Australian prudential regulation authority

Introduction

The current global financial crisis, which commenced in 2007 (BBC News 2009), which threatened the survival not only of national and international banking institutions but also the financial markets, has been described as "the worst in human history" by the Governor of the Bank of England (Monoghan 2008). In the wake of this crisis much attention has been focused upon the perceived inadequacy of the financial regulatory in preventing the systemic failures that occurred (GOA 2009). As a result, this criticism has led national governments to assess their regulatory systems with a view to identifying areas in need of improvement, with this review being designed to eliminate the reoccurrence of the current crisis.

As a part of this process, this report is being prepared for the chairman of the APRA[1]. Following an overview of the current structure of the Australian regulatory system, the intention is to identify the issues and concerns raised as a result of recent events and, from this, to provide recommendations for future improvements of this system.

Australian banking regulatory system

The responsibility for regulation of the banking and financial markets in Australia is currently shared by three regulatory bodies, each of which have a different sphere of influence and control, although the data collected is shared across the three institutions through the council of financial regulators (figure 1).

Jointly and severally, it is the responsibility of these regulators to ensure that banks and other financial institutions comply with the current financial legislation, which includes the Banking Act (1959) and the Corporation Act (2001). As an integrated part of their duties, the APRA also has to ensure that the banking institutions comply with the internationally agreed standards of the Basel II accord (APRA 2003 and 2010, and Basel II 2006), which Australia has signed up. However, in some financial areas, including consumer credits, regulation and control is also subject to individual state legislation.

Recent regulatory events

It is generally accepted that Australia's banking sector has not been as affected by the financial crisis as its counterparts in the US and UK. Indeed, the major adverse events in this sector in the past two years been limited to locally based subsidiaries of international financial institutions such as Lehman Brothers and Lloyds TSB (AAP 2008). The Australian Banking Association (ABA) suggest that this has been predominantly the result of the continuing balance sheet strength of the corporate balance sheets which, as can be seen from the following diagram (figure 2).

Nevertheless, despite this position, and because of the banking sector's exposure to the international financial markets, the Australian government (2008a) were forced to introduce a $AUS 700 billion guarantee scheme to protect large depositors and facilitate wholesale funding. In this respect therefore, the introduction of this scheme can be seen as a response to the impact of the continuing volatility that was being experienced in the international financial markets as a result of the crisis (Barton et al 2003 and Cooper 2008).

Furthermore, following growing international concern about the banking regulatory system, particularly the Basel Accord, the regulators have taken steps to improve the current system. This is an area where the APRA has been active, which has resulted in the organisation initiating new proposals that focus on improvements to the Basel II accord and liquidity requirements within the banking sector (APRA 2009a and 2009b).

In addition, and in an attempt to address growing concerns about the current fragmentation of the Australian regulatory system. The Australian Government (2008b) also published a green paper, which was a consultative document that focused upon the following objectives: -

  • the development of a comprehensive approach to the regulation of mortgages and mortgage broking advice;
  • the regulation of margin lending;
  • the creation of a national market for trustee corporations through the implementation of Commonwealth legislation;
  • reforms to improve the existing regulation of debentures;
  • the investigation of issues relating to property investment advice, including property spruikers; and
  • the consideration of the most appropriate regulation of a range of remaining credit products, such as credit cards, personal loans and micro-lending.

In other words these proposals are designed to simplify and improve the current regulatory system within the country, potentially placing control and monitoring within a unified environment, which transfers the current state involvement back to national regulators.

Other issues and concerns

However, as regulatory controls were in force at the time of the financial crisis it is important to understand the key issues that need to be addressed within any review of these systems. As Milne (2008) indicates, it was not only the sub-prime event that caused the crisis. In his view "that was merely a symptom of a deeper disease, the failure to impose proper standards for accounting and valuation of structured securities. This deeper problem affects not just sub-prime mortgage backed securities (MBS), but all other structured credit product."

Therefore, there is a need to address the deeper issues that contributed to regulatory and banking sector failures, over and above those that concentrate primarily upon the raising of the capital adequacy level. In the opinion of the author, these issues relate to the four following areas.

  1. Balance Sheet analysis and reporting
  2. Basel II includes specific instructions regarding the type of assets that needed to be taken into account when banks conduct their capital adequacy test. What was missing in this requirement was a test to determine the liquidity situation related to these assets.

    For example, it became apparent that banks had been using credit derivatives as a means to "transfer risk," for instance within the sub-prime sector (Choudhry 2004), but still including these within the capital adequacy equation. Similarly, in some case these products were also being moved 'off balance sheet,' which effectively led to a misinterpretation of the bank's strength.

  3. Limitations of institutional scope
  4. Current Basel II (2006) accords and national regulations have been limited to financial and banking institutions that provide services to the markets and the consumer. Therefore, the presence Hedge Funds and other financial and shadow banking organisations that have grown in number in the past decade has largely been ignored in terms of the imposition of regulatory control (Duffee and Zhou 2001).

  5. Definition of fair valuation
  6. Although many attempts have been made to more clearly define 'fair valuation' of banking assets such as derivatives, both this definition the diverse basis of measurement available have led to lack of transparency and, as has been evident during the crisis, a significant level of overvaluation.

  7. Control of the regulatory body vested with the government
  8. The main regulators are currently comprised of bodies appointed by the government. The main issues with this type of regulatory structure are related to the lack of market expertise and knowledge of the financial market systems (Levison 2003); than would be the case if regulatory control was vested in existing financial institutions like the central banks.

