Macroprudential Analysis and Policy in the Australian
Financial Stability Framework – September 2012
6. Decision-making Processes and Policy Tools
The main tools for macroprudential supervision in Australia are only exercisable by APRA. APRA is the only agency which has power to act to directly change the behaviour (and if necessary, the balance sheets) of entities to achieve macroprudential outcomes. The main tool that APRA exercises is to vary through the cycle the intensity of supervision, backed up as appropriate by APRA's prudential tools (particularly capital) and, in extreme cases, its direction powers (see below). This is mainly an outcome of the framework of risk-based supervision described earlier where the risk ratings of institutions and the supervisory response are impacted by changes in economic conditions. In effect the PAIRS and SOARS model plays a role as an automatic stabiliser for the financial system (see Box B). APRA can also change prudential standards to dampen risk in the system. These tools are not used frequently but they have been used in the past to dampen risky behaviour in the home lending market. APRA also has the ability to alter the behaviour of regulated entities through suasion, via communication with individual entities, industry-wide communication and through the promulgation of messages during presentations at a range of public fora. Finally, APRA can use its direction powers aimed at individual entities.
6.1 Inter-agency Consultation and Coordination
The use of APRA's powers is more likely to come about following assessments made by APRA about risks it observes at an entity or system level. Some items might however be discussed in the CFR, for example, if ASIC is the responsible regulator or if changes to legislation are required. Typically, industry or system-level risks and behaviours will be discussed with the RBA in the regular Coordination Committee meetings.
6.2 Prudential Tools and Prudential Policy
APRA's supervision involves continuous monitoring and oversight of entities' behaviour to ensure that they comply with prudential standards, are in a sound financial condition and maintain effective governance and risk management systems. APRA follows a proactive and risk-based approach under which institutions that pose greater risks receive more intensive supervision. APRA has developed a constructive relationship with the industries it supervises that helps it achieve its supervisory objectives through regular dialogue and consultation. It is nonetheless also able to respond to risks through direct intervention if necessary. For example, reflecting risks within individual institutions, APRA often imposes minimum prudential capital requirements for individual ADIs beyond the minimum requirements of the Basel framework.
APRA also has a wide range of legislated powers that enable it to take direct action if it identifies behaviour or financial distress that may threaten an ADI's ability to meet its financial obligations to depositors, or otherwise threaten financial system stability. These include powers to:
- obtain information from an ADI;
- investigate an ADI;
- give binding directions to an ADI (such as to recapitalise);
- and, in more extreme circumstances, appoint a statutory manager to assume control of a distressed ADI.
6.2.1 Suasion and directions powers
APRA generally prefers to adopt a suasion approach to ensure there is improvement when weaknesses are identified in a regulated entity. Entities are strongly encouraged to take ownership of issues and agree on an action plan with APRA. This is typically the case where entities are placed in ‘Oversight’ and APRA's goal is to see these entities return to ‘Normal’ status. As the severity of the problem increases, APRA will increase the overall intensity of supervision and use more aggressive techniques including use of its directions power. Under this power in the Banking and Insurance Acts, APRA possesses the broad ability to direct firms. This power is triggered if an entity is unable to observe its regulatory requirements, or APRA considers that the entity is operating unsoundly, or in a manner that could reasonably lead to its failure. Importantly, the directions power triggers well before actual or imminent failure by a regulated firm, so when necessary supervisors can issue directions in time to avert failure.
6.2.2 Engagement with Boards
APRA's engagement with boards is central to its supervisory approach. Meetings with a board and its committees give APRA the opportunity to reinforce its expectations of board performance and to form firsthand impressions of whether these expectations are understood and accepted by directors. Discussions across the table enable directors to explore with APRA ways in which its prudential concerns could be addressed. The exchanges also enable APRA to take good soundings on the risk appetite of the board, its command of strategy, the transparency and candour with which the board approaches problems and, more generally, on how it sets the ‘tone at the top’ for the institution. In recent times engagement with boards has increased in three areas that could raise systemic risk: risk appetite, executive remuneration and credit standards in housing lending.
