Tag: APRA

APRA has published their submission to the Productivity Commission review into Competition in the Australian Financial System.

Their submission focuses on APRA’s role in the financial system, potential indicators of competitive dynamics within the industries APRA supervises and its approach to balancing the objectives of financial safety and stability with considerations of competition and competitive neutrality.

A strong prudential framework contributes to strong financial entities and these, in turn, help create robust competitors and intermediaries that are able to support economic growth and activity, throughout the economic cycle.

Most industry sectors regulated by APRA display relatively high levels of concentration, with a small number of large entities holding a significant combined share of the market. However, industry concentration may not, of itself, be a comprehensive measure of the level of competition in individual markets for financial services products. There appear to be strong indicators of competition in certain financial services product markets, for example residential mortgages.

APRA recognises that its objectives are interlinked, with a strong and stable financial system delivering significant efficiency benefits and the promotion of a competitive financial sector. The efficiency and competition benefits of a stable financial system are not limited to the financial sector but extend to the broader Australian economy.

APRA is of the view that, with the right balance, stability and competition are mutually reinforcing objectives. However, competition can also lead to instability in the financial system and there are times where it is important for APRA to actively temper competitive forces. Periods of excessive and unsustainable competition can result in financial institutions inappropriately pricing risk or unintentionally accepting excessive risk in order to gain or retain market share.

Turning to their specific observations on the banks, they say there has been no material growth in the combined market share of the major banks over recent years. The share of the four major banks as at end-June 2017 was 75.2 per cent, compared with 75.8 per cent as at end-June 2016. Five years ago, the corresponding figure was 74.5 per cent.

Return on equity (ROE) for the banking industry for the twelve months to 30 June 2017 was 11.7 per cent. This remains below the ten-year average of 13.4 per cent (which itself has declined in recent years) and is primarily driven by net interest margins, which continue to be challenged by the low interest rate environment. Margin pressure has eased following recent mortgage repricing actions (particularly on investor and interest only products); however, rising funding costs and slowing credit growth may offset much of the benefit afforded by upwards repricing. All else being equal, increasing regulatory capital expectations will also likely negatively impact industry ROE.

Since the global financial crisis there has been a significant convergence in ADI net interest margins. The net interest margins of other Australian banks (including the large regional banks) as shown in Figure 5 have increased over the past ten years, from 0.8 per cent at June 2008 to 1.6 per cent at June 2017, partly driven by wholesale funding being replaced with cheaper funding as volatility in funding markets has eased. Conversely, the net interest margins of other mutual ADIs have been compressed over the same period, falling from 3.2 per cent at June 2008 to 2.3 per cent at June 2017, driven by a combination of pricing competition in both lending and retail deposit markets

Expense management and efficiency continue to be a focus as both large and small ADIs seek to become more competitive and profitable. Cost to income ratios for the majority of ADIs continue to trend downward. The cost to income ratios of large banks compare favourably to those of peers in foreign jurisdictions.

Large banks are likely to have a strong competitive and information advantage in supplying lending products to these businesses through their ability to cross sell or bundle other banking products, particularly payment systems/merchant terminals and transaction accounts. For many smaller ADIs, offering finance to small and medium enterprises would potentially result in the ADI operating outside tolerance levels established by their own risk appetite. However, as an alternative to accessing funding from the larger banks, small businesses may also access trade credit or asset/equipment finance from specialist companies that are not regulated by APRA to fund their establishment or expansion.

Four observations. First, they should have compared returns and NIM on an international basis. Australian banks are super profitable relative to players in many other countries thanks to weaker competition and the market moving rates together (see the recent mortgage repricing).

Second, we may have better cost income ratios here, but that has more to do with income from superior profits than core efficiency. The cost-income metrics are meaningless in isolation.

Third, the current regulatory and competitive settings still create a significantly tilted playing field in favour of the big four, and the barriers to new entrants are too high.

Fourth, we have strong vertical and cross product integrated (e.g. wealth management, retail banking); financial advice, mortgage brokers, as well as product manufacturing.  This tight integration allows players to control prices and margins. This is a structural problem, which no-one wants to address.

