Financial Stability Review – March 2007 Developments in the Financial System Infrastructure
A stable and efficient financial system requires a robust payments and settlement system and sound financial infrastructure – the regulatory, accounting and legal framework that supports the day-to-day operations of financial intermediaries and markets. While Australia's financial infrastructure is regarded highly – a view confirmed by the recent International Monetary Fund (IMF) review of the Australian financial system under the Financial Sector Assessment Program (FSAP) – the various financial regulators continue to examine areas where current arrangements can be refined. Recent issues considered include crisis management arrangements, trans-Tasman banking, the existence of overlapping or redundant regulations, compensation arrangements for retail clients of financial services licensees, and preparations for dealing with an avian flu outbreak.
Crisis Management Arrangements
As outlined in some detail in the September 2006 Review, the Council of Financial Regulators has endorsed the introduction of a scheme in Australia 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. The issue of crisis management arrangements was also considered in depth by the IMF as part of the recent FSAP review. As part of the Australian Government's consideration of the Council's proposal, the Treasury, together with regulatory agencies, has recently held a further round of discussions with the main industry bodies on specific design features of the scheme and on the potential costs of implementation.
As discussed in the March 2005 Review, the Trans-Tasman Council on Banking Supervision (TTC) was established in 2005 comprising officials from the Australian and New Zealand Treasuries, the Australian Prudential Regulation Authority (APRA), the Reserve Bank of New Zealand (RBNZ) and the Reserve Bank of Australia. The mandate of the TTC is to enhance co-operation on the supervision of trans-Tasman banks, to promote and regularly review crisis management arrangements, and to guide the development of policy advice to both governments.
One of the first tasks of the TTC was to report to Ministers on legislative changes required to ensure that the respective bank regulators (APRA and the RBNZ) can support each other in the performance of their current regulatory responsibilities at least regulatory cost. The TTC submitted its proposals to Ministers in August 2005 and based on their recommendations, the Australian Treasurer and the New Zealand Finance Minister proposed changes to the relevant legislation in both countries. These changes came into force in Australia on 6 December 2006 and in New Zealand on 15 December 2006.
As a result of these changes:
- each bank regulator is required to support the statutory responsibilities of the other regulator relating to prudential regulation and financial system stability, and to the extent reasonably practicable, avoid any action that is likely to have a detrimental effect on financial system stability in the other country;
- where reasonably practicable, regulators must consult each other before exercising a power that is likely to have a detrimental effect on financial system stability in the other country; and
- an administrator or statutory manager appointed to a bank must advise the regulator if a proposed action by them is likely to have a detrimental effect on financial system stability in the other country.
Streamlining Prudential Regulation
Over the past year, APRA and the Australian Securities and Investments Commission (ASIC) have been working together to identify ways of reducing regulatory burden. As part of this exercise they have jointly examined legislative sources of regulatory overlap, inconsistency or duplication and have contributed to a discussion paper on legislative reform, prepared by the Australian Treasury, entitled Streamlining Prudential Regulation: Response to ‘Rethinking Regulation’. The paper recommends:
- the various prudential acts administered by APRA – the Banking Act 1959, Insurance Act 1973, Life Insurance Act 1995, Superannuation Industry (Supervision) Act 1993 and related legislation – be refined and updated to provide for greater consistency across legislation;
- harmonising the reporting of breaches under the prudential acts and the Corporations Act 2001, and minimising multiple breach reporting to APRA and ASIC; and
- that a more consistent and transparent approach be adopted for decision-making, helping to ensure proper accountability. Merits review, for example, would be available for administrative decisions made by APRA, such as licensing decisions and decisions aimed at ensuring that an entity or individual meets minimum standards. It would not be available, however, for decisions relating to an entity where APRA reasonably believed that its failure to act immediately would materially prejudice the beneficiaries of the institution or the stability of the financial system.
APRA and ASIC have also identified some areas where the administrative burden on entities regulated by the two agencies might be reduced. There is, for example, some duplication of data reporting and audit requirements for Australian financial services licensees that are also APRA regulated. APRA and ASIC will also produce an industry guide to explain their licensing objectives, requirements and processes for jointly regulated superannuation trustees. While there is little overlap between the agencies' licensing obligations, the guide will point to existing provisions and practices that reduce regulatory burden.