6.2.3 Prudential Capital Ratio (PCR) Requirement
APRA also has the power to set individual capital requirements for regulated entities. This tool currently applies to ADIs, including banks, and general insurance companies and will shortly be extended to the life insurance sector. The ability to set individual capital requirements under the ‘Pillar 2’ approach to supervisory discretion is viewed as an important tool for dampening the risky behaviour of supervised entities. APRA routinely sets and varies Pillar 2 capital requirements for ADIs, and this approach has a good track record. However, balance is necessary. APRA neither sets nor varies capital requirements for an individual entity without careful consideration and a substantial internal review. This ensures the intervention is based on sound risk assessment.
Box B: PAIRS-SOARS Framework
APRA adopts a measured and risk-based approach to supervision, focusing supervisory attention on those areas of an entity or industry which pose the greatest risk. The PAIRS and SOARS framework helps to ensure that an appropriate supervisory response is taken, commensurate with the nature and degree of risk.
APRA's prudential supervision framework, which includes PAIRS, SAPs and quarterly risk reviews, supports a supervisory response appropriate to the nature, scale and complexity of regulated entities. APRA supervisors undertake PAIRS assessments to identify those entities that are of higher overall risk of failure and greater potential impact of failure, and thus of potentially ‘systemic’ importance. Under APRA's baseline supervision requirements, entities assessed as being of extreme impact must be subject to a prudential review and a prudential consultation at least annually.
The SOARS framework ensures that APRA's supervisory stance is aligned with the risks facing entities, and the economic environment. As the overall risk of failure rises, APRA's supervisory stance is ramped up in intensity. The SOARS grid has been set so that the larger the regulated institution, the earlier and more proactively APRA responds to a given risk of failure.
Individual SAPs set out the proposed supervisory activities to address the key risks and issues identified in the PAIRS assessment of the entity or the group. The SAP will be commensurate with the nature and degree of risks; for example, an entity with plans to enter into new markets outside of its traditional operations may be scheduled for an on-site risk team visit. SAPs promote a forward-looking approach, and must be updated at least annually and more frequently if necessary, for example where a risk warrants a change to PAIRS. Additionally, the depth of supervisor's off-site analysis such as in the quarterly risk review is determined by the risk profile of the entity.
The APRA structure also supports an appropriate supervisory response to potentially systemically important entities. First, APRA has a separate supervisory area – Diversified Institutions Division – for large and complex financial groups. This division has a concentration of supervisor skills and knowledge that strengthens the prudential supervision of larger and more complex financial groups. Second, the size of the APRA supervision team on any one group is commensurate to the nature, scale and complexity of the group. Larger institutions will typically have a higher number of dedicated supervisors, in contrast to smaller and less complex entities where a single supervisor may look after multiple entities. Together, these structural factors ensure that APRA takes an appropriate supervisory response to potentially systemically important institutions.
As risks in the system increase, the impact of these rising risks will flow through to the risk rating of individual entities and the level of capital they hold. For example, tougher economic conditions will be reflected in a higher probability of default for individual loans and in forecast levels of loss given default.
6.2.4 Recalibration of prudential settings
APRA adjusts its prudential settings in response to assessed changes in systemic risk. APRA is generally recognised as taking a conservative approach to risk-weightings and capital definitions. Some of the decisions APRA has taken which result in this more conservative treatment have been in response to the build-up of risk in particular sectors. For example, in response to its stress testing of the housing loan portfolios of ADIs in 2003, APRA made some significant adjustments to the risk-weighting of housing loans as well as adjustments to the capital regime for lenders mortgage insurers (LMIs).
APRA believes that this type of response to systemic or industry-wide concerns is more likely to be effective than a narrow focus on a particular aspect of lending standards such as the loan-to-valuation ratio. APRA's prudential standards already include requirements to avoid excessive reliance on collateral when making decisions to extend credit; supervision around this standard can be intensified across the whole range of lending, rather than impinging only on loans for which a cap on the ratio would be binding.
Box C: Application of the Counter-cyclical Capital Buffer
The counter-cyclical capital buffer is an element of the Basel III capital standard that is explicitly intended to operate as a macroprudential tool, to deal with the time-series component of systemic risk, as expressed in credit boom–bust cycles. The buffer is designed to ensure that banks have additional capital in advance of a bust, to absorb any additional losses that might result in the downturn. The buffer does not purport to lean against credit booms prior to the bust, although the BCBS documents do cite this as a possible side benefit. Part of the reason leaning against the boom is not considered the primary objective is that the buffer only applies to the banking system and would not prevent non-ADI lenders from funding a credit boom. In addition, there is as yet no direct evidence that additional capital would help head off a boom–bust cycle.
