Financial Stability Review – September 2006
Developments in the Financial System Infrastructure
3.1 Crisis Management Arrangements
As discussed in the previous Review, the Council of Financial Regulators has recently been reviewing crisis management arrangements in the Australian financial system. As part of this review, the Council concluded that there is a strong case for the introduction of a scheme to provide depositors in a failed authorised deposit-taking institution (ADI) and policyholders in a failed insurer with timely access to at least some of their funds. While current legislation provides considerable protection to depositors and policyholders, it does not provide for timely payments to be made if an institution fails and closes its doors. Indeed, given the lengthy nature of a wind-up process, it could take many months before funds in a failed institution are made available for distribution. In the Council’s view, this delay is likely to place considerable pressure on the Government to step in and provide protection beyond that set out in the legislation, particularly given the expectation by the public that the Government would behave in this way. While such actions might be in the interests of the depositors or policyholders of the failed institution, they have the potential to be costly to taxpayers and to weaken market discipline.
The Council’s review was sent to the Treasurer in August 2005. It recommended that the Government consider the introduction of a limited facility to be operated by the Australian Prudential Regulation Authority (APRA) that would provide funds on a timely basis, with the facility being post-funded rather than pre-funded. Depositor preference would remain in place, with the scheme having the limited objective of providing access to deposits in a timely fashion and providing increased protection to policyholders.
The Treasurer subsequently asked the Council to consult with the finance and insurance industries regarding its proposal. This consultation has now been completed. As well as consulting on the original proposal, the Council sought views on a number of proposed changes to the scheme that addressed concerns raised by industry.
The industry associations representing ADIs expressed opposition to the introduction of any scheme along the lines proposed by the Council. While a number of associations recognised the limitations of the current system, they typically argued that the Council’s proposed scheme would be unlikely to pass a cost-benefit test, particularly as it could make people less careful about where they placed their deposits (the ‘moral hazard’ argument). Some industry associations also argued that it was appropriate that the Government bear some of the costs of compensating depositors in a failed institution, given that, in their view, the failure would necessarily imply that APRA had not done its job properly. Concerns were also expressed that the scheme would advantage one type of ADI over another.
The Council has not been persuaded by these arguments. In particular, it does not accept the moral hazard argument, especially given the evidence from a recent Reserve Bank survey which suggests that most Australians already believe that the Government would step in to ensure either full or partial repayment of their deposits. In the Council’s view, it is the current system, rather than the one being proposed, that is more likely to be subject to moral hazard.
The Council also rejected unequivocally the idea that the failure of an ADI necessarily means that APRA has not done its job properly. The responsibility for the success or otherwise of a financial institution ultimately rests with the management of that institution.
One other concern expressed by industry during consultation was that levies on surviving institutions, in the event that an institution failed, could adversely affect the profitability and health of the surviving institutions. In response, the Council sought views on giving the scheme first claim over the assets of the failed ADI. This change, which was supported by the industry, would significantly reduce the chance that a levy would ever need to be imposed on surviving institutions. In the unlikely event that a levy had to be imposed, the Council is of the view that the scheme should have the flexibility to take into account a range of factors – including the implications for risk taking – in setting any levies.
The Council also sought views on reducing the cap on payments under the scheme from the $50,000 originally proposed to $20,000. Most industry associations supported the lower cap, particularly given that the primary objective of the scheme is to provide liquidity. This support, however, was not universal, with some associations concerned that a lower cap could adversely affect the competitive position of some institutions. On balance though, the Council favours this lower cap. It also favours, on the grounds of administrative simplicity, paying depositors the full amount up to the cap, rather than imposing a ‘hair cut’ of 10 per cent as was originally proposed.
The Council also considered an alternative scheme for providing liquidity to depositors suggested by the Australian Bankers’ Association. Under this alternative scheme, a hair cut would be applied to all creditors of a failed institution, with the institution then being able to reopen on a limited basis to provide liquidity. The Council, however, assessed that such a scheme would face considerable practical difficulties, including likely requiring some form of government guarantee of the failed institution’s liabilities once it reopened.
With respect to the protection of policyholders in a failed insurer, the insurance industry does not support the Council’s proposal, although it recognises the case for the introduction of some sort of compensation arrangements. Its opposition to the proposal relates to the broader regulatory environment for insurance, and concerns on a range of regulatory matters that are outside the ambit of the Council’s crisis management work. Notwithstanding these concerns, discussions with insurance industry representatives, such as the Insurance Council of Australia, have been useful in considering the possible design of a scheme for policyholders.
Following the consultation process, the Council remains strongly of the view that a scheme along the general lines of the one discussed above would represent a significant enhancement of Australia’s crisis management arrangements. The proposed scheme has been designed to minimise regulatory burden, and in the Council’s view would be likely to strengthen, not weaken, market discipline. The Council has recently provided the Treasurer with a summary of the consultation and suggested a number of changes to the scheme originally proposed.
