Macroprudential Analysis and Policy in the Australian
Financial Stability Framework – September 2012
5. Conduct and Sharing of Analysis

The distribution of responsibilities between APRA and the RBA is such that there are necessarily areas of overlapping interest. While APRA is primarily a supervisor of institutions and the RBA is primarily focused on the system as a whole, both institutions have a clear interest in developments at both levels. To work effectively, this structure requires coordination to ensure a coherent policy approach and appropriate sharing of information and analysis.

5.1 Analytical Approaches

The global financial crisis has prompted some rethinking in the economics profession about the kinds of models and assumptions that should be used, both for macroeconomic policymaking and for gauging the risks and vulnerabilities in the financial system. Some recent academic work has provided new insights on financial stability issues such as leverage, risk appetite and interconnectedness. Some researchers have rediscovered existing work that had not previously been incorporated into the standard macroeconomic models, such as those that emphasise information asymmetries; others have borrowed from other fields, such as network analysis and agent-based modelling.

The Australian authorities have never focused on a single class of models or single analytical approach. Since real-world data are imperfect and all theoretical models are by definition incomplete, practical policymaking has been best served by an eclectic approach that tries to piece together a coherent story by cross-referencing a broad range of data and applying a judgement overlay. This section details some of the perspectives or analytical approaches that the Australian agencies use to detect emerging vulnerabilities and risks in the financial system or some part of it.

The events of the crisis have shown how important balance sheet size and structure can be in determining spending and other economic decisions, as well as a sector's resilience to shocks. Balance sheet considerations can constrain the actions of households and non-financial firms as well as banks and other suppliers of credit, and changes in the balance sheets of one sector inherently affect those of other sectors. Accordingly, the two agencies monitor data on both aggregated and institution-level balance sheets. Key indicators include developments in credit, corporate sector gearing and measures of net wealth and indebtedness in the household sector. Measures of balance sheet structure are also monitored, such as the composition and term structure of funding of financial and non-financial firms. Measures of asset quality for financial intermediaries fall into this category of indicators. The set of data monitored is subject to ongoing review, according to criteria such as data quality, relevance and analytical usefulness.

In monitoring these kinds of data, the two agencies are looking for signs that balance sheet developments could make that entity or sector more vulnerable to particular shocks. For example, rising gearing can leave firms or sectors vulnerable to falling asset prices or incomes, while increased shorter-term funding can leave them vulnerable to rollover risk if debt markets became dysfunctional. Deviations from historical experience can be but are not necessarily taken as a signal of vulnerability, as there are cases where structural change in the economy implies that the maximum safe levels of a particular balance sheet quantity or ratio can change through time.

As noted in the previous section, behavioural indicators such as risk appetite and exuberant expectations are also helpful for detecting risks to financial stability. Periods of financial instability are invariably preceded by boom periods when investors and other decision-makers are exuberant, risk-taking increases, demand for and supply of credit are both strong, and new financial products and markets have become prominent. Qualitative observations of attitudes and behaviours are therefore useful signals; to avoid these being distorted by anecdotal impressions, the two agencies cross-check their behavioural observations with hard data. Among the data that the two agencies track to detect these patterns of behaviour are asset prices, saving and borrowing behaviour, credit conditions, lending standards and the distribution of credit and spending by sector and purpose. The various dimensions of lending standards – that is, the features of the loan and the decision process before it is granted – are key indicators for detecting excessive risk-taking by lenders as well as borrowers.

Although it is not the role of policymakers to second-guess the decisions of other people in relation to their own affairs, the two agencies are alert to signs that risk-taking has gone too far. Among other things, two patterns of behaviour are most relevant:

  • decisions are being taken based on optimistic perceptions of risk and future outcomes; and
  • much of the risk is being taken by agents on behalf of others, with the ultimate bearers of that risk having little understanding or control over these decisions.

