Financial Stability Review – March 2009
Developments in the Financial System Architecture
The current turmoil in the global financial system has put many aspects of the existing architecture and regulation of financial systems around the world under the spotlight. Among the issues currently under review are: the role of credit rating agencies; the internal incentives within financial institutions to take and manage risk; the adequacy of current capital and liquidity requirements; how to give a greater macro-prudential focus to regulation, and other policies to address the excess procyclicality of the financial system; and the role that central counterparties and settlement arrangements can play in addressing counterparty risk and in managing the failure of a financial institution. A looming issue is the effect on financial systems of having a significant number of institutions operating under effective government ownership or control. Substantial policy work is taking place at the international level on many of these topics, generally under the guidance of the G-20, the Financial Stability Forum and the International Monetary Fund. The main focus nonetheless remains on how to address the more immediate problem of restoring confidence in many financial systems.
Regulatory arrangements in Australia appear to have worked effectively over recent years, with the Australian financial system widely regarded as being well regulated. Unlike the situation in many other countries, the Australian Government has not had to take the extraordinary steps of injecting capital into banks, buying troubled assets or offering large-scale asset insurance schemes to banks. Even so, as discussed in the chapter on The Australian Financial System, the highly unusual conditions that existed in the wake of the Lehman’s failure saw the Australian Government introduce guarantee arrangements for deposits and wholesale funding in October last year.
Since the current turmoil began, the Council of Financial Regulators has provided a vehicle for co-ordination between the various regulatory agencies – APRA, ASIC, the Reserve Bank and Treasury. In particular, the Council has provided advice to the Government on the specific design of the guarantee arrangements and has kept the arrangements under review. The Council has also held discussions with the regulatory authorities in New Zealand regarding Trans-Tasman developments.
Longer-term Regulatory Issues
Credit Rating Agencies
As the current crisis has unfolded there have been widespread concerns over the role played by the credit rating agencies (CRAs) and, in particular, the accuracy of their ratings of structured financial products, including US sub-prime RMBS and CDOs. Reflecting these concerns, there have been several international reviews of the role of CRAs, with one key outcome being a revision to the International Organisation of Securities Commissions’ (IOSCO) Code of Conduct Fundamentals for Credit Rating Agencies. The new Code strengthens the oversight of CRAs in the areas of: quality and integrity of the ratings process; independence and avoidance of conflicts of interest; responsibilities to the investing public, including the use of differentiated ratings for structured credit products; and greater transparency. Although no agency has committed to developing an identifier for structured product ratings, all three major agencies have revised their own codes of conduct to partially respond at least to the IOSCO revisions and have agreed not to make proposals or recommendations on the design of structured finance products which they rate.
The framework for the regulation of CRAs in Australia – a market that is almost entirely comprised of the three major global agencies – has been subject to a joint review by ASIC and the Australian Treasury. As a result, CRAs will now be required to have an Australian Financial Services Licence as well as issue an annual report detailing compliance with the revised international code of conduct. The review confirmed that research houses in Australia are required to hold a financial services licence; they will also be required to issue an annual report providing similar information as that for CRAs.
Incentives and Remuneration
Another issue that has attracted considerable attention is the incentive structures within financial institutions and the role that remuneration arrangements play in shaping those incentives. This reflects the concern that the risk metrics used in the remuneration process in some financial institutions have been too focused on short-term profits, and have thus contributed to excessive risk-taking. Work in this area is directed towards the development of principles governing the design of remuneration arrangements, with institutions’ compliance with these principles to be assessed as part of the supervisory review process. In broad terms, these principles aim to promote effective governance of compensation arrangements by boards, who should be responsible for ensuring that the level, timing and mix of compensation is appropriately adjusted for all risks taken in the business unit or institution, and that staff bonuses are reduced or cancelled if the business’ performance is poor. APRA is playing an important role in the international work in this area and anticipates that it will release a discussion paper on Australian application in coming months, with implementation to occur during the second half of 2009.