3.2 The Financial Sector Assessment Program
The International Monetary Fund (IMF) recently concluded an assessment of Australia’s financial system under the auspices of the Financial Sector Assessment Program (FSAP). A core element in this process was an evaluation of Australia’s compliance with a number of internationally accepted standards and codes relating to banking, insurance, securities regulation and systemically important payments systems. The FSAP findings are expected to be released publicly in October following consideration by the IMF’s Executive Board. The assessment is expected to confirm that Australia’s financial system is in a sound condition and that, in almost all areas, regulatory practices are in accordance with the relevant international standards.
Another important part of the FSAP process was a stress-testing exercise of the banking system jointly undertaken by the IMF staff, the Australian authorities and the five largest Australian banks. The exercise consisted of two main parts: a macroeconomic stress test and a series of single-factor stress tests to gauge the sensitivity of bank profits to sharp movements in market interest rates. In addition, at the IMF’s request, APRA undertook a partial update of its 2003 mortgage portfolio stress test.2
The approach used for the macroeconomic stress test was to specify a three-year macroeconomic scenario and then ask banks to assess how they expected to perform. The scenario, developed by the IMF in conjunction with the Reserve Bank, APRA and Treasury, focused on two potential risks previously identified by the IMF in its surveillance work. These were: a large fall in house prices contributing to a sizeable recession; and domestic banks having difficulty rolling over their foreign liabilities, resulting in higher funding costs and a significant depreciation of the exchange rate.
The scenario had the following key features.
- a 30 per cent fall in house prices, a 10 per cent fall in commercial (office) property prices and a 27 per cent fall in equity prices;
- a 37 per cent depreciation of the exchange rate, higher wholesale funding costs for banks and unchanged official interest rates;
- a short recession in which real GDP falls by 1 per cent in the first year, before recovering under the influence of the significantly lower exchange rate. The recession is driven by an unprecedented contraction in household consumption, which falls by 2½ per cent in the first year, is flat in the second year and recovers in the third; and
- an increase in the unemployment rate from around 5 per cent to around 9 per cent.
Movements in some of the key macroeconomic and financial variables are shown in Table 16.
The detailed scenario was provided to the banks in November 2005. An initial round of results was provided to the authorities in March 2006. Discussions were then held between the reporting banks, the Reserve Bank and the IMF, following which the banks submitted a second round of results in June.
In aggregate, the results showed a decline of around 40 per cent in the banks’ profits after around 18 months, although there was considerable variation across banks (Graph 62). By the end of the three-year scenario, profitability had recovered somewhat, but remained around 25 per cent lower than in December 2005. The reduction in profits largely came from higher bad-debt expenses, although banks also reported lower net interest income due to higher funding costs. Those banks with large funds management operations also reported a decline in profits from asset management.
The reported credit losses on housing loan portfolios were smaller than those on business loan portfolios despite a significant fall in house prices and a sharp increase in unemployment (Graph 63). The increase in credit losses primarily occurred not because households could not repay their housing loans, but because households cut back consumption, partly in the effort to service their loans, causing problems for the business sector and thus for banks’ business loan portfolios. In the banks’ modelling, losses on housing loans were ameliorated by the ability of borrowers to draw on buffers built up through previous repayments being higher than those scheduled and also through the use of mortgage insurance. Moreover, the impact of the problems in the business sector on bank performance was not as severe as it might otherwise have been, owing to the current good shape of business balance sheets, and an improvement in the performance of export and import-competing industries due to the depreciation of the exchange rate.
While the exercise was useful, there are a couple of important caveats to the results. The first relates to the difficulties of interpreting aggregate outcomes when there are large differences in results across banks. While these differences may be partly explained by variations in the structure of individual bank balance sheets, they also reflect the very different approaches used by the banks to model their outcomes. Some banks took a very granular approach, modelling the impact of the scenario at individual business levels, while others took a highly aggregated top-down approach.
A second caveat relates to the design of the scenario, which involved a domestic recession but ongoing expansion of the global economy. All previous recessions in Australia have been associated with a global downturn, and incorporating a weaker world economy in the FSAP scenario would have made for a significantly more challenging environment for the banking sector. Another issue with the scenario was that banks were provided with the future path of all the key economic variables, eliminating the uncertainty that would face them in an actual downturn.
Despite these caveats, the exercise provided a vehicle for promoting a useful dialogue between the authorities and the banks regarding the measurement and management of risk. The exercise highlighted the importance of banks looking beyond historical experience in assessing the risk in their mortgage portfolios and the importance of taking into account the changing nature of the correlations between these portfolios and commercial loan portfolios.
The Council of Financial Regulators sees merit in repeating a macroeconomic stress test of the banking system on a regular basis and plans to conduct another exercise in around two years time.
