Surviving the downturn: APRA's role in Financial Crisis Management

David Lewis, General Manager - Continuity Forum - Business Continuity Summit, Brisbane

I gave this talk to a Continuity Forum event in Melbourne last November. At that time, the Global Financial Crisis was just breaking out. But much has changed since then.

What started out as a Global Financial Crisis has now turned into a Global Economic Crisis.  But, whereas last year the crisis was all about access to funds and liquidity, the next phase of the crisis will be all about withstanding the slowdown in economic activity.

Today, I’d like to talk to about APRA’s role in financial crisis management.  In doing so, I’ll cover:

• Can prudential supervision prevent financial market crises?
• The turmoil in financial markets:  what happened?
• Preparing for the unexpected:  APRA’s crisis response capability.
• Good supervision or good luck:  why have we done better in Australia?

APRA’s role:  Can prudential supervision prevent financial market crises?

The first thing to say about APRA’s approach to handling financial crises is that we aim not to have them.  Most of our attention and supervisory resources are fixed firmly on prevention.  For the most part, APRA works successfully ‘behind the scenes’ to improve the risk positions of Australia’s regulated financial institutions.  

As you know, APRA’s job is to ensure that Australia’s banks, building societies and credit unions (collectively known as authorised deposit-taking institutions, or ADIs), its insurance companies and its superannuation funds are well-placed to meet their obligations to beneficiaries as they fall due.  In doing so, we also seek to contribute to the promotion of financial stability more broadly.

To this end, last year, APRA undertook:

• 624 prudential reviews of regulated financial institutions;
• 192 on-site risk assessments;  and
• 3,220 analyses of financial data which we require to be submitted by regulated financial institutions.

On top of this, we dealt with countless other ad hoc risk issues and regulatory approvals that came up over the year.

And, if you think that this sounds like over-regulation, believe me; in the United States – with its multi-layered regulatory structure – they can do a lot more than this.

But, for all that, we don’t have x-ray vision and don’t see everything.  The fact is that, in all financial activity, a certain degree of risk is inevitable and cannot be avoided – despite the best efforts of prudential regulators at risk reduction. Prudential regulation is all about shifting the odds in favour of safety and soundness, but it’s not a panacea against all ills that can befall financial institutions. 

No matter how vigilant our prudential oversight, there will always be instances of financial distress – and, sometimes, the impact of these will be widespread (as we are seeing today).

The turmoil in financial markets:  What happened?

The immediate causes of the global financial crisis are, regrettably, familiar:

• there was a long period of global economic prosperity and growth;
• rising asset prices fuelled lending growth;
• prudent lending standards gave way to excessive reliance on collateral values;
• too many loans were made to too many people with too little capacity to repay.

Of course, the inevitable market correction occurred as the market caught up with economic reality.  The resultant revision in asset values led to the crystallisation of substantial losses – more than enough, and concentrated enough, to put some very large global banks out of business and necessitate widespread Government intervention to stabilise financial markets.  In the United Kingdom, for example, the Government now owns all but two of the five major ‘High Street’ banks that were operating in private hands a year ago.

I’d hasten to add that all this happened outside Australia – particularly, in the United States where problems were exacerbated by a dysfunctional loan origination model and some seriously misaligned incentive structures.  

In Australia, there has been very little evidence of this sort of lending behaviour. The asset quality of our banks is strong, and they are well-managed and well-capitalised.

But that doesn’t mean that Australian banks have been left unaffected by the financial crisis.  The failures overseas have left global financial markets skittish and unstable.  This has resulted in a loss of confidence in financial markets which has seriously impacted the availability and the tenor of funding for all banks.

If you are a bank, this is never a happy situation.  There have been some telling reminders from overseas of just how quickly a bank – with otherwise sound assets – can fall into difficulty when liquidity and funding have been mismanaged.  This is the area on which APRA has been focussing its supervisory attention.

It is also why APRA supported the Government’s intervention as prudent and necessary.  The Government’s guarantee of deposits and term debt issues was designed to boost confidence in the Australian banking system and ease funding pressures.  To date, it has had the desired effect.

To date, 19 countries have issued guarantees of some form or other in support of their banking systems.  And we are not talking about ‘banana republics’ here: most of these are developed countries with established banking systems.

Moreover, some countries have felt the need to go much further, making direct capital injections into troubled financial institutions. 

Preparing for the unexpected:  APRA’s crisis response capability

Now, because things can and will go wrong (prudential oversight notwithstanding), a core component of APRA’s prudential regulation is maintaining a capacity to respond to instances of financial distress when these emerge.  In order to fulfil its regulatory mission, APRA must be ready to intervene whenever there is a threat to a regulated institution’s ability to meet its obligations to its depositors, policyholders or superannuation fund members.

Maintaining this capacity is part of our core business.  So, when we talk about financial crisis management at APRA, we are not talking about business continuity – although some of the skills and capabilities required are clearly complementary. We are like firemen:  for us, financial crisis management is about being ready to respond to crises that overwhelm other institutions.

