Financial Stability Review – March 2005 3. Developments in the Financial System Infrastructure

A major challenge for regulatory authorities is ensuring that the financial infrastructure – the regulatory, accounting and legal framework that supports the day-to-day activity of financial institutions – is keeping pace with evolving risks within the financial system.

One of the more significant issues for the financial system over recent years has been the rapid growth in borrowing by households. Reflecting this, in 2003, APRA conducted an extensive stress test of the ability of financial institutions to withstand a simultaneous substantial increase in home loan defaults and a 30 per cent fall in property prices. The results of this test have been discussed in previous issues of the Review. More recently, APRA has reviewed the regulatory arrangements that apply to various, potentially riskier, types of housing loans, and has also released draft prudential standards which, upon implementation, will increase the minimum capital requirements for mortgage insurers. In addition, both APRA and the Reserve Bank have drawn public attention to changes in lending practices over recent years and the implications that these might have for both households and financial institutions. There has also been a review by the Ministerial Council on Consumer Affairs of the fragmented regulatory arrangements that apply in the mortgage-broking industry.

Later this year, the risks facing the financial system are likely to come under greater scrutiny as Australia is scheduled to participate in the Financial Sector Assessment Program (FSAP) conducted jointly by the International Monetary Fund (IMF) and the World Bank with the assistance of outside experts. As part of the FSAP process, Australia's compliance with key international financial standards and codes will be assessed, as will crisis-management arrangements. The assessment is also likely to involve additional stress tests of the banking system.

3.1 Capital Requirements on Housing Lending

Historically, lending for housing has been a very low-risk activity. On average, around 0.1 per cent of insured mortgages have defaulted in any given year, with the maximum default rate in any single year being 0.27 per cent.[3] Actual losses have been far lower, as most housing loans are well secured by the underlying property.

Given the record of relatively small losses, housing loans typically attract lower regulatory capital requirements than business loans. Under the current framework for capital adequacy developed by the Basel Committee on Banking Supervision, housing loans have a risk weight of 50 per cent, rather than the 100 per cent weight that applies to business lending. This means that, in effect, an authorised deposit-taking institution (ADI) must hold four cents of capital for each dollar of most housing loans, rather than the eight cents that must be held against most other types of loans.

For a loan to qualify for the lower capital requirement, APRA requires that it be well secured, by either having a loan-to-valuation ratio (LVR) of less than 80 per cent, or by the lender having taken out mortgage insurance on the loan, covering the lender for any losses. Partly reflecting this, mortgage insurance has come to play an important role for ADIs, with around one fifth of outstanding ADI-originated housing loans being insured.

The rapid growth of low-doc loans and the mortgage-broking industry prompted APRA to review these requirements last year. Low-doc loans, in particular, are recognised as likely to have both higher probabilities of default and greater variability in default rates than standard loans, warranting more conservative regulatory capital arrangements. Under changes that became effective in October 2004, APRA now only permits a 50 per cent risk weight on uninsured low-doc loans if the LVR is below 60 per cent, rather than the 80 per cent threshold that applies to standard loans. In addition, the 60 per cent threshold also applies to loans originated by mortgage brokers if the ADI does not have procedures in place to substantiate critical information provided by the borrower.

3.2 Capital Requirements on Lenders' Mortgage Insurance

APRA has also recently reviewed the capital requirements that apply to lenders' mortgage insurers (LMIs). These insurers have come to play an important role in the financial system. Not only do they allow ADIs to reduce their regulatory capital requirements, they also provide the credit enhancement that has helped underpin the growth of the Australian mortgage-backed securities market. The vast bulk of securitised mortgages are either insured individually or as part of a pool of loans.

The lenders' mortgage insurance market is highly concentrated, with the three largest LMIs (one of which no longer writes business) accounting for around 80 per cent of the total value of outstanding policies. The other 20 per cent of policies are mostly written by captive insurers that provide cover only to the ADIs that own them. In contrast to a number of other countries where lenders' mortgage insurance is also used heavily, there are no longer any government-owned LMIs in Australia.

As part of its stress testing of the banking system to a fall in house prices, APRA noted that a significant rise in mortgage defaults could have serious implications for the mortgage insurance industry. Partly in response, a number of changes have been proposed to regulatory arrangements, with these planned to come into effect on 1 October 2005.

The most significant of these changes is an increase in minimum capital requirements for LMIs. Under the proposed arrangements, the capital requirement on any given insured loan will depend upon the LVR, the age of the loan, and whether it is a standard or non-standard loan (such as low-doc mortgages). For most loans, the proposed capital requirements will be more than double those that currently apply. The overall increase in LMIs' capital holdings, however, is likely to be less than this as the LMI industry's capital position is well in excess of current requirements and approximately equal to the new requirements.

