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Financial Stability Review – September 2009

Developments in the Financial System Architecture

As foreshadowed in the March 2009 Review, substantial work is underway in international fora to review financial regulations in light of lessons from the financial crisis. The major international bodies, such as the IMF, G-20, Financial Stability Board (FSB) and Bank for International Settlements (BIS) and its associated committees, have taken a prominent role in these discussions. As part of these efforts, the FSB (formerly the Financial Stability Forum) established additional internal structures to progress its work, and both the FSB and the BIS committees widened their membership substantially. As a result, Australia’s representation on the FSB was expanded, the Reserve Bank and APRA became members of the Basel Committee on Banking Supervision (BCBS) and the Reserve Bank became a member of the BIS Committee on Payment and Settlement Systems.2

The FSB is playing a key role in co-ordinating these initiatives, with the reform proposals grouped around a number of main themes, including: strengthening capital regulations and liquidity requirements; improving the incentives for sound risk management through compensation practices; addressing systemic risk and interconnectedness and expanding oversight of the financial system more generally; and strengthening accounting standards. It is also considering issues around the exit from the extraordinary public sector financial support measures introduced over the past year or so. G-20 leaders are to consider these issues at their meeting on 24–25 September.

Australia’s approach to these initiatives is being considered by members of the Council of Financial Regulators – APRA, ASIC, Australian Treasury and the Reserve Bank. The current focus is turning to how best to implement the reforms as they are developed, in order to accommodate different country experiences and capacities to implement changes. The need to distinguish country circumstances is particularly relevant for Australia, where regulatory arrangements have worked effectively over recent years and the financial system has weathered the past year or so better than many others.

The key items on the international financial regulatory agenda and some implications for Australia are outlined below, followed by details of other regulatory developments in the Australian financial system.

The International Regulatory Agenda and Australia

Strengthening the Capital Framework for Authorised Deposit-taking Institutions (ADIs)

There is general acceptance internationally that the capital framework needs to be strengthened and that the quality of capital in the global financial system needs to improve. This reflects the concern that, globally, the banking system entered the crisis with a Tier 1 capital standard that was insufficiently harmonised and less than fully transparent. The consensus among the major regulators internationally is moving towards defining Tier 1 regulatory equity to be predominantly ordinary shares and retained earnings, or their equivalent for non–listed institutions. This is based on the principle that the highest quality capital must be able to absorb losses on both a going concern basis and in the case of insolvency.

While the precise details of any changes are still to be determined by the BCBS, Australian banks should be well placed to accommodate these moves. As noted in The Australian Financial System chapter, following the capital raisings by the Australian banks this year, the Tier 1 capital ratio for the banking system is at its highest level in over a decade. In addition, APRA’s existing prudential standard requires that the highest form of capital (such as ordinary shares and retained earnings) must account for at least 75 per cent of Tier 1 capital (net of deductions); other components, such as non-cumulative preference shares, are limited to a maximum of 25 per cent. In some other countries this split has been closer to 50:50.

Another area where further developmental work has progressed is the proposal to introduce counter-cyclical capital requirements. The aim is to promote the build–up of capital buffers during good times that can be drawn down during periods of stress, thereby limiting how much the banking sector amplifies the underlying cycle in economic activity. This objective was endorsed by the G-20 at their summit in April, after which the BCBS commenced work on how such an approach would operate in practice, including how to calculate the buffers and the method by which they would be increased and decreased. One of the key issues that needs to be worked through is the criteria for triggering the build–up and release of capital, with options including earnings or credit-based indicators. The BCBS is expected to outline its preferred approach to counter-cyclical capital requirements by the end of the year.

As noted in the March 2009 Review, an unweighted leverage ratio is to be introduced, as a supplement to the Basel II risk-based framework, aimed at putting a ceiling on the build–up of leverage in the banking sector. Further work is to be progressed by the BCBS over the coming months to determine how the ratio should be calculated. To ensure comparability, the details of the ratio will be harmonised internationally, including adjusting fully for differences in accounting standards. While the ratio should be as simple as possible, its design will also need to minimise any perverse incentives that could otherwise arise through its interaction with the risk-based framework.