The second of these issues points to another area that may signal future risks and vulnerabilities: governance issues, including potential conflicts of interest. Where governance is insufficient, rent-seeking can thrive. This is a particular issue in complex, opaque markets, such as the structured credit boom in the years before the crisis. Governance issues can also enable excessive risk-taking that would not be allowed to take place if an institution's shareholders or other principals were fully informed about their employees' or agents' activities.

These kinds of issues are not easily detectable using standard datasets. Instead, APRA and the RBA are alert to imprudent terms and conditions in contracts and products, and whether there is an unusual flow of new financial products being introduced to the market. Compensation practices and other indicators of poor governance can be used as indicators of the potential for rent-seeking. A common symptom of rent-seeking, as well as excessive investor exuberance, is heightened activity in the market for corporate control.

As noted in the previous section, system-wide analysis still requires disaggregated data to be monitored, in order to detect concentrations of risk in particular sectors or segments, which could propagate to the broader system. These concentrations could include large gross exposures of particular entities to a particular risk – for example, movements in the exchange rate.

Both agencies therefore monitor data on individual financial institutions. APRA focuses on regulated institutions, including their large exposures; the RBA also monitors data on other financial firms, which APRA collects under the terms of its powers under the Financial Sector (Collection of Data) Act 2001. The two agencies are constrained by legislation from publishing certain kinds of data on individual financial institutions, but make extensive use of such data internally and in discussions with each other. In addition, the RBA obtains and analyses disaggregated data on household and non-financial business sector financial positions drawn from household surveys, databases on listed companies, and credit reference agencies. For privacy reasons, all disaggregated data on non-financial sectors are suitably anonymised. These disaggregated data can then be presented using various distributional metrics, such as percentiles or share of the population above or below some threshold value.

In analysing data of this type, the two agencies are looking for signs that risk or vulnerability to shocks is disproportionately concentrated on a subset of that sector or group of entities. Industry analysis, disaggregation by household characteristics, and other metrics can be used to identify these more vulnerable subgroups. The implications of such concentration of risk depend on the size of the subgroup, its connections with other parts of the economy, and its capacity to mitigate the effects of a particular shock.

5.2 Conduct of Analysis

The following two sections describe the processes in the two agencies for conducting macro-level and industry analysis and feeding the results of that analysis into policymaking. While the results of that analysis are often shared between the agencies, the analysis itself is usually in the first instance conducted within each agency separately.

5.2.1 RBA

At the RBA, the analysis and policy development on financial stability issues is primarily the responsibility of Financial Stability Department. The analytical process is divided into regular monitoring of key variables, issues-based analysis of data outside the core set of regularly reported data, and longer-term analytical projects. These duties are distributed across teams responsible for specific subject areas, including international developments, the domestic financial system and the non-financial sectors. The educational backgrounds of the analytical staff include a mix of economics, finance and actuarial science, although economics predominates.

The department's regular data monitoring and analysis covers all the approaches to analysis described in the previous section. Among the routine outputs are statistics related to banking and financial stability that the RBA regularly publishes on its website. Although much of the source data for these statistics are drawn from APRA and ABS collections, RBA staff assist in their compilation and quality assurance. These functions are the first stage in the process of analysis and risk identification that culminates in the publication of the semi-annual Financial Stability Review (FSR).

The next stage in the process is the analysis of recent data for internal circulation. Some of the topics are routinely reported on, while others might be proposed by staff or commissioned by senior management. Written reports on both routine and one-off topics are approved by departmental management and circulated to the Governors and staff in other parts of the RBA. The RBA's top management is therefore exposed to data reporting and analysis related to financial stability issues on an ongoing basis. Some routine data analysis and longer-term projects are joint work with other departments.

Some of the department's regular and one-off analysis is commissioned specifically for publication in the RBA Bulletin and, in particular, the FSR. As well as being the RBA's primary regular channel for communication with the public about financial stability issues (see Section 6.4.2), the FSR provides structure to the regular cycle of monitoring and analysis. The process of drafting the FSR begins with a meeting of the department and the Assistant Governor (Financial System), where the themes for the issue, including possible risks to the Australian financial system, are discussed. Drafts of the material proposed for inclusion are reviewed and approved by the senior management team and the Governors, and are also circulated to the other CFR agencies for comment prior to publication.