In addition to the macroeconomic stress test, the IMF and the authorities also undertook a number of single-factor stress tests consisting of the following interest rate shocks.
- a 300 basis point proportional steepening of the yield curve out to three years;
- a 200 basis point upward shift in the yield curve; and
- a 100 basis point downward shift in the yield curve.
The impact of large changes in the volatility of interest rates was also considered. Of these various scenarios, it was only the introduction of a sharply steeper yield curve that had a noticeable impact on earnings. The relatively benign results from the single-factor stress tests reflect the fact that Australian banks run relatively small trading books with limited open positions.
Finally, APRA’s partial update of its mortgage portfolio stress test suggested that authorised deposit-taking institutions (ADIs) would remain well capitalised in the event of a substantially weaker housing market.
3.3 The New Basel Capital Framework
Preparations are continuing for the implementation of the new capital adequacy regime for ADIs, known as the Basel II Framework and released by the Basel Committee on Banking Supervision. The new Framework is a major global initiative designed to harness the best practices in risk management for regulatory purposes and to provide for more risk-sensitive capital requirements. The Basel II Framework will be implemented in Australia from 1 January 2008 through APRA’s prudential standards.
The vast majority of Australian banks, building societies and credit unions will use the more straightforward Basel II standardised approach to determine their regulatory capital charges. ADIs wishing to adopt the more sophisticated approaches for calculating their capital needs require approval from APRA to do so. If accredited, these ADIs will be able to use their own quantitative risk estimates as inputs to determine their regulatory capital requirements, rather than apply the supervisory rules of the standardised approaches.
APRA is currently considering the applications of a number of Australian-owned banks that wish to be accredited for the use of the more advanced approaches from January 2008. These banks account for a large share of banking sector assets. The accreditation process is a rigorous one, reflecting the importance that is attached to the role of capital in maintaining the financial strength of an ADI and in retaining public confidence. Accreditation of subsidiaries of foreign-owned banks will be co-ordinated by APRA with the regulator of the parent bank and will follow a different timetable.
Throughout the development of the Basel II Framework, one concern has been that the introduction of a new approach might lead to a reduction in the overall level of capital in the global banking system. Such an outcome would be counter to the original intentions of the reforms and would be unwelcome to individual regulators at the national level. Accordingly, the Basel Committee arranged periodic studies to assess the quantitative impact of the proposed reforms and to determine whether there might be a case to adjust the capital requirements proposed under the new Framework.
The results of the fifth and final Quantitative Impact Study (QIS 5), undertaken by 31 countries including Australia, were released in May. These confirmed that, at the aggregate level, the minimum required capital under Pillar 1 of Basel II would decline relative to that required under the existing Framework, though the outcomes varied significantly across banks and countries. Interpretation of the outcomes and comparisons with previous studies have been complicated by changes in the global economy over time and, partly reflecting this, the Basel Committee has opted, for the time being, against further scaling up of the capital requirements under the more complex approaches. The results for Australian participants in QIS 5 indicated a larger fall in minimum regulatory capital levels under Pillar 1 than in many other countries. This is partly attributable to the higher proportion of housing loans on the books of Australian ADIs compared to their overseas peers and the relatively low credit losses on residential mortgages in Australia in the past. APRA is currently assessing the implications of the results for the implementation of the new Framework in Australia.
3.4 Prudential Approach to International Financial Reporting Standards
In May 2006, APRA released final prudential standards and guidance notes in response to the adoption of the International Financial Reporting Standards (IFRS) by ADIs. Although APRA has substantially aligned the prudential and reporting framework with that for IFRS‑based financial reports, it has de-coupled some aspects. Two notable differences are that the definition of capital instruments eligible for Tier 1 capital will differ from Australian accounting standards, and that the calculation of provisions for credit losses will differ between accounting and regulatory frameworks (for further details see Box A in the Financial Intermediaries chapter of this Review). An additional area where accounting and regulatory requirements have been de-coupled is the treatment of securitised assets. APRA will continue to allow ADIs to hold securitised assets off-balance sheet, even in cases where they might have to be brought back onto the balance sheet for financial accounting purposes, provided that these securitised assets meet APRA’s risk separation rules.
APRA’s new reporting requirements came into effect from 1 July 2006 for banks and other ADIs, while similar changes came into effect from 31 December 2005 for life insurers. Changes for general insurers will be introduced from 1 January 2007, following a consultation period on APRA’s general insurance ‘Stage 2’ reforms regarding capital, assets in Australia and custodial arrangements.