Under the new arrangements, the required minimum amount of capital in the financial system will still typically fall when an ADI takes out mortgage insurance, with the only exception being for high-LVR or low-doc loans. One justification for this reduction is that, by taking out insurance, the losses from loan defaults are spread more widely through the system. The effect on overall capital requirements from insurance is illustrated in Graph 53 which shows the approximate capital requirements applying to LMIs for various types of insured loans. If, for example, a new standard loan has an LVR of 87 per cent, the insurer's capital requirement on the loan would be around one cent in the dollar, compared with the capital saving of four cents in the dollar for the bank taking out the insurance. For a low-doc or other non-standard loan with the same LVR, the insurer's capital requirement on the loan would be around 1½ cents, although this would increase to almost five cents if the LVR was in the range of 95 to 100 per cent.

Another proposed change relates to the authorisation of LMIs. Currently, ADIs can only apply the 50 per cent risk weight to an insured loan if the LMI has either an ‘A’ credit rating or, if unrated, is considered by APRA to have financial strength consistent with that rating. The new prudential standard will dispense with this rating condition, and locally incorporated LMIs will need to be authorised directly by APRA. For LMIs not domiciled in Australia, the LMI will need to be licensed in its home jurisdiction and supervised to APRA's satisfaction by the home regulator. The new standards also stipulate that if an LMI, or a reinsurer, has contractual recourse to the ADI that originated the loan, the ADI will not be eligible for the lower capital charge.

3.3 Regulation of Mortgage Brokers

Another recent development has been rapid growth in the use of brokers by individuals borrowing for residential property. As the number of lenders has proliferated and the complexity of loan products has increased, many borrowers have turned to mortgage brokers for advice. The growth of the broking industry has, in turn, prompted greater competition amongst financial institutions, helping to deliver cheaper housing loans to many households (see Box B).

This growth, however, has also focused attention on the regulatory arrangements that apply to mortgage brokers and the incentives that they face. Of particular concern has been the fact that although brokers effectively work for borrowers, they may be influenced in their recommendations by commissions offered by lenders. There have also been reports that some brokers have ‘coached’ borrowers so that they qualify for larger loans than would otherwise have been the case, as well as reports of brokers falsifying documents that support a loan application by a potential borrower.

Currently, the regulatory framework applying to mortgage broking, and to finance broking more generally, is fragmented. There are both federal and state regulations, but significant gaps in the regulatory framework remain. At the national level, ASIC is the chief regulator, but its licensing powers do not extend to brokers that only advise on credit products. At the state level, only Western Australia has an occupational licensing regime for finance brokers, and disclosure of financial benefits that brokers receive from lenders is required only in some states. There is no specific regulation of finance brokers in Queensland, South Australia, Tasmania and the Northern Territory.

The disparate regulatory arrangements were recently reviewed by the Ministerial Council on Consumer Affairs (MCCA) which, in December last year, released a Regulatory Impact Statement proposing uniform regulation of finance brokers. Under the proposals, regulation would be administered by the states on a nationally harmonised basis, and would apply to all brokered loans, other than business loans to large firms or amounts over $2 million.

The proposals address business conduct, disclosure (especially of fees and commissions), mechanisms for dispute resolution, ‘fit and proper’ background checks, and minimum standards of education or experience. For example, on disclosure of commissions, the MCCA has proposed that contracts between consumers and brokers disclose whether or not the broker will be receiving a financial or other benefit from a third party. The MCCA also recommends that brokers be required to justify recommendations and provide a suitability test for loan products.

The MCCA also proposes extending arbitration for dispute resolution beyond the existing system, which is voluntary and not available to all customers of brokers. The MCCA envisages a non-judicial, but compulsory, mechanism involving an industry ombudsman. It also proposes that mortgage brokers be required to hold professional indemnity insurance against the risk of breaching regulations.

3.4 Financial Sector Assessment Program

As noted above, Australia is scheduled to participate in the FSAP conducted by the IMF and World Bank. The process will commence later this year, with the final report expected to coincide with the conclusion of the regular Article IV Consultation in mid 2006. The Australian Treasury will co-ordinate the process, with participation by APRA, ASIC, the Reserve Bank and private financial institutions.