We think APRA have traded off competition in favour of financial stability, which is their primary concern. But as a result consumers and small business customers are paying more than they should for financial service products, which is effectively a tax on all Australians.

Wayne Byers, Chairman of APRA spoke today at the ‘The Regulators’ Finsia event, Sydney.

His specific comments on bank lending practice, in terms of household affordability, benchmarks, pre-existing debt and overrides are important.

Unquestionably strong capital ratios

I’ll start with bank capital.

The quest for an answer to what ‘unquestionably strong’ capital ratios look like has been with us since the Financial System Inquiry (FSI) reported in late 2014. We had been keen to wrap up this recommendation alongside the international reforms we had hoped would emanate from the Basel Committee well before now. Once the Basel Committee’s deadline was missed, we indicated we didn’t think it appropriate to wait any longer to respond to the FSI.

So as you know, in July this year we set out our assessment on how much APRA’s minimum capital requirements would need to be strengthened for the banking sector to have capital ratios that would unquestionably be considered strong. For the major banks, for example, we flagged that we intended to increase their applicable capital requirements by 150 basis points, with a view to having them operate with a Common Equity Tier 1 (CET1) capital ratio of at least 10.5 per cent. For smaller ADIs that don’t use internal models to determine their capital requirements, the increase in minimum CET1 requirements will be less – in the order of 50 basis points. And we set out our expectation that these new benchmarks could be achieved in an orderly fashion by the beginning of 2020, if not before.

This announcement was designed to give the industry greater clarity as to the ultimate destination, and the time they had to reach it. What we haven’t done yet is identify exactly which parts of the capital framework we’ll adjust to deliver this increase. The adjustments – which we plan to say more about around the end of this year – are expected to accommodate domestic measures to target residential mortgage lending – about which I’ll comment more shortly – as well as changes eventuating from (we hope) the finalisation of the outstanding Basel III reforms.

I think our information paper was fairly well understood, but there’s possibly still some uncertainty about the impact of the future changes, and whether this will mean, for example, more capital might be required beyond that needed to meet the 10.5 per cent benchmark. That’s not our intent. If a major bank has sufficient dollars of capital to be above the 10.5 per cent benchmark under the current capital framework, we expect that – all other things being equal – it will have sufficient capital to meet whatever new requirements we implement.

However, its reported capital ratio may well change. When we change measures of capital and risk weights, we’re effectively using a new measurement system. A bank’s underlying position doesn’t change, even though the measure used to signify it generates a different ratio. The best analogy I can offer is when I switch from measuring my height in inches to centimetres: the number I report is larger but I haven’t gotten any taller. So as we revise the measurement of capital, it’s possible that the 10.5 per cent benchmark for the major banks may also change. But what’s important to remember is that that is primarily a difference in the units of measurement, rather than a change to the underlying capital requirement.

Housing lending

In thinking about where and how we allocate increases in capital requirements, we’ve flagged that at least some of it will be generated by addressing the risk in housing loan portfolios. There are two inter-related aspects to this: risk sensitivity (ensuring higher risk lending has appropriately higher capital requirements) and concentration risk (dealing with the dominance of housing lending on the balance sheet of the banking system). That shouldn’t be taken to imply that there will be a dramatic increase in capital requirements for housing lending. But housing is an obvious place to start in delivering stronger capital ratios.

Having said that, we don’t see more capital as the sole means to build resilience in bank balance sheets. We are spending just as much time on the quality of lending, and reinforcing sound lending standards. We do so for good reason. Done well, housing lending can be an important source of stability to bank balance sheets in times of stress. Overseas experience shows us what can happen when done poorly.

Here I’d like to like to make a distinction that will be important for our work in 2018: oversight of lending policies, and scrutiny of lending practices. For credit standards to be genuinely raised, both need attention: policies should be strengthened where needed, but they also must be genuinely put into practice.

Prudent policies

APRA’s oversight of lending policies has involved several steps. We’ve sought assurances from Boards that they were actively monitoring their credit standards. We’ve collected more granular data. We issued industry guidance on prudent mortgage risk management. As the risk environment continued to elevate, we took the somewhat unusual step of establishing specific benchmarks for investor loan growth and interest rate assumptions in serviceability assessments. Earlier this year, we added an industry benchmark on interest-only lending.