3.5 Managing Risks from Outsourcing
In March 2006, APRA issued draft prudential standards on minimum requirements for managing risks from the outsourcing of material business activities of ADIs, general insurers and life insurers. Outsourcing is defined as ‘an agreement entered into by a regulated institution and another party to perform, on a continuing basis, a business activity which currently is, or could be, undertaken by the regulated institution itself.3 APRA has adopted a principles-based approach, with institutions able to formulate their own policies provided that they satisfy the relevant principles. Importantly, institutions remain ultimately responsible for any outsourced business activities. Although the standards are similar to those currently in effect for ADIs, they establish greater flexibility in the approach to intra-group outsourcing and specifically outline principles related to so-called ‘offshoring’ (the practice of outsourcing business activities to service providers located outside of Australia). For any outsourcing arrangement – domestic or offshore – institutions are required to have arrangements in place that maintain business continuity in the event that service providers cannot fulfil their obligations.
3.6 Managing Conflicts of Interest
Since 1 January 2005, licensed financial services providers have been required under the Corporations Act 2001 to have adequate arrangements in place to manage conflicts of interest (this is in addition to common law obligations to manage conflicts of interest). In April 2006, the Australian Securities and Investments Commission (ASIC) released a discussion paper that used several different case studies to suggest practical ways of managing conflicts of interest for financial advisers, licensees, research report providers, product issuers and fund managers. After consultation, the case studies are likely to be incorporated into ASIC’s policy statement on managing conflicts of interest.
In April 2006, ASIC also released the results of a survey that assessed whether the advice that consumers were receiving after the introduction of legislation enabling choice of superannuation fund complied with the law.4 The survey focused on two potential conflicts of interest – those arising when advisers receive higher remuneration if consumers follow their advice, and those arising when they recommend products from an in-house fund. Based on more than 300 instances of advice given to consumers in the second half of 2005, the survey found that in more than one third of cases where the advisers had a remuneration conflict, the advice received clearly did not, or probably did not, have a reasonable basis. Where there was no remuneration conflict of interest, the comparable figure was only 6 per cent. Similarly, when advisers had a conflict over in-house products, they were three times more likely to recommend an associated product. ASIC has also reported that inappropriate advice was more common when financial advisers receive commission-based remuneration. It has emphasised that remuneration arrangements – whether they are commission-based or fee-for-service – should not influence the quality of advice, including the products recommended.
3.7 Anti-money Laundering and Counter-terrorism Financing
The Government is updating Australia’s anti-money laundering and counter-terrorism financing (AML/CTF) regime to reflect developments in financial crime and revised international standards from the Financial Action Task Force on Money Laundering (FATF). Following a period of consultation, a draft AML/CTF Bill has been released. The Bill confers regulatory responsibility on the Australian Transaction Reports and Analysis Centre (AUSTRAC). The agency currently administers the Financial Transaction Reports Act 1988 (FTR Act), which involves the monitoring of suspicious transactions and record-keeping obligations. In its proposed expanded role, AUSTRAC will have similar obligations in administering the FTR Act, but those obligations will cover more financial institutions. AUSTRAC will also be required to regulate reporting entities’ obligations relating to customer identification and verification, anti-money laundering programs, correspondent banking and record-keeping requirements.
3.8 Review of Debt Agreements
The Government announced in July 2006 that Part IX of the Bankruptcy Act 1966 will be amended to improve the operation of debt agreements. These agreements were introduced in 1996 as an alternative to bankruptcy for debtors who were having difficulties meeting their obligations, but could nevertheless still afford to make some payments to creditors. In 2005/06, there were nearly 5,000 debt agreements, comprising 19 per cent of all administrations under the Bankruptcy Act.
The decision to amend the legislation follows a review of debt agreements by the Insolvency and Trustee Service Australia and the Attorney-General’s Department. The review noted that although it was originally envisaged that debt agreements could be administered by any individual, the vast majority of agreements are administered by providers charging a fee for the service. The administrators of these agreements were typically paid before other creditors. The review also found evidence of instances where inappropriate advice was given by administrators to debtors with unmanageable debt.
Under the new requirements, firms administering five or more debt agreements will need to be licensed. The Bankruptcy Act will also outline the duties of an administrator, including: informing debtors with unmanageable debt of all their available options; fully examining the debtors’ circumstances to determine what they can afford to repay; and ensuring that debt agreements are only used when they are a suitable option. Administrators will be required to take their fees proportionately over the life of a debt agreement, not in priority to creditors, and at least 15 per cent of the administrator’s fee cannot be received until all creditors have been paid in full. Among other changes, a majority of creditors, both in number and value, must approve a debt agreement proposal for it to be accepted, and all creditors are to be repaid in proportion to the amount owed to them.
- See Australian Prudential Regulation Authority (2003), ‘Stress Testing Housing Loan Portfolios’, APRA Insight, 3rd Quarter.
- See APRA (2006), ‘Outsourcing’, Discussion Paper, 23 March.
- See ASIC (2006), ‘Shadow Shopping Survey on Superannuation Advice’, April.