As members of the BCBS, both APRA and the Reserve Bank will be participating in the development of these initiatives, with APRA having responsibility for determining any changes to Australia’s prudential standards in response. At the international level, it is intended that the concrete proposals should be largely finalised by the end of 2009. While banks will be required to move in a timely manner to raise the quality and level of capital to the new standards, in doing so it is recognised that national supervisors will need to ensure that the stability of the domestic banking system and the broader economy is promoted. It is likely that any new capital rules will be subject to quantitative impact assessments during 2010, with material changes not implemented until 2011.

The above proposals are in addition to the significant changes agreed by the BCBS over the past six months to strengthen banking sector capital through the introduction of new rules that increase the capital requirements for banks’ trading books, resecuritisations and exposures to off-balance sheet vehicles. Trading books were a major source of unexpected losses and the build–up in leverage during the financial crisis. In response, the BCBS has strengthened the rules governing market risk in the Basel II capital framework, by increasing the capital requirements to capture the credit risk of complex trading activities as well as introducing a more robust requirement for modelling risk, which should act to dampen the cyclicality of the minimum regulatory requirement. The BCBS is also introducing higher risk weights for resecuritisation exposures – such as collateralised debt obligations backed by asset-backed securities – to better reflect the risk inherent in these products. Capital requirements for short-term exposures to off-balance sheet asset–backed commercial paper conduits have also been increased significantly. Banks will also be required to conduct more rigorous credit analyses of externally rated securitisation exposures. Disclosure requirements for trading activities, securitisations and off-balance sheet exposures are also to be enhanced. The BCBS requires that the new rules be implemented by the end of 2010. To facilitate this, APRA is preparing a discussion paper setting out proposed changes to Australian prudential standards. Because Australian banks rely less heavily upon financial markets trading than most of their international peers do, the proposed improvements to trading book capital requirements are not expected to increase total Australian bank capital requirements materially.

Strengthening Liquidity Risk Frameworks

One of the lessons from the financial crisis is that some banks that had adequate levels of capital still experienced difficulties due to deficiencies in their liquidity management. In September last year, the BCBS released Principles for Sound Liquidity Risk Management and Supervision. These Principles provided further background for a broad–ranging review of liquidity standards that APRA already had underway, with a view to revising the prudential framework for liquidity risk management in Australia. A new draft liquidity prudential and reporting framework for Australia has recently been released by APRA for consultation. The draft proposals have regard to the experiences of Australian financial institutions during the crisis, as well as to the BCBS Principles and responses by other regulators internationally to those Principles. APRA is proposing that larger ADIs will need to move beyond the current requirement for five days of liquidity under stressed conditions, to 20 business days of self-sufficiency, and up to three months of resilience to generally adverse market conditions. APRA also proposes to require ADIs to provide more data to allow APRA and the Reserve Bank to better monitor liquidity risk.

APRA’s proposed liquidity improvements are designed to be compliant with forthcoming updates to international standards. The BCBS is working to further increase banks’ resilience to liquidity stresses by introducing a minimum global liquidity standard for application in a cross–border setting. This will include a liquidity coverage ratio relevant for a stressed funding scenario and a longer–term structural liquidity ratio.

Compensation and Incentives

Another key element in the effort to make the banking sector more resilient is strengthening the link between compensation practices and sound long–term risk management. With this in mind, the FSB released Principles for Sound Compensation Practices in April 2009, which were subsequently integrated into the supervisory review process of the Basel II framework, for immediate implementation. This process links individual bank capital requirements to compliance with the principles on compensation. APRA has released draft prudential standards and a prudential practice guide on sound compensation practices, which once implemented will strengthen the links between compensation and risk management in the prudentially regulated sector. Following a two–stage consultation process, APRA expects to finalise the standards in November 2009, with effect from 1 April 2010.

Systemic Risk, Interconnectedness and Oversight of the Financial System

In certain countries, the financial crisis was complicated by the size and interconnectedness of major cross–border banking institutions. There is a concern that these firms’ contribution to risk in the financial system increases disproportionately with their size and that, in the event of any failure, they are likely to impose higher costs on the system than indicated purely by their size. The international response has been to examine whether such ‘systemically important institutions’ should be subject to stronger regulation and oversight, reflecting these potential higher costs. This includes an assessment, to be undertaken by the BCBS, of the need for a capital surcharge to mitigate the risks associated with systemic banks. Other elements being investigated include: requiring such firms to develop specific contingency plans to allow for the winding up of the firm; establishing crisis management groups for the major cross–border firms to strengthen international co-operation during the resolution process; and examining the potential to strengthen the legal framework for crisis intervention and winding up of these firms. Since 2002, APRA has implemented a strategy of increasing supervisory intensity for larger firms in Australia presenting potential systemic risk. This supervisory strategy has proven reasonably successful to date.

