Responses to the global financial crisis the Australian prudential perspective

Charles Littrell, Executive General Manager - APEC Regional Symposium: Enhancing financial policy and regulatory Co-operation

Thank you for the opportunity to speak today on a topic close to APRA's heart: how can we reduce the probability of and damage from future financial crises?

Lessons from the financial crisis

A great many people have said quite a lot on the lessons to be learned from the global financial crisis, so I will avoid repeating the conventional wisdom on leverage, poor risk management, conflict of interest, and lax regulation. Instead I will propose two lessons which from my perspective have not received enough attention.

First, financial crises are inevitable. After every crisis, there is a well-meaning cry of "never again"—but it seems the case that cyclical instability is a permanent condition in the financial markets. Even the best juggler sometimes drops a ball, and even the best singer sometimes misses a note. In the same way, even well managed and well regulated financial systems will sometimes experience a crisis.

Second and conversely, financial crises may be inevitable, but they are also partially predictable, and therefore partially avoidable and manageable.

This combination of inevitability, predictability, and manageability gives important pointers to how the public sector should prepare for financial crises.

From the global financial crisis, APRA has drawn conclusions about how it should act, and I will share these conclusions with you today. I emphasise that neither I nor APRA is saying that other countries should copy what we do. Every country will need to make its own decisions about how to regulate its financial system.

The implications of inevitable crises

Any society aspiring to reasonably efficient, competitive, and innovative financial markets must accept the possibility of financial failure, including systemic financial failure.

At some point in its development, a society takes steps, such as the introduction of central banks and prudential regulation, to moderate the financial boom/bust cycle. It has proven largely impossible, however, for any developed economy to become immune from financial crises. I shall not repeat the catalogue of woe associated with the history of financial crises, other than to note that in any given half century for the past several centuries, some, most, or all of the developed economies of the era have suffered from financial crises. There is no reason to think that this will not be the case in the future.

But clearly inevitability does not mean hopelessness.

I suggest that a hopeful response to avoiding financial crises looks something like the discipline practiced by non-drinking alcoholics. They do not say: "I am no longer an alcoholic". Instead they say: "I am an alcoholic, but I am not going to drink today." The cognate for APRA in good economic times is: "We have every temptation to become light touch regulators, but we are not going to become light touch regulators today." Then keep repeating this mantra, for as many days, years, and decades as are necessary.

Some concrete steps to avoiding and minimising crises

There is no guaranteed program for avoiding financial crises, but there are several strategies and tactics which will help in averting or minimising such crises. Given my limited time today, I shall focus on two critical issues:

1. Preparing the regulator and the industry for the next crisis; and
2. Building a whole of public sector capacity to support the necessarily intrusive supervision to defer and hopefully moderate the next crisis.

Preparing for the next crisis

Substantial financial institutions fail for reasonably predictable reasons. In the banking sector, for example, crises generally stem from overly rapid and insufficiently sound credit growth, which eventually triggers loss of confidence and a liquidity crisis. To put a local flavour on this, Australian banks are particularly exposed to home lending and therefore to house prices. The Australian economy is also exposed to recessions among our major trading partners, traditionally in America and Europe but with Asia emerging as the critical region over the past decade.

APRA does not know when, if, or how economic reverses will lead to problems in the Australian economy. We possess a reasonably good feel, however, for the range of likely issues that can lead to failure. It is not APRA‟s job to predict the course of the Australian economy. Our somewhat easier job is to consider what might be the most plausibly negative course for the economy and for each of the industries we supervise. From this base, we strive to ensure that our regulated entities can survive these scenarios of maximum reasonable adversity. In recent years, you will be unsurprised to hear, we have tested our banking industry for exposure to a home loan crisis and to a general recession, our life and general insurance industries to the risk of an avian „flu outbreak, and our life companies to the risks associated with drastic falls in financial asset prices.

APRA searches for the next crisis in the full knowledge that we will find many more crises than will eventuate, and the even more frustrating knowledge that the actual crisis is most unlikely to closely match any of our preconceptions. The Global Financial Crisis of 2007 and 2008, for example, was clearly driven by appalling credit standards, but nobody was expecting the losses to be crystallised via AAA rated structured credits, and AIG‟s Financial Products Group, and all the other non-traditional credit loss sources we encountered. Furthermore, nobody including APRA expected the world‟s money markets to freeze late in 2008, shutting out even the soundest non-sovereign credits, including perfectly sound securitisations.

In the years preceding the crisis, fortunately, APRA and the industry built up stronger capital quality, and encouraged good credit underwriting standards, particularly for home loans. Through the Council of Financial Regulators, all of APRA, the Reserve Bank of Australia, the Australian Treasury, and ASIC spent many years collectively preparing for an eventual crisis, even though we knew that we could not predict the course of that crisis.

