-parts. There is always a careful balance to be struck between financial safety on the one hand, and competition, efficiency and innovation on the other. Ahead of the global financial crisis, that balance had tilted too far away from safety considerations but prudential regulators are well aware of the risks of over-correcting.

Summing up

In sum, APRA and our regulated institutions have some work ahead of us on the regulatory front. As I said at the outset, however, a fundamental overhaul of Australia's prudential framework is not on our agenda — there are large parts of the framework that have proven their effectiveness during the crisis and do not need revisiting. The enhancements that will be made, after extensive consultation, will strengthen the role of boards; will promote higher quality liquidity buffers and capital; will require capital management for the cycle, not just good times; and will discourage excessive reliance on short-term funding. These are not enhancements that a well-capitalised, prudently run regulated institution, with "good practice‟ risk management systems, has reason to fear.