finsia leadership luncheon series 22 march 2013.pdf

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FINANCIAL REGULATION AND FINANCIAL SECTOR EVOLUTION:LOOKING AHEAD

JOHN F LAKER

ChairmanAustralian Prudential Regulation Authority

Australian Centre for Financial Studies/Finsia Leadership Luncheon SeriesMelbourne

22 March 2013


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Introduction

I am pleased to join this reunion tour with a slightly different and

expanded line-up and reprise the panel discussion on the future of thefinancial system that took place at the Australian Conference of Economistslast July. As I said then, a prudential supervisor is not in the economicforecasting business. Our role is to ensure that regulated financialinstitutions and the financial system as a whole are sufficiently strong tocope with any reasonably foreseeable adversity, however that adversity mayunfold. Hence, I will leave prognostications to others.

Underpinning the strength of financial institutions, and the effectiveness ofa supervisor, must be a robust prudential framework the rules of thegame, so to speak. As we all know, the global rules had been found

wanting in the crisis and an ambitious reform effort driven by the G-20Leaders has been underway to redress weaknesses. APRAs involvement inthis effort, largely through its membership of the Basel Committee onBanking Supervision, has focussed mainly on the so-called Basel III reforms.

The thrust of the Basel III reforms should be well-known to this audience. Itis to improve the resilience of the global banking system by raising thequality, quantity and international consistency of bank capital and liquidity,constraining the build-up of leverage and maturity mismatches, andintroducing capital buffers that can be drawn upon in stressed times. Thereforms are also aimed at improving the pricing and management of risk aswell as strengthening banks transparency and disclosure. APRA has spokenextensively about the detail and implementation of these reforms.

In a recent speech, I stated that in the areas of particular interest to APRA global reforms have now largely moved into the implementation phase.Indeed, I believe we are now over the hump of reforms to the prudentialregime in Australia. That is not to say that our policy team will not be verybusy for some time to come.1 Let me use my introductory remarks toexpand on that statement and, hopefully, to placate the coast-watchersstaring anxiously out for signs of another tsunami, to use the colourful

language of the organisers of todays event. I will confine my remarks tothe Australian banking system, although my over the hump commentapplies equally to reforms of domestic origin in insurance andsuperannuation.

Basel III capital reforms

Starting first with Basel III capital. From 1 January 2013, APRA formallyintroduced the Basel III definition of regulatory capital, the minimumrequirements for the different tiers of capital, and the stricter eligibility

1

J.F.Laker, The Importance of Good Governance, Speech at Australian British Chamber ofCommerce, Melbourne, 27 February 2013.


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criteria for capital instruments. However, for in-principle reasons, APRA didnot adopt the concessional treatment available for certain items incalculating regulatory capital. Australia was one of 11 out of 19 BaselCommittee jurisdictions that had final Basel III regulations in place by thisstart date.

1 January 2013 also marked the date of a key milestone in Basel IIIimplementation. From this date, authorised deposit-taking institutions(ADIs) were required to meet a minimum Common Equity Tier 1 requirementof 4.5 per cent of risk-weighted assets, after regulatory adjustments. Thiswas at the early end of the globally agreed timetable, although fullyconsistent with the Basel Committees view that, when they can, bankinginstitutions should comply with the Basel III reforms as soon as possible. Ouraccelerated timetable provoked comment during consultations thatAustralia was over-zealous in its Basel III implementation. We were notalone in that zeal. As we understand it, six other jurisdictions did not avail

themselves of the phase-in arrangements and some of these jurisdictions such as Switzerland (10 per cent) and Canada (seven per cent) set higherminimum common equity requirements for some or all of their banks.

The next key milestone is 1 January 2016, when the capital conservationbuffer is introduced. From that date, ADIs will be required to meet aminimum Common Equity Tier 1 requirement of 7.0 per cent, including thebuffer.

The larger Australian banks have been providing Basel III capital data to theBasel Committee and ourselves as part of a Basel III monitoring exercise. As

at end-September 2012, the weighted average Common Equity Tier 1 capitalratio for the major Australian banks under APRAs requirements was 7.8 percent; preliminary data for end-December 2012 suggest a slightly higherfigure. Hence, these banks have already passed both milestones. Basel IIIcapital data for other ADIs will not be available until after end-March 2013but we have no doubt the data will show that passing the first milestonewas easy and, in all likelihood, so too will be achieving the second.