In addition, the department produces a financial stability paper for the RBA Board's March and September meetings. The contents of this paper are largely replicated in the issue of the FSR that is released at the end of that month. Senior staff in Financial Stability Department and the Assistant Governor (Financial System) attend the pre-Board meeting of senior Bank staff each month, and can provide input to the monetary policy decision based on the department's assessment of conditions in the financial system. The financial stability paper is also discussed at this meeting in the relevant months.

Some other pieces are commissioned for consideration by the CFR. For example, the RBA has committed to providing the CFR with an annual analysis of the so-called ‘shadow banking’ sector. Although this sector is small in Australia, the experience of other countries shows that it could in principle pose systemic risk if this were to change. This annual review is designed to ensure that such a development would not be missed. Another recent example of work commissioned for the CFR was a detailed analysis of the risks associated with banks’ offshore funding.

5.2.2 APRA

To support supervisors APRA has a set of systems, tools and processes that monitor industry trends and potential industry risks.

Industry Risk Management Framework

APRA has an Industry Risk Management Framework, the general purpose of which is to assist APRA in identifying and acting on significant emerging industry-wide risks. The goal of the framework is to identify thematic or macroprudential risks and develop an appropriate response that mitigates those risks, prioritises the use of resources and facilitates consistent treatment across institutions. The aim is to be forward looking and to head off identified risks before they develop into something less easily manageable by both APRA and the industry.

Industry Analysis team

The Industry Analysis team, embedded within APRA's supervisory divisions, has as one of its primary responsibilities the task of conducting analysis and research on current and emerging industry risks and disseminating relevant and useful information to APRA supervisors.

The team prepares a range of internal tools and reports which are used by supervisors and APRA management to assess industry risks, identify relevant macroeconomic factors and take stock of industry issues. These include preparation of regular industry overviews, as well as chart packs and dashboards which show trends in industry data and performance against risk tolerances and comparisons across peer groups.

Industry groups

The industry group is the key forum for addressing, and seeking APRA-wide consensus on, emerging industry issues. Each industry group is a cross-divisional forum with senior representatives from supervision, industry technical services, industry analysis, policy, statistics and legal. The industry groups liaise with industry (including professional bodies) and other regulators so as to identify emerging issues to be escalated for appropriate policy or supervisory response. They also provide advice to the APRA Members (APRA's leadership group) and other relevant APRA committees about major developments affecting the industry: information which would be made available to other regulators if needed.

Risk registers

A key feature of the framework is the suite of industry risk registers. These registers record any material emerging concern or business practice common to more than one institution in the industry that has a heightened possibility of having significant adverse prudential consequences for the industry. The industry risk registers act as both a management and a communication tool.

Risks identified are those affecting, or those that have the potential to affect, a large number of entities and/or a high proportion of the industry. The risks are intended to capture threats that could affect regulated entities or the financial system in the short to medium term. They are not intended to capture remote speculative risks that could emerge at some indefinite future point. The definition of each industry risk is kept sufficiently specific such that it is possible to develop meaningful responses to that risk. Only risks rated as ‘high’ or ‘medium’ are reported on risk registers. APRA's Management Group must approve the addition or removal of a ‘high’ risk.

The risk registers are intended to consider elevated risks not normally seen in the industry, whether driven by internal or external factors. They are not intended to cover normal or idiosyncratic risks facing an institution, nor those that are perennially high. These ‘chronic’ risks are dealt with in APRA's broader supervision framework, such as through Probability and Impact Rating System (PAIRS) assessments and modules, industry groups, risk-based prudential reviews and consultations, and internal training courses and conferences.