In Australia, APRA has committed to adopting the counter-cyclical capital buffer as part of its implementation of the Basel III reforms. In doing so, APRA will draw on the analysis done by the RBA, as well as its own prudential observations and analysis.
In the BCBS documents, the ratio of credit to GDP, detrended in a particular way, received favour as a ‘guide’ to decisions to deploy the buffer. The specific measure has been used in earlier work that showed that asset price booms are more likely to end badly when they are accompanied by credit booms.[*] The documents acknowledge that other data series should be monitored when assessing whether to deploy the buffer. However, the presumption seems to be that the information set used will be relatively small, pre-specified and entirely comprised of macro-level data.
The Australian authorities have some reservations about the specific measure presented as a buffer guide and the detrending technique that produces it. While credit booms typically precede periods of financial instability, the ratio of credit to GDP can change trend for other reasons, including that the onset of financial deregulation or rapid economic development can spark financial deepening at a faster pace than previously. In these situations, the suggested detrending method will incorrectly detect a credit boom that might not necessarily be problematic. It is also not clear that the detrending procedure or the specific parameterisation presented in the BCBS documents is the appropriate technique for detecting a genuine credit boom that might require a policy response.
The procedure is designed to detect cycles of a particular frequency, which must be pre-specified and therefore might not be appropriate for the actual data. In addition, it has been shown in the literature to sometimes detect cycles that are not there.[†] The results of the procedure are also very sensitive to small changes in its parameterisation.
For these and other technical reasons, the Australian authorities do not propose to restrict their analysis to a single indicator or small number of pre-specified indicators. The full array of available data and analysis will be marshalled to support the detection of a harmful credit boom, and the full suite of prudential tools – including but not limited to this buffer – remain available for use in response.
6.3 Conduct of Supervision
APRA's supervisory activities are aimed at ensuring that, under all reasonable circumstances, regulated entities will continue to meet financial promises to beneficiaries (see also Box D). The activities undertaken are commensurate with a regulated entity's risk profile and desired supervisory outcomes. This includes increasing supervisory intensity in line with SOARS stances. During times of economic stress the level of risk in supervised entities generally increases and this would be reflected in a deterioration in PAIRS ratings and, consequently, an increase in supervisory intensity. Where issues or concerns are identified, prompt corrective actions are pursued.
In some instances, APRA may have serious prudential concerns that must be rectified through specific intervention and remedial enforcement action. Distress and enforcement situations represent a serious threat to the financial security of beneficiaries and will result in two possible outcomes: either a regulated entity will take sufficient action and return to a phase of heightened ongoing supervision, or it will be actively managed by APRA to exit the industry.
Box D: Risk Management Framework
APRA's supervisory approach makes it clear that the board is primarily responsible for the risk management framework established within its regulated entities. The broad framework should embrace ‘the totality of systems, structures, processes and people’ within the entity in the context of risk management. APRA has suggested that within this broad framework, entities should also articulate a risk management strategy, which must, among other things, set out the entity's risk appetite. This focus on the risk appetite of entities is a relatively new focus for APRA but it is considered important because without this, risk management throughout the business will be carried out with unclear boundaries and expectations on an uncertain foundation. To date the focus has been on developing a checklist for supervisors – what they should look for in an entity's approach to risk appetite.
Four broad areas have been identified for assessment – governance, risk management, implementation and communication. In terms of governance, APRA is seeking evidence that: the board has been engaged in the development of the risk appetite and has demonstrated ownership by its approval of relevant documents; that the risk appetite considers the interests and expectations of relevant stakeholders – depositors and policyholders as well as shareholders; that the risk appetite is periodically reviewed in the context of the prevailing economic conditions and the competitive environment; and that there is a feedback loop from management.
From the perspective of risk management, it is expected that the risk appetite will consider all material types of risks to the entity and that it is core to the risk management framework and sets clear boundaries and expectations. The entity's strategic objectives and business plans must be consistent with its risk appetite as must the entity's capital management plan. The board must ensure that risks necessary to produce required returns on capital are kept within the risk appetite.