And, of course, there is something of a ‘catch-22’ in this for us – one that I’m sure will be familiar to an audience of business continuity professionals.  This is because, even though financial crisis management is one of our core functions, it is something that we hardly ever have to do.  Added to this, the responses required to instances of financial distress can differ significantly from one instance to another.

It would also not surprise you to hear that we rely on scenario planning and simulation exercises to compensate for this.  However, the simulations that we do tend to be based more around what I’d term ‘decision-making under uncertainty’, rather than a ‘fire-drill’ style of exercise.  By this I mean that the focus is less on practising a procedure to follow and more on assessing what remediation strategy works best in any given situation.

APRA has extensive and wide-ranging powers it can draw on to resolve a crisis situation that threatens the beneficiaries of a regulated financial institution.  For example, it can:

• assume control of the business;
• transfer its assets and liabilities;  or
• replace its board and management.

The challenge for us is to deploy these powers quickly and effectively so as to best protect the interests of beneficiaries.  For this, settling on the right remediation strategy is crucial. 

Let me draw on a medical analogy to give you a flavour of what I mean.  

Assume that, despite APRA’s best attempts at preventative medicine, our patient presents in mortal distress:

1. Resuscitation:  APRA’s first level of intervention would always be to explore what could be done to resuscitate the patient.  For example, can the business be restored by injections of new capital or liquidity?  Can it be restructured?
2. Transplant:  It may be that the interests of beneficiaries will be best served by a transfer of the business to a fitter, healthier provider.  Often this will be achieved voluntarily by private sale but, if necessary, APRA can employ its transfer of business powers to compel such a transfer.
3. Surgery:  A serious solvency shortfall may well require surgery to separate ‘cancerous’ assets from an otherwise healthy body.  A ‘good bank/ bad bank’ split is an example of such an operation which has been employed successfully in Australia in the past.
4. R.I.P:  But, if vital signs cannot be restored, statutory management and/ or liquidation may be the only option – in which case, there are statutory protections in place to look after the interests of depositors and policyholders.

There is a fifth option: the ‘kiss of life’.  Governments can, and often do, intervene to rescue failing institutions.  In recent months, we have seen many instances of this overseas.  But this not a standard item in the regulator’s ‘little black bag’.  By far, APRA’s first preference is to facilitate a private sector solution.  Government intervention typically only occurs when the systemic or macroeconomic impacts of allowing a particular financial institution to fail would impose unacceptable costs on the community.  

Good supervision or good luck:  Why have we done better in Australia?

It is always salutary for a regulator to reflect on whether what he or she does makes a difference to the economic well-being of Australians.  Sometimes this is not clear-cut.  While a prudential regulator’s best work is done in peacetime, the true value of that work is often only revealed when stressed by a crisis.

Let me highlight three factors that I think have played a significant part in maintaining the resilience of the Australian financial sector and which have helped its institutions to withstand the worst effects of the current financial crisis better than many of their overseas counterparts:

1. Structural differences

Firstly, the dynamics of mortgage lending in Australia differ significantly from those in the United States.  While securitisation has long been part of the Australian lending environment, intermediation is still the dominant model.  This has meant that incentives and risk-taking have stayed, more or less, in sync and have acted to constrain pressures to expand loan volumes without paying adequate regard to risk.

2. Strong financial institutions

Secondly, the Australian financial system is dominated by financial institutions that are large relative to the size of our economy.  And, as former Reserve Bank Governor, Ian MacFarlane has observed, they have been spared from the excessive takeover pressures that have been evident in many overseas markets by the operation of the ‘four pillars policy’.  

For the most part, Australian financial institutions are profitable and well-managed.  Healthy risk management cultures can be observed in the vast majority of Australian financial institutions.  Without doubt, this has been a considerable source of stability in the current crisis.

3. Effective regulation

But effective regulation, too, has played its part.  

Let give you a couple of examples:

The first is APRA’s approach to broker-originated loans.  We have never said that ADIs cannot use third party loan originators.  Rather, we insist that, where this is done ADIs must ensure that the originator applies the ADIs’ own credit assessment standards.  Moreover, the ADI must monitor and audit loans being originated via a broker to ensure on-going compliance with its lending criteria.  Prudent best practice for ADIs is also to include a risk-based component in the fees it pays for broker-originated loans.

Second, APRA has always been wary of “sub-prime” lending which has been prevalent in the United States.  In this vein, we introduced significantly higher capital charges for “low-doc” loans in 2004.

It is often observed that APRA adopts a more conservative stance on capital adequacy than many of its overseas counterparts.  We make no apologies for this. We think that healthy capital buffers are an important source of confidence for our financial institutions.   

More generally, APRA’s regulatory approach is one that focuses on ‘substance over form’.  As a regulator, we don’t believe in trying to tie-down everything that moves.  Rather, we take a ‘risk-based’ approach to regulation.  APRA has nowhere near the volume of prudential regulation that applies to financial institutions in the United States.  Prudential regulation in Australia relies much less on ‘black letter’ law and more on adherence to sound risk management principles.  

At APRA, we believe that prudential regulation works best its goals – sound risk management – are internalised within regulated institutions.  This is a method academics refer to as “meta-regulation” – and we are adherents of it.

Thank you.