Each risk is allocated a risk owner whose responsibility it is to ensure the management of the risk. The role of a risk owner will vary depending on the scoped activity for the industry risk. Some risk owners will manage significant projects requiring resources from across APRA. Other risk owners may be essentially adopting a watching brief on a risk. The industry group is responsible for mapping each risk to a risk matrix describing its probability and impact. Each risk is also rated on its overall relative intensity and urgency.

Supervisors use the risk register in setting Supervisory Action Plans (SAPs), to the extent that the risk is relevant to the circumstances of each entity. Risk registers also provide details of expectations for supervisors in regard to each risk. While the risk registers are maintained continuously by the Industry Analysis team, a comprehensive review of existing and emerging risks is undertaken by industry groups at least annually.

5.3 Information Sharing

5.3.1 Legislative framework

In undertaking its role, APRA exchanges information with other relevant supervisors and authorities subject to confidentiality, purpose and use requirements. Section 56 of the APRA Act provides for the protection of confidential information and its release to other supervisors and agencies. APRA has a robust framework for the exchange and protection of such information. APRA has well-established relationships with the Reserve Bank and ASIC which facilitate the exchange of information.

In the case where exchange of information will assist a financial sector supervisory agency to perform its functions or exercise its powers, such exchange does not require the existence of an agreement or understanding. This is also true where the agency is specified in regulation 5 for the purposes of section 56. The agencies specified under either section 56 or regulation 5 include the Reserve Bank, ASIC and the Council of Financial Regulators.

Similarly, the RBA has exemptions under the Reserve Bank Act to share relevant information with APRA even when that information is institution-specific information protected under section 79A of the Act and therefore cannot be revealed to the public or before a court. The sharing of such protected information with APRA must be for the purposes of one or more of several laws including the Banking Act, which includes prudential matters.

5.3.2 Structured coordination

The key formal structure for bilateral cooperation between the RBA and APRA is the regular meeting of the Coordination Committee. This meeting occurs roughly every six weeks, with the venue and chair alternating between the two agencies. The attendees from the RBA are usually the Assistant Governor (Financial System) and the Head and Deputy Head of Financial Stability Department; from APRA, the Executive General Managers of Diversified Institutions Division, Supervisory Support Division and Policy, Research and Statistics Division, as well as the General Manager of Industry Technical Services have been the usual attendees in recent years.

The Coordination Committee's standing agenda includes discussions on market developments and any issues of note concerning specific institutions. Ahead of the meeting, the two agencies typically circulate relevant internal analysis to each other.

Several other, less frequent, vehicles for coordination have also been put in place over the past decade. Analysts from both agencies meet two to three times a year to present and discuss their recent work and share findings of mutual interest. Senior staff from Financial Stability Department give a presentation to APRA staff following the release of each FSR, as well as to the annual internal meeting of supervisors of ADIs.

More broadly, as noted above the RBA provides relevant staff at the other CFR agencies with drafts of the FSR for their comment. This ensures that the FSR incorporates the expertise and knowledge of the other agencies, as well as serving to alert the other agencies to any financial stability concerns and views of the RBA that have not already been raised elsewhere.

5.3.3 Informal liaison

Because strong relationships between the agencies are so important to the effectiveness of financial stability oversight, cooperation cannot only occur through formal processes: close informal relationships are also vital. As noted above, both agencies recognise that cooperation between them is a professional duty of their staff. Staff members at both senior executive and working levels are expected to build and maintain relationships. Maintenance of relations with senior APRA executives is one of the key position objectives listed on the position description for the RBA's Head of Financial Stability Department. Position descriptions for senior executives and policy staff at APRA typically require them to develop and maintain strong external relationships with relevant stakeholders, which include the RBA, and the list of performance measures includes demonstrating approachability and actively promoting sharing of information.

One way these relationships are reinforced is via periodic staff secondments, in both directions, mainly at the working level. Such secondments generally last between three months and a year, depending on the nature of the work envisaged. Staff are also in frequent contact through various CFR working groups and to coordinate Australia's position ahead of international meetings.