This increasing focus on risk appetite is expected to have a moderating impact on entity behaviour as systemic risk increases, because entities will be expected to adjust their activities to fit within the risk tolerances which have been adjusted to increasing risk.
6.4 Communication Strategy
Effective communication by APRA and the RBA is essential both for the purposes of ensuring accountability and to influence financial risk-taking behaviour. The following sections detail the communication methods typically employed by the two agencies, and how they interact with other policy actions.
6.4.1 Approach to communication of risks
Both APRA and the RBA have considerable operational independence in carrying out their respective responsibilities. It is therefore important that they remain accountable for those actions. In addition to the formal accountability processes, such as appearances before Parliament, the agencies can use public communication to explain their actions. As part of their cooperative relationship, the RBA will on occasion use its own communication to support regulatory actions by APRA and put them in the context of the overall financial stability policy framework. In doing so, the RBA seeks to enhance the efficacy of those actions.
In normal times when the system is stable, communication – particularly forward-looking statements – can be a policy tool promoting financial stability. Explicit warnings about potential adverse future outcomes, and about the behaviours that would contribute to them, can in principle help avert those outcomes. The goal of such communication is to mould risk perceptions and thus risk-taking behaviour. It is therefore important to draw attention to those concerns early, before the behaviours that could lead to future distress have become too entrenched. For this reason, much of this communication is likely to focus on undesirable risks and behaviours. The two agencies do not in general publish forecasts or targets for indicators that might be related to financial stability, but may make qualitative statements such as warning against excessive expectations of balance sheet expansion or asset price increases.
In periods of financial fragility or crisis, timely, coordinated and consistent communication by both agencies can be essential in maintaining confidence in the financial system. Communication in these circumstances is likely to be focused on filling information gaps, militating against unfounded rumours and misinformation.
6.4.2 Financial Stability Review (FSR)
As noted above, the FSR provides the Bank's assessment of the current condition of the financial system and potential risks to financial stability. It contains a number of boxes on topics of special interest, along with occasional articles. The FSR is issued in March and September, and is reviewed by the other Council agencies prior to release. Its intended audience includes analysts and decision-makers in financial institutions and the investment community.
The FSR provides a vehicle for publishing an array of data on the financial sector that are of interest periodically, but that are not part of either agency's regular statistical reporting. It seeks to place these and other data in context, assess whether they point to potential future vulnerabilities, and describe possible means of mitigating these risks.
6.4.3 Joint media releases
On occasion, the CFR or the two agencies will communicate jointly via coordinated media releases or CFR publications. Where simultaneous release of cross-agency communication is essential, the CFR agencies have agreed that the RBA will be responsible for the publication of a joint media release, as well as managing embargo and lock-up arrangements for journalists ahead of such releases.
6.4.4 Speeches
Speeches are commonly used by both agencies to convey views on specific issues. They should be seen as complementary to written publications, in that their audiences can differ. By their nature, speeches lend themselves more to discussion of risks and contingent outcomes than to exposition of previously unreleased data. It can be anticipated that more speeches on financial stability topics will be scheduled during periods of heightened concern about growing risks, than in more normal times.
6.4.5 Supervisory communications
APRA has a range of means for communicating with industry. It can deliver important messages to entities about areas of supervisory focus or particular concerns through articles in its regular publication, Insight. APRA also provides industry with a comprehensive outline of developments each year in its annual report. Speeches provide APRA senior staff with the opportunity to highlight particular themes. APRA also writes to entities if it has specific issues which it needs to raise (e.g. in providing feedback to the industry on its review of remuneration practices following the introduction of relevant prudential requirements, outlining expectations with respect to reports prepared by appointed auditors and alerting banks to relevant international regulatory developments). If it is seeking a more focused response it may also write to the boards of entities, often seeking that they examine some particular area of concern or to highlight a specific risk issue (e.g. reminding banks' boards of the need to maintain underwriting standards in the face of low credit growth).
Footnotes Box C
See Borio C and P Lowe (2002), ‘Asset Prices, Financial and Monetary Stability: Exploring the Nexus’, BIS Working Papers No 114. [*]
See, for example, Cogley T and JM Nason (1995), ‘Effects of the Hodrick-Prescott Filter on Trend and Difference Stationary Time Series: Implications for Business Cycle Research’, Journal of Economic Dynamics and Control, 19(1–2), pp 253–278. [†]