Compensation Arrangements for Financial Services Licensees
The Australian Treasury is currently reviewing compensation arrangements for retail clients who make successful claims against Australian financial services licensees under Chapter 7 of the Corporations Act 2001. The main types of breach giving rise to compensation claims relate to poor services (for example, inappropriate advice), disclosure and misleading or deceptive conduct. The review is designed to address concerns that some licensees may be unable to meet all claims against them and that the complexity of financial products increases the probability that less sophisticated consumers may not understand the nature of the product or service being offered.
The draft regulations proposed by the Treasury are designed to:
- ensure adequate professional indemnity insurance by licensees (in the absence of ASIC approving alternative compensation arrangements);
- require financial services licensees to note their indemnity insurance in their Financial Services Guide;
- prescribe factors that ASIC must take into account before approving alternative arrangements; and
- exempt certain licensees (prudentially supervised institutions and certain related entities) from the requirements.
Submissions on the draft regulations closed at the end of November 2006 and are now publicly available on the Treasury's website.
Pandemic Contingency Planning
Over the past few years, there has been increasing concern about the possibility of an influenza pandemic. As part of its preparation, the Australian Government has released the National Action Plan for Human Influenza Pandemic outlining how Commonwealth, state, territory and local governments would work together in the event of a pandemic. Supporting this are detailed plans by individual agencies covering how they would respond to an influenza pandemic.
Within the financial sector, APRA released a Prudential Practice Guide (‘PPG 233 – Pandemic Planning and Risk Management’) and an Information Paper in October 2006 to assist financial institutions in their preparations for a potential pandemic. The Guide emphasises the importance of each institution developing a plan to help them identify their critical business functions, such as the clearing and settlement of financial obligations, and how these can be maintained in the event of high levels of staff absenteeism over an extended period. APRA is also conducting a stress test of insurance companies to assess the potential financial impacts of a pandemic on life and general insurance businesses.
APRA, ASIC and the Reserve Bank are similarly developing their own capabilities to ensure that they will be able to co-ordinate closely in any financial crisis involving a pandemic. The Reserve Bank's responsibilities in such a crisis would include ensuring the continued operation of the high-value payments system, maintaining an adequate nation-wide supply of cash and helping to ensure the provision of banking services to the Australian Government.
APRA Draft Prudential Standard on Securitisation
Authorised deposit-taking institutions (ADIs) make extensive use of securitisation markets, either as a means of funding their lending activities or reducing the amount of risk-weighted assets against which they need to hold capital. APRA's existing requirements for securitisation are designed to ensure that a reduction in capital requirements will only occur where an ADI can demonstrate that it has no responsibility for how the assets that have been securitised subsequently perform. The new Basel II capital framework includes internationally agreed guidance on the capital treatment of securitisation. In November 2006, APRA released a draft revised prudential standard (‘APS 120 – Securitisation’) to reflect this guidance and to take account of market developments since it was originally issued.
Because some of the more complex securitisation transactions are structured with the assistance of credit derivative instruments, at the same time that it released the draft standard on securitisation, APRA also outlined some proposals for the treatment of credit derivatives under the Basel II framework. These provide guidance on the treatment for capital adequacy purposes of single-name credit default and total-rate-of-return swaps, credit-linked notes and first- and second-to-default basket products.
Financial Soundness Indicators for Australia
As foreshadowed in the March 2005 Review, the IMF has conducted an exercise to compile an internationally harmonised set of ‘financial soundness indicators’ (FSIs), with around 60 countries, including Australia, participating.
The 39 indicators are divided into two sets: a ‘core’ set of 12 that relate to the health and performance of the deposit-taking sector; and an ‘encouraged’ set of 27 covering deposit-taking institutions, other financial corporations, the household and corporate sectors, and financial and real estate markets. As part of the exercise, each participating country was asked to compile these indicators, on a best-efforts basis, for calendar 2005 (for flow variables), or as at end December 2005 (for stock variables). The data were then published on the IMF's website in January 2007, along with detailed information on the compilation methods used by the participating countries, with Australia ranking very highly in terms of both the coverage and quality of the data supplied. The various FSIs for Australia are reproduced in Tables 9 and 10.
Later this year, the Executive Board of the IMF will decide on how best to follow-up on the exercise, including the possibility of establishing a framework for regular reporting of these FSIs.