In APRAs 2012 Annual Report, I commented that APRAs approach to theBasel III capital reforms reflects its firmly held view that conservatismhas served Australia well before and during the crisis, that the milestonesare not demanding, and that the impact of higher capital requirements onthe overall funding costs of ADIs are likely to be small. Developments overrecent months, particularly the reductions in risk premia for major banksand investor enthusiasm for hybrid capital instruments issued by ADIs, onlyconfirm us in that view.

Meeting minimum Basel III capital requirements, however, is only part of aprudent approach to capital planning and management. There are othercritical elements:


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ADIs may be subject to a Prudential Capital Requirement that is higherthan the Basel III minimum, based on APRAs assessment of the riskprofile of the institution;

institutions designated by APRA as domestic systemically important

banks (D-SIBs) will, from 1 January 2016 onwards, also be subject to aso-called D-SIB capital surcharge, that will take the form of CommonEquity Tier 1. I will say a little more about D-SIBs in a moment; and

ADIs also need to hold a sufficient buffer above minimum prudentialrequirements to ensure that they can absorb losses in stressedsituations.

The setting of these buffers is an essential part of the Internal CapitalAdequacy Assessment Process (ICAAP) for ADIs (and insurers). We publishedguidance on this process earlier in the month. In the case of ADIs, APRAexpects a board to satisfy itself that capital buffers and capital targets areset in line with the risk appetite of the institution and take into account theimpacts of severe but plausible stresses identified in robust andconservative stress-testing. A prudent board will also consider otherfactors, such as growth expectations, capital volatility, dividend policy andcredit ratings where relevant. Peer comparisons, whether domestic orinternational, are not sufficient, a lesson learned in the crisis.

In short, the appropriate level of capital that an ADI targets and seeks tomaintain is a more nuanced and forward-looking assessment than a focus on

minimum prudential requirements would suggest. This needs to be keptfront of mind when siren calls for share buy-backs, special dividends orhigher dividend payout ratios get louder. And they surely will!

The Basel Committee has developed a standardised disclosure template thatis intended to address concerns about the international comparability ofregulatory capital ratios. APRA will be consulting on this template shortly.We have expanded the template so that users will readily be able toreconcile the capital position of ADIs under APRAs requirements and underthe so-called harmonised Basel III requirements.

The disclosure template focuses on the numerator of the capital ratio. TheBasel Committee is currently undertaking a substantial exercise on thedenominator the measurement of risk-weighted assets aimed atensuring consistent implementation of the full Basel capital framework,including Basel II and Basel II.5, so as to maintain market confidence inregulatory ratios and provide a level playing field. The exercise includeshypothetical test portfolio analysis designed to identify areas and sources ofmaterial inconsistencies, on both the banking book and the trading book,across banks and jurisdictions. Preliminary findings for the trading bookwere published in January this year.

The remaining component of the Basel III capital reforms is the leverageratio. This is a simple, transparent ratio that is intended to help contain


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the build-up of leverage in the banking system and to provide additionalsafeguards against model risk and measurement error. The BaselCommittee is currently finalising the specification of the leverage ratio andassociated disclosure requirements; when it has done so, we will begin ourconsultations. We have time on our side here. Under Basel III, the leverage

ratio is not scheduled to migrate to a Pillar I requirement until 1 January2018, but disclosure requirements will come into effect from 1 January2015. We are now in a parallel run period.

Basel III liquidity reforms

Let me turn now to the Basel III liquidity reforms. The centrepiece of thesereforms is two new global standards, which seek to promote strongerliquidity buffers and a more sustainable maturity structure of assets andliabilities. Most attention has been directed to the Liquidity CoverageRatio. This aims to promote a banks short-term resilience by ensuring that

it has an adequate stock of unencumbered high-quality liquid assets (HQLA)that can be converted into cash easily and immediately in private marketsto meet its liquidity needs under a 30-day liquidity stress. The LCR rulestext was first published by the Basel Committee in December 2010 and,following further assessment ofthe LCRs calibration, was revised in January2013.

The revisions include an expansion in the range of assets eligible as HQLAand some refinements to the assumed inflow and outflow rates. They alsoinclude a revised timetable allowing a phase-in of the LCR.

Our consultations on the revised LCR will commence shortly. We havealready been offered advice that APRA should adopt the revisions withoutdemur, although it is not always clear that commentators have fullyunderstood the Basel III rules. There is devil deliberate devil in thedetail!

Take the expansion in the definition of HQLA. The revised Basel III rulesgive national authorities the discretion to include certain additional assetsin a new Level 2B category, provided they fully comply with the qualifyingcriteria. These assets are residential mortgage-backed securities (RMBS)with a long-term credit rating of AA or higher; corporate debt securities

with a long-term credit rating between A+ and BBB-; and a selection oflisted non-financial equities. But note the qualifying criteria, which arefundamental and tight: these assets should be liquid in markets during atime of stress and, ideally, be eligible for use in central bank repooperations.