For corporations in general, the Government has requested the Productivity Commission to examine Australia’s remuneration framework for company directors and executives and has also announced that it would amend the Corporations Act to significantly lower the threshold at which termination payments (also known as golden handshakes) must be approved by shareholders.
Capital and Liquidity Requirements
The recent turmoil has also led to a reappraisal of existing bank capital regulation and the appropriateness of the level and quality of the capital buffers that banks currently hold. Accordingly, the Basel Committee on Banking Supervision (BCBS) has announced a number of changes to the Basel II framework. Among the changes are an increase in risk weights for re-securitised assets such as CDOs of RMBS, and the liquidity facilities extended to entities holding these assets. For example, risk weights on senior exposures to CDOs of RMBS will roughly triple across all ratings levels. More generally, regulatory minimum capital ratios will be reviewed, although this change will be introduced over time in order to avoid raising capital requirements in a period of market stress. Greater attention will also be paid to the quality of banks’ capital, with increased emphasis being given to ordinary equity and other forms of shareholders’ funds, rather than hybrid securities whose genuine capacity to absorb losses has come into doubt. This work is to be progressed by an expanded BCBS, with seven countries including Australia being added to the existing membership. Both APRA and the RBA will be represented on the expanded committee.
On top of the existing risk-weighted capital requirements, an unweighted leverage ratio is to be introduced. This change reflects concerns that some large banks had been able to report high ratios of capital to risk-weighted assets, while having very low ratios of capital to total assets, leaving them vulnerable to misjudgements about the riskiness, and thus the appropriate risk weighting, of these assets.
Another significant area of focus is the supervision of liquidity risk, with it widely recognised that supervisors and banks did not pay sufficient attention to this risk over the past decade. In particular, insufficient attention was paid to the possibility that market liquidity could dry up for considerable periods, and to the risk that many contingent funding lines could be called upon at around the same time. As detailed in the September 2008 Review, APRA is currently examining the prudential framework for liquidity risk management in Australia and expects to issue a paper for consultation in the middle of 2009.
Procyclicality of the Financial System
While the primary focus of policymakers remains on solving the immediate problems, attention is also being paid to the longer-term issue of dealing with the tendency for investors to underestimate risk in the good times and build up excessive leverage. One idea is that the valuation approaches for some assets need to be reconsidered, particularly for those which trade in very illiquid markets, for which ‘fair’ values can move considerably even when there is no change in the expected underlying cash flows. In October 2008, the International Accounting Standards Board indicated that where transaction prices are not considered to represent fair value – particularly in illiquid markets – it may be more appropriate to use other valuation approaches, such as models and expected cash flows. In response to this guidance, a number of European banks have amended their approach to valuing some assets to be more in line with that used historically for loans on banks’ balance sheets. Several Australian-owned ADIs, as well as a number of the subsidiaries and branches of foreign ADIs operating in Australia, have also amended their approach to valuing a smaller number of assets.
Another issue under discussion is the extent to which financial institutions should build up their capital buffers in the good times, either as a result of regulation or by them taking a more active approach in dealing with the economic cycle. In particular, the BCBS recently announced that it would be introducing standards to promote the build-up of these buffers, although the details have not yet been finalised. A related proposal draws on the approach taken in Spain involving ‘dynamic provisioning’ rules. Under these rules, banks are forced to make provisions for credit impairment in the good times even if loan portfolios are performing well. This system of provisioning has been credited as one of the reasons why the major Spanish banks have, to date, been less affected by the credit turmoil than have the banks of many other countries. This approach, however, raises concerns amongst the accounting profession, who view it as potentially giving a misleading picture of an institution’s profits and balance sheet at a point in time.