Recommendations

Although the banking sector deals with assets that give rise to risk" (Singh 2007, p.62), the credit crunch has proven that there were flaws within the international community's reliance upon efficient market system as a method of self-regulation, thus requiring limited governmental regulation (Cooper 2008, p.155). As identified, these problems have been further because of the issues discussed in the previous section of this report. It is therefore recommended that the restructuring and review of both the Australian regulatory systems and codes take into account the following comments.

  1. Basel Accord
  2. The focus of the APRA's contribution to the discussion of improvement of the Basel accord should focus upon the following: -

    1. Ensure the assets used within the capital adequacy equation have sufficient liquidity to be regarded as adequate, which includes a test on liquidity of CDO's
    2. Ensuring that all commercial organisation and institutions whose activities and services that are either directly or indirectly connected to the financial and banking markets are licensed by and included within the regulatory regime.
    3. Revise the position regarding 'off balance sheet' items to ensure these do not have an adverse impact upon the institution's capital strength.
    4. Provide a more robust and less subjective definition of 'fair value' and, in addition, restrict the number of asset valuation models that can be used by the banks, preferably to a single form.
  3. Regulatory system
  4. That the control structure for the regulatory system within the Australian banking sector should be managed by the central bank and any state regulatory control and legislation be transitioned to the national legislative environment. In addition, it is important to ensure that regulatory employees have skills and competences that are equivalent to those within the banking institutions.

    Regular review

    It is also important that the developments within the financial and banking markets are kept under constant review to ensure that regulatory action that is required to control and monitor these new developments can be taken immediately, therefore improving the ability of regulators to help avoid the occurrence of similar crisis in the future.

    Conclusion

    There is little doubt that the current financial crisis has revealed inadequacies within the current regulatory system that exists in Australia and elsewhere. As identified, most of these issues have been concentrated upon the lack of liquidity and increased risks associated with type of financial products that have been used by the banks within their capital structure. In addition, there have been failures of the regulatory regimes in recognising the need to include non-banking and shadow banking institutions within the regulatory environment at an early stage. It is considered that the recommendations made within this report, if implemented, would reduce the risks of future failures.

References

  • AAP (2008). Victoria gets Lehman jitters; Sydney Morning Herald, Sydney, Australia
  • ABA (2004) A Strong Banking System, Available from: http://www.bankers.asn.au/Default.aspx?ArticleID=587 [Accessed 22 March 2010]
  • APRA (2003) Basel II in the Australian Context, Available from: http://www.apra.gov.au/speeches/03_21.cfm [Accessed 22 March 2010]
  • APRA (2010), The APRA Supervision Blueprint, Available from: http://www.apra.gov.au/AboutAPRA/upload/APRA-Supervision-Blueprint-FINAL-08Jan2010.pdf [Accessed 21 March 2010]
  • APRA (2009a), APRA consults on enhancements to Basel II Framework, Available from: http://www.apra.gov.au/Policy/Proposed-Basel-II-Enhancements-2009.cfm [Accessed 22 March 2010]
  • APRA (2009b), APRA proposes enhanced liquidity requirement for ADI's. Available from: http://www.apra.gov.au/media-releases/09_32.cfm [Accessed 22 March 2010]
  • Australian Government (2008a), Guarantee Scheme for Large Deposits and Wholesale Funding, Available from: http://www.guaranteescheme.gov.au/ [Accessed 22 March 2010]
  • Australian Government (2008b), Green Paper: Financial Services and Credit Reform, Available from: http://www.treasury.gov.au/contentitem.asp?NavId=037&ContentID=1381 [Accessed 22 March 2010]
  • Barton, D., Newell, R and Wilson, G (2003). Dangerous Markets: Managing in Financial Crises. John Wiley & Sons, New Jersey, US
  • Basel II (2004). International convergence of capital measurement and capital standards: A Revised Framework. Basle Committee of Banking Supervision. Available from: http://www.bis.org/publ/bcbs107.pdf?noframes=1
  • BBC News (2009). Timeline: Credit Crunch to downturn. Available from: http://news.bbc.co.uk/1/hi/business/7521250.stm [Accessed 24 June 2009]
  • Choudhry, M (2004). An Introduction to Credit Derivatives, Butterworth-Heinemann, Oxford, UK
  • Cooper, G (2008). The Origin of Financial Crisis: Central banks, credit bubbles and the efficient market fallacy. Harriman House, Petersfield, UK
  • Duffee, G.R and Zhou, C (2001). Credit Derivatives in banking: Useful tools for managing risk? Journal of Monetary Economics, Vol.48, Issue.1, pp.25-54)
  • Fisher, C and Lovell, A (2009), Business Ethics and Values, 3rd edition, Harlow: Prentice Hall
  • GAO (2009). Letter from Robert J. Cramer. United States Government Accountability Office, Washington, US
  • Levinson, M (2003). Guide to Financial Markets, Bloomberg Press, Princeton, US
  • Milne, A (2008), Re: Credit Crunch: Structured Securities, Re: Cass Business School Vol (1), pp.1-5
  • Monaghan, A (2008 a). Financial crisis: Figures point to recession as markets tumble. The Telegraph, London, UK (24 October 2008).
  • Weber, A.A (2008). Financial Market Stability. Speech reproduced in BIS Quarterly, No.72

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