The argument is being put that if APRA were to designate particular types ofassets as eligible HQLA, this would encourage depth and liquidity in themarkets for these assets. The designation would be self-reinforcing, so tospeak. That may well be the case over time. However, the Basel III rulesdo not reward wishful thinking; they require national authorities toacknowledge the facts. Australia has been through the live stress of the


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global financial crisis when financial markets were severally disrupted attimes and the behaviour of financial assets during this period will be acritical factor in our assessment of HQLA eligibility.

There is more to this story, of course. Some types of debt securities in the

list of potential Level 2 assets are eligible collateral for the CommittedLiquidity Facility that will be provided by the Reserve Bank of Australia aspart of Australias rather unique LCR arrangements. These include RMBSrated AAA or higher and some corporate debt securities. ADIs with access tothe Facility will no doubt hold these debt securities as part of a well-diversified liquid assets portfolio, even if the assets do not qualify as HQLA,and that may in itself encourage market depth.

Next, take the revised timetable allowing for a phase-in of the LCR. TheLCR will be introduced as planned on 1 January 2015, but the minimumglobal requirement has now been set at 60 per cent and will rise to 100 per

cent over the following few years. Note, this is a minimum requirement andnational authorities have the discretion to accelerate the timetable. Nodoubt, we will again be accused of being over-zealous if we do not adoptthe graduated approach. However, this approach was introduced, in thewords of the Chairman of the Basel Committee, in light of theconsiderable stress facing banking systems in some regions.2 Australia isnot one of those regions. And Australia would not be in the lead here. Onend-June 2012 data, the Basel Committee has estimated that the weightedaverage LCR for a sample of around 200 of the worlds largest banks, on therevised calibration, is around 125 per cent. Only around one-quarter of thatsample could still be below 100 per cent. This convoy has already sailed,and it would hardly be wise to be seen at the back!

The Basel Committee will be refining the Net Stable Funding Ratio, whichaddresses the longer-term structure of bank debt, between now and the endof 2014.

Other major policy initiatives

Very briefly, let me run through the other major initiatives in banking thatare keeping our policy team busy.

Firstly, we are finalising our proposed prudential framework forconglomerate (Level 3) groups. These are groups that have materialoperations in more than one APRA-regulated industry and/or have one ormore material entities operating in non-APRA-regulated industries. Theproposed Level 3 framework consists of four components: requirements forgroup governance, risk exposures, risk management and capital adequacy.Draft prudential standards for group governance and risk exposures werereleased in December last year and draft standards for the other twocomponents will be released within the next couple of months. This has

2

S. Ingves, From Ideas to Implementation, Speech to BCBS/FSI High Level Meeting, CapeTown, 24 January 2013.


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proven a complex exercise with little global precedent to draw on, but thebenefits to Australia of avoiding a so-called AIG problem are very real.

Secondly, we are currently reviewing our prudential standard onsecuritisation, with a discussion paper outlining our proposed reforms

planned for mid-year. As we have foreshadowed, these reforms willinclude:

an explicit framework within which ADIs may engage in securitisation forfunding purposes, without any capital benefit. This will be a simple andstraightforward framework; and

a somewhat less simple method though simpler than currentarrangements under which ADIs can also achieve capital relief throughsecuritisation.

We want to ensure that the unduly complex and obscure securitisationstructures that proved so toxic in securitisation markets abroad do notemerge in Australia and that Australian securitisations are seen as amongstthe simplest and safest structures in the world. Our approach, whichfocuses on the issuer, will naturally take into account the work of the BaselCommittee, which is focussed on the holder of securitised assets and isseeking to make capital requirements for securitisation products simpler,better reflective of risk, less reliant on credit ratings and without significantcliff effects.

Thirdly, but well back in the policy queue at this point, we are beginning

work on implementing the framework for dealing with D-SIBs, as endorsedby the G-20 Leaders late last year. Under the principles-based approach,APRA is required to establish a methodology for assessing the degree towhich banks are systemically important in Australia, publically discloseinformation that provides an outline of the methodology employed andensure that any D-SIB has higher loss absorbency, fully met by CommonEquity Tier 1. We think it important to develop a methodology that will notonly help us to identify current D-SIBs but also help us identify banks thatare gaining in systemic importance, and why that is so. The D-SIBframework does not come into effect until 1 January 2016 so, in that area

too, we have time on our side.

finsia leadership luncheon series 22 march 2013.pdf

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