Central Counterparties in Over‑the‑counter Derivatives Markets
The international regulatory community has been placing increasing emphasis on reducing operational and counterparty risks in over-the-counter (OTC) derivatives markets, given their rapid expansion in recent years. One specific policy proposal for improving the infrastructure in these markets is for the establishment of central counterparties for OTC credit derivatives markets, further details of which are outlined in Box B: Central Clearing of Over-the-counter Credit Derivatives. As well as helping to manage counterparty risk, central counterparties can reduce the complexity of the interlinkages between market participants, thereby reducing the dislocation that could occur if a participant were to fail.
The Reserve Bank is working with APRA and ASIC to assess international initiatives in this area and to consider how best to promote safe, efficient and robust practices in the Australian OTC derivatives market. A survey of OTC derivatives market participants is being undertaken to help assess: the scale of activity in the various OTC derivatives product segments; the split between onshore and offshore activities; the risks in existing risk-management and post-trade practices; and the use of automated facilities at each stage in the post-trade life-cycle.
One driver of the global policy interest in central counterparties is that they are increasingly offering their services across national borders. Reflecting this general trend, the Reserve Bank has recently established arrangements that allow a foreign central counterparty to offer services in Australia in a way that ensures that the central counterparty meets high standards, while avoiding unnecessary regulatory duplication. In particular, if the central counterparty is from a country with a ‘sufficiently equivalent’ regime to that in Australia, it will be exempt from formal compliance with the Reserve Bank’s Financial Stability Standard for Central Counterparties provided that the home country regulator provides an annual statement that the foreign central counterparty has complied with its regulatory requirements. Such central counterparties will, however, retain some obligations to the Reserve Bank including to provide information on a regular basis.
In Australia there have been a number of other regulatory and market developments since the previous Review. As discussed in the chapter on The Australian Financial System, guarantee arrangements were announced for deposits and wholesale funding in October 2008. The Australian Government has also set up a special purpose funding vehicle to provide finance for motor vehicle dealers. On the regulatory front, progress has been made in the establishment of uniform national regulation of consumer credit and new arrangements have been established for short-selling and securities lending.
The Government has established a special purpose vehicle (SPV) to help provide wholesale financing to those motor vehicle dealers that were financed by GE Money Motor Solutions and GMAC, both of which announced their intention to exit the Australian market as a result of the global financial environment. The SPV is being established as a financing trust, with the joint support of the Government and the four largest Australian banks, to provide liquidity to car dealer financiers through the securitisation of eligible loans provided to car dealers. The expectation is that the SPV could be required for up to a year, with its funding now expected to total around $850 million from an initial $2 billion estimate. The lower funding requirement in part reflects the willingness of the remaining finance providers to grow their loan books and to finance a large number of former GE and GMAC dealers. The Government’s support to the SPV is in the form of a guarantee on the portion of the securities issued as subordinated notes.
In addition to this funding vehicle, the Government has established arrangements under which the Australian Office of Financial Management (AOFM) purchases RMBS. In particular, in late September 2008 the Government announced that the AOFM (the agency responsible for the management of Australian Government debt and certain financial assets) could purchase outright up to $8 billion of newly issued RMBS. The securities to be purchased must be rated AAA, or equivalent, by one of the major credit rating agencies and any one issue is subject to a minimum investment by the AOFM of $100 million and a maximum of $500 million. Conditions also apply to the mortgage pool, including: the value of low-doc loans cannot exceed 10 per cent of the initial principal value of the pool; and the individual loans must be of a maximum size of $750,000 and have a maximum loan‑to‑valuation ratio of 95 per cent. The Government also stipulated that at least half of the investments in RMBS be allocated to issuers that are not ADIs.
The investment by the AOFM has been spread out over several rounds. The first round took place in late 2008 and involved the AOFM investing nearly $2 billion across four issues. A second round, involving an investment by the AOFM of $1.25 billion across three issues, has recently been completed. In both cases, the AOFM’s purchases accounted for the bulk of the issue.