When the crisis became most acute during 2008, neither APRA nor anyone else could predict where it was going. We could say to the Government and other interested parties, however, that Australian prudentially regulated entities were generally well capitalised, well managed, and understood the risks they were taking. This was not completely the case for every single entity, but was close enough to complete to give confidence that the Australian financial system would survive the global financial crisis in reasonably good shape.

This leads to the core advice that I would like to give you today. If the prudential regulator is prepared for all the reasonably predictable crises that could hit a financial system, and takes effective steps to ensure that industry is also ready for these plausible crises, then any nation‟s financial system and major institutions are much more likely to survive the unpredictable crisis that will in all likelihood eventually emerge.

Whole of public sector crisis-proofing

It is not enough for the prudential regulator to maintain crisis-readiness. The prudential regulator must work with the central bank, finance ministry, securities regulator, and government of the day, often for many years, and often without apparent results, to ensure that the nation is as prepared as is reasonably possible for the inevitable crisis.

The prudential regulator has two advantages in this work: focus and context. All the other public sector agencies have many competing demands upon their attention, but the prudential regulator is, or certainly should be, permanently focussed upon a safe financial system comprising soundly managed and regulated entities. As for context, good prudential regulators need to understand the financial and managerial quality of their regulated entities, both locally and against international benchmarks. Any local laggards should be brought up to the mark in good times, so they are ready for bad times. Any institutions or people not able to achieve minimum standards of safety in good times are clearly going to be problems in a crisis, so the trick is to deal with them in the good times. In this context, prudential regulators are rather like shepherds. We bring the strays back to the flock, and from time to time it is necessary to cull the weakest members of the flock, to protect the stronger members.

Remaining a good shepherd becomes increasingly difficult as good economic times continue. The executives who lived through the last crisis move to other pursuits, and eventually retire. To keep up the necessary pressure on industry for the necessary years or decades, the prudential regulator must have allies in the public sector. It will be necessary to curb the aspirations of the private sector, and this curbing inevitably pinches most on the brashest, most self-confident firms and executives, who will have little hesitation about arguing their position in the public and political spheres. If prudential supervisors are unsupported by the rest of the public sector, particularly the political sector, then eventually prudential supervision will wear away to ineffective observation, rather than effective intervention.

How do prudential regulators ensure public sector support? Primarily, by encouraging and educating natural allies. Finance ministries, for example, often seek to promote industry development, and "industry development" is far too often short-hand for "let industry grow as fast as it likes". A wise prudential regulator will point out to finance ministries and finance ministers that too much laxity in the private sector, particularly among banks, is the most common prelude to a financial crisis. Or to use a shorter version: "politicians should never like banks too much, or they will end up buying them". And this purchase will occur, of course, when the terms of trade are least favourable during a crisis.

There is no good prudential regulation without good supervision. There is no good supervision without a culture of effective intervention. Effective intervention over the necessary years and decades is impossible without broad public sector support, most of all from politicians across the political spectrum. If you show me a country where the politicians listen to bankers more than they listen to regulators, I will show you a country which is guaranteed to have a banking crisis.

Central bankers, with their financial stability focus, are natural allies of prudential regulators, and in many countries the central bank is a prudential regulator. On the other hand, central bankers tend to a whole of economy perspective. This is not quite the style for a successful prudential supervisor, who must constantly, but hopefully mildly, intervene with individual institutions. In the best circumstances, and in Australia between the RBA and APRA I am confident we are close to the best circumstances, the central bank and the prudential regulator build up mutual trust, personal connections, and institutional links during the good years. This work really pays off during the crisis, as both organisations can work together building an effective and coordinated response to the crisis.

Summary

In summary, anybody who joins a prudential regulator hoping to become popular has made a serious career mistake. Our choice is not whether we are popular or unpopular, but is limited to who we are unpopular with. Ideally prudentially regulators are consistently unpopular with the most aggressive institutions in the financial community, who will become both more aggressive and more numerous during good economic times. We will be unpopular because we don‟t let such institutions impose unwarranted risks upon society, and this will limit the bull market profits available to such institutions.

The alternative, which has unhappily played out in so many countries in recent years, is that the prudential regulator, and very likely the central bank, finance ministry, and politicians, become intensely unpopular with millions of citizens who have had their financial prospects blighted or destroyed in a financial crisis. In Australia we strive to avoid this outcome, in the full knowledge that success can never be guaranteed, but supervisory resolution in perpetuity is the necessary first step in limiting failure.

Thank you for your attention, and best wishes for a successful conference.