Another initiative aimed at reducing systemic risk is the effort to improve the infrastructure underlying over-the-counter (OTC) derivatives markets. One focus of this work has been the move towards the establishment of central counterparties (CCPs) and exchanges for credit derivatives.3 In recent months two new CCPs have commenced operations to clear credit derivatives transactions in Europe, and the flow of trades to the existing US-based CCP has increased markedly, albeit from a small base. In addition, to underpin improvements in regulators’ ability to oversee OTC derivatives markets, several jurisdictions are considering introducing specific legislation that will require ‘standardised’ OTC derivatives to be cleared through a CCP, and all other transactions to be recorded in trade repositories.

In Australia, APRA, ASIC and the Reserve Bank have been jointly monitoring international industry developments and assessing the conduct of business in the Australian OTC derivatives market. A first step has been to carry out a survey of OTC derivatives market participants in Australia, focusing particularly on risk management and post-trade processing practices.4

The Survey results, released in May 2009, found that the scale of activity and magnitude of outstanding exposures in the Australian OTC derivatives market are low by international standards and, with the exception of interest rate and foreign exchange products, are also quite low in absolute terms. Nevertheless, the market plays an important role in the overall functioning of the Australian financial system and any disruption to activity could have wide-ranging implications. As such, the Survey identified several areas in which practices in the Australian OTC derivatives market might be enhanced to ensure that the market is well placed with regards to future growth and international best practice. The agencies have been meeting with industry participants, to discuss the Survey findings and to promote further enhancements.

A third area of work internationally in the area of systemic risk is on ensuring that all systemically important activity across the financial system is subjected to appropriate oversight, so as to prevent the emergence of new risks and regulatory arbitrage. This includes consideration of a consistent regulatory framework for the oversight of hedge funds, involving elements such as mandatory registration, ongoing oversight and provision of information to regulators so they can better ascertain systemic risk. In addition, the International Organization of Securities Commissions (IOSCO) is evaluating whether the regulatory changes that have been developed in, for example, the United States and Europe, to provide for stronger oversight of credit rating agencies, are consistent with its revised Code of Conduct for such agencies. IOSCO has also been examining ways to introduce greater transparency and oversight to certain financial products, particularly the securitisation and credit default swap (CDS) markets, as well as improving investor confidence in these markets. The focus in the securitisation market is on addressing the flaws and distorted incentives in the securitisation model, enhancing disclosure, strengthening investor suitability requirements and promoting adherence to good practices for investor due diligence. The focus in the CDS market is on addressing operational risk and the lack of transparency, as well as issues surrounding counterparty risk which are encapsulated in the work on CCPs.

Strengthening Accounting Standards

The financial crisis has resulted in a refocus on accounting standards, in particular those relating to recognition and measurement of financial instruments, off–balance sheet activities and loan loss provisioning. There has been progress in addressing some of these. However, the achievement of a single set of high–quality global accounting standards – an aim endorsed by G–20 leaders in April 2009 – remains complicated by the ongoing lack of convergence in approaches between the two key accounting standard setters, namely, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB). The IASB worked for some years in the first part of this decade to develop a single set of global accounting standards. Those standards, the International Financial Reporting Standards, have been implemented in many countries, including Australia, from the middle of the decade, whereas US firms have continued to operate under the FASB standards. Achieving consistent standards, particularly on the measurement of financial instruments and provisioning, will therefore need further consultation by the independent standard setters.

Strategies for Exit from Financial Sector Support Packages

A further area that the international community is considering is exit strategies from support programs, such as the wholesale funding guarantee schemes that were introduced successfully in a number of countries, including Australia, in response to the extraordinary conditions experienced around 12 months ago. These temporary arrangements must ultimately be withdrawn, as it is in the long–run interest of institutions and the financial system for institutions to rely on their own credit standing for funding. The exit strategies for these arrangements will need to be carefully managed, taking into account market conditions and exit arrangements adopted by other countries (as discussed in The Global Financial Environment chapter). While these are decisions for governments, the Reserve Bank is participating in international discussions on this topic, including through the FSB. These issues are being actively considered by the Council of Financial Regulators, which continues to advise the Government on design aspects of the guarantee scheme.