National Regulation of Consumer Credit
In July 2008, the Council of Australian Governments agreed to transfer responsibility for the regulation of all consumer credit to the Commonwealth Government and, in doing so, simplify and standardise the regulation of financial services and credit across Australia. This standardisation is to occur via the Commonwealth enacting the existing State legislation, the Uniform Consumer Credit Code (UCCC), into Commonwealth law. As part of this process, the UCCC will also be extended to cover the provision of consumer mortgages over residential investment properties. In addition, a national licensing regime will be introduced that will require all consumer credit providers, as well as credit-related brokering services and advisers, to obtain a licence from ASIC. Licensees will be required to observe a number of general conduct requirements, including responsible lending practices. ASIC will be the sole regulator of the new framework and ASIC’s enforcement powers are to be enhanced. It is anticipated that the relevant Commonwealth, State and Territory legislation will be amended by the end of June 2009.
The issue of margin lending will be specifically addressed under the new consumer credit regime. The Corporations Act will be extended to cover margin lending products, with providers required to issue new product disclosure statements. The format of these statements will be similar to those introduced for First Home Saver Accounts, and the Financial Services Working Group will oversee this exercise as part of its responsibility for formulating a national margin lending regulatory regime. The disclosures will include information about the risks of margin lending, as well as the fees and charges and any commission paid by margin loan providers to advisers who sell such products. As with all other credit providers and brokers, margin lending providers will have to be licensed by ASIC and will need to be trained to provide that advice and observe general conduct requirements.
Short Selling and Securities Lending
In September 2008, after regulators in a number of countries imposed bans on short selling of equities to help preserve financial stability, ASIC banned both naked and covered short selling of stocks listed on the ASX. (A ‘covered’ short sale is a sale of a product that the seller, at the time of sale, does not own, but does have an existing right to obtain, typically via a binding securities lending agreement, while a ‘naked’ sale is one where the seller has no such right at the time of sale and must acquire it prior to settlement.) The ban on covered short selling of non-financial stocks was lifted on 19 November 2008 and the ban on covered short selling of financial stocks remains in place, while the ban on naked short selling of all stocks is permanent (subject to certain limited exemptions). In making its recent decision to extend the ban on covered short selling of financial stocks until end May, ASIC noted that it had weighed the continued volatility in global financial markets and potential damage from aggressive or predatory short selling against the possible loss of some market efficiency or price discovery.
In December 2008, the Government amended the Corporations Act to give legislative force to these changes and to simplify and clarify the regulatory framework governing short selling more generally. The amendment also provides for the establishment of an enhanced disclosure framework for short sale transactions, with the detailed aspects of the disclosure framework currently being developed. In the interim, clients are required to inform their broker when they execute a short sale, with brokers then obliged to inform the market operator of their daily flow of short sales in each security. The data are aggregated by the ASX and published daily in an online report.
As reported in the September 2008 Review, the Reserve Bank has also been working with industry to improve disclosure of securities lending activity in the Australian equities market. The specifics of the new arrangements have now been agreed and they have been given regulatory backing through changes to the relevant measure of the Financial Stability Standard for Central Counterparties.3 Under the new arrangements:
- the ASX will require all transactions related to securities loans to be ‘tagged’ when they are submitted for settlement;
- participants in the settlement facility will be required to report to the ASX on a daily basis outstanding securities borrowed and loaned; and
- the ASX will publish daily data on both the gross flow of securities loan-related transactions and the stock of loans outstanding.
There will be a phased approach to implementation of the new disclosure regime. A pilot phase for the direct reporting of the stock of loans outstanding is due to commence at the end of April 2009, with full implementation by the end of December 2009. During the pilot phase the Reserve Bank will work with the industry to encourage those entities that are significant players in the securities lending market, but are not settlement participants, to participate in the reporting arrangements. The tagging of securities loan-related transactions submitted for settlement is scheduled to be introduced from October 2009.
- See Reserve Bank of Australia (2009), Disclosure of Equities Securities Lending, February.