A core element in the process is an assessment of Australia's compliance with internationally accepted standards and codes relating to the financial infrastructure. The IMF currently recognises 12 such standards relating to accounting, auditing, anti-money laundering and combating the financing of terrorism, banking supervision, corporate governance, data dissemination, fiscal transparency, insolvency and creditor rights, insurance supervision, monetary and financial policy transparency, payment systems, and securities regulation. Typically, compliance with only a subset of these standards is assessed as part of the FSAP process. It has not yet been decided which specific standards will be examined in Australia's case.

A related element of the FSAP process is an assessment of procedures for dealing with financial crises involving major difficulties at one or more financial institutions. These arrangements are currently being reviewed by the Council of Financial Regulators.

A third element involves stress tests of the financial system. Here the FSAP is likely to build on the earlier work by APRA examining the impact of a significant fall in house prices. The exact scenarios to be used will be developed in consultation with the banking industry and the FSAP team. They will then be given to financial institutions, which will model the implications of the scenarios for their own health.

Financial Soundness Indicators

In the course of the FSAP visit, the IMF will also be reviewing the quality and comprehensiveness of Australia's financial statistics.

Interest in financial data has increased greatly over recent years as financial factors have come to play a more important role in shaping economic outcomes. In contrast to the plethora of statistics on output and employment that exists in most countries, collection of financial sector data has typically lagged behind, and there is far less standardisation across countries. One obvious example to which the Reserve Bank has drawn attention in recent times is the relatively limited data on house prices, although by international standards Australia is quite well served in this particular area.

In an effort to improve the quality and comparability of data, the IMF has developed a set of Financial Soundness Indicators (FSIs) that it hopes will be calculated on an internationally harmonised basis, and be released quarterly by most countries. These indicators are divided into two sets. The first, or ‘core’, set includes statistics on the health and performance of the deposit-taking sector. The second, or ‘encouraged’, set includes additional statistics on deposit-taking institutions as well as statistics relating to the household and corporate sectors, real estate markets and non-bank financial institutions. All up, there are 39 FSIs, of which 12 are on the core list (Box E).

To promote and support the compilation of FSIs, the IMF is organising a Co-ordinated Compilation Exercise involving around 60 countries, including Australia. Participating countries are required to compile the core indicators and as many of the second set of indicators as possible. Data for end December 2005 are to be submitted by end July 2006, and the IMF hopes to publish the results by end 2006. The Reserve Bank is co-ordinating Australia's participation. Overall, Australia's data are expected to compare favourably with those of most other countries, although some gaps remain to be filled.

3.5 Other Developments

Trans-Tasman Banking

Last year, the Australian Treasurer and the New Zealand Minister of Finance commissioned a working group of officials from their respective Treasuries, APRA, the Reserve Bank of New Zealand (RBNZ) and the Reserve Bank of Australia to explore options for closer integration of the regulatory and crisis-management arrangements of both countries. In the case of banking, business integration is well advanced, with some 85 per cent of the New Zealand banking market by assets owned by the four major Australian banks. New Zealand subsidiary and branch operations represent the largest overseas exposure of the four major Australian banks and account for some 15 per cent of their total assets. The options canvassed by the working group included an ‘enhanced home-host supervisory model’ that would build upon the existing, but separate, regulatory frameworks, and a more far-reaching initiative involving a larger role for APRA in the supervision of Australian banks in New Zealand.

This work has been given further impetus following a Ministerial meeting on 17 February 2005. A joint Trans-Tasman Council on Banking Supervision has now been established, chaired jointly by the Secretaries to the two Treasuries. The terms of reference require the Council to develop enhanced 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.

The Council has been asked to report to Ministers by 31 May 2005 on legislative changes that may be required to ensure that APRA and the RBNZ can support each other in the performance of their current regulatory responsibilities at least regulatory cost.

Business Continuity Planning

For some time, the Reserve Bank has been working with the finance industry in identifying risks to the operational resilience of the financial sector. This parallels work being undertaken overseas examining such issues as industry-wide contingency planning and testing, crisis communications procedures, and the resilience of critical telecommunications services used by the financial industry. In 2003, an advisory group for the Australian banking and finance sector was established under the Government's Trusted Information Sharing Network for Critical Infrastructure Protection. The group has broad membership among financial institutions, industry associations, and operators of market infrastructure. At the end of 2004, it provided a preliminary report to the Reserve Bank summarising its analysis to date of risks and potential options for mitigating them. Now under the chairmanship of one of the major banks, and with the Reserve Bank as deputy chair, the group is developing a work plan and initiating a series of projects to address the issues identified in the report.


See Reserve Bank of Australia (2004), ‘Box C: Measures of Housing Loan Quality’, Financial Stability Review, September. [3]