Related to this is the future structure of deposit protection arrangements, which many countries expanded at the height of the financial turmoil last year. In a number of cases, these expanded arrangements are due to expire over the next one to two years. Some guidance for the appropriate design of future arrangements, and the transition process, can be drawn from international standards prepared by the BCBS and the International Association of Deposit Insurers. In Australia, the arrangements for deposits of $1 million and below are due to conclude in October 2011. To advise the Government on policy in this area, the Council of Financial Regulators is considering a number of issues, including transition arrangements from the current scheme, the appropriate cap and the merits of pre- and post-funded schemes. As there are significant linkages between the wholesale funding and deposit guarantee arrangements in Australia, the winding back and move to more permanent measures and any related effects are being considered jointly.

Other Domestic Developments

Market Supervision, Conduct and Disclosure

In August 2009, the Government announced that ASIC will take over, from the Australian Securities Exchange, responsibility for supervision of real–time trading on all of Australia’s domestic licensed financial markets. Once implemented, the change will mean that ASIC will be responsible for both supervision and enforcement of the laws against misconduct on Australia’s financial markets. There is a considerable amount of transitional work to be done in preparation for this transfer, including legislative changes, with the handover expected to be completed by the third quarter of 2010. This move will create a regulatory framework that would accommodate competition between market operators.

The ban on covered short selling of financial securities in Australia, which had been in place since September 2008, was lifted in May 2009. This followed a review by ASIC of market conditions, which concluded that the balance between market efficiency and potential systemic concern had moved in favour of the ban being lifted. In announcing the removal of the ban, ASIC noted that it would pay particular attention to short selling by participants (including activity by hedge funds and similar institutions) and it would not hesitate to reimpose the ban (using its enhanced powers under the Corporations Amendment (Short Selling) Act 2008) if it considered market conditions warranted such action.

Further to the disclosure issues that were detailed in the March 2009 Review, the permanent disclosure regime for short selling that is being developed by the Government is expected to be announced soon, and the arrangements for the disclosure of securities lending transactions are on track to move from the pilot phase to full implementation in December 2009. Consultation has also commenced on improving the substantial holding disclosure in respect of securities lending and prime broking, amid concerns that there has been a lack of transparency of substantial holdings acquired through such transactions. Similarly, concern over the adequacy of the disclosure regime for equity derivatives has resulted in the Government commencing a consultation process on ways to improve the existing regime.

National Regulation of Consumer Credit

As reported in previous Reviews, the Council of Australian Governments agreed in 2008 that all consumer credit regulation would be transferred to the Commonwealth Government. In June 2009, the Commonwealth Government introduced legislation to provide enhanced regulation of consumer credit provision and related consumer protections. Margin loans are now included as a financial product under the Corporations Act, making them, for the first time, subject to the same level of investor protection as other types of financial products regulated under the Corporations Act.

There will now be a national licensing regime regulating providers of credit or credit-related services, to be administered by ASIC, covering all ‘credit providers’ and ‘credit assistants’ – lenders, brokers and other intermediaries who assist consumers to obtain credit. People whose business will be regulated under the new regime will have to register with ASIC and apply for an Australian Credit Licence. Those who lose their licence will now be banned from operating Australia-wide, while licensee misconduct carries potential civil and criminal penalties.

The previous state-based Uniform Consumer Credit Code is to be largely replicated in the Commonwealth’s credit regulation, with some additional features. For example, the provisions will now apply to residential investment property loans, lenders will be required to provide the consumer with information when a direct debit is dishonoured, and lenders will be prohibited from using essential household goods as security. The threshold below which consumers can apply for hardship provisions or stays of enforcement will also be raised significantly.

There will also be responsible lending requirements covering all credit licensees, not just credit providers. These requirements state that licensees must not provide or suggest unsuitable credit to a consumer. Licensees will have to assess that a credit contract meets the requirements of the consumer and that the consumer has the capacity to repay their obligations.

  1. For more detail on these organisations, their work during 2008/09 and the Reserve Bank’s role in this work, see the chapter on International Financial Co-operation in the Reserve Bank of Australia’s Annual Report, 2009.
  2. A discussion of the role of central clearing for OTC credit derivatives can be found in Box B of the March 2009 Financial Stability Review.
  3. See APRA, ASIC, Reserve Bank of Australia (2009), Survey of the OTC Derivatives Market in Australia, May.