Overall, we see these measures as having a positive impact. We’ve seen serviceability assessments strengthen, investor loan growth slow and high LVR lending reduce. New interest-only lending has also fallen, and appears on track to fall below our benchmark later this year. All of these moves are strengthening the quality of banks’ home loan portfolios, in an environment that continues to be one of heightened risk.

Prudent practices

However, firmer lending policies are one thing. What if they aren’t always followed? We’ve therefore looked harder at actual lending practices, seeking additional assurance that tighter loan policies are actually translating into more prudent lending decisions.

While the review process is not yet complete, APRA has three core expectations in this area.

• Firstly, it’s important that lenders accurately assess borrower income and living expenses. Living expenses, in particular, are difficult to measure, and so banks often utilise benchmarks as a proxy where borrower estimates appear too low. In fact, our recent work showed the lion’s share of loans by the larger lenders are assessed using expense benchmarks, rather than the borrower’s own estimates. There is nothing wrong in principle with using benchmarks, provided they aren’t seen as a substitute for proper inquiries of the borrower about their expenses. Benchmarks also need to be genuinely representative, incorporate a degree of conservatism, and responsive to a changing external environment. We still see scope for improvement here.
• Secondly, a lender should have robust controls to check for information on borrowers’ pre-existing debts, to ensure that all debt repayments are accurately factored into loan assessments. Here, the industry has been slow to adopt positive credit reporting, creating a blind spot in terms of sound credit assessments. A move to positive credit reporting is needed to mitigate this shortcoming.
• Finally, there should be effective oversight to ensure that lending practices consistently meet standards, with close management of any policy overrides, and well-targeted assurance processes. Stronger policies mean little if they can be overridden, or if data deficiencies mean compliance with policy cannot be fully monitored.

As I’ve made clear before, APRA’s supervision isn’t about managing conditions in the housing market or house prices; we have a simpler goal of ensuring that core standards stand up to scrutiny, both in policy and in practice. Given the environment that we are in – high house prices, high household debt, low interest rates and subdued income growth – that scrutiny won’t lessen any time soon.

Banking Executive Accountability Regime

I’d like now to turn to the package of measures announced by the Government in the budget to improve accountability in the banking system – now fondly known as the BEAR.

APRA has long had an interest in establishing appropriate accountability frameworks for regulated institutions. Tools to promote this are the standard fare of prudential regulators, and already exist within the Banking Act 1959 (for example, the power to remove and/or disqualify individuals from their roles) and our own prudential standards (in terms of requirements in relation to governance, remuneration and the fitness and propriety of individuals).

Therefore, the BEAR can be seen as a strengthening of the existing prudential framework. Although there are a range of new elements, it is not new territory.

Our existing regime – seen as overbearing (no pun intended) when it was introduced – would now be seen internationally as somewhat limited. APRA has therefore been providing input to Government on the overall design of the BEAR. Changes to the Banking Act will set out the overarching framework, to ensure that it achieves the Government’s objective that the BEAR has ‘teeth’, but it will then be up to APRA to implement the framework through our supervision process. It will also necessitate consequential changes to our supporting prudential standards.

Given the legislation is still being drafted, it is difficult to be precise about how the new regime will work. But the core objective – establishing clearer accountabilities for, and expected standards of behaviour by, senior executives within banks – is difficult to argue against. Indeed, once the new framework is put in place for banks, APRA intends to think about whether some of the concepts within the regime have broader application.

There have been questions raised about whether aspects of the new accountability regime will change the nature of APRA supervision. While our supervisory approach is always evolving, we intend to remain a supervision-led regulator, working to prevent problems rather than simply wait for them to happen and find fault after the event.

If we are successful in that approach, the new powers granted to APRA should only need to be used rarely. That should not be interpreted as saying we would be reluctant to use them. But the goal must be that, with clear boundaries and obligations set out by the regulatory framework, Boards and executives conduct their affairs in such a manner that intervention by APRA is not needed. It is a much better outcome, for example, that Boards hold their executives to account for poor outcomes than have to rely on the regulator to do it for them. My observation is that this has been the experience in the UK, where a similar regime is already in place. Although there are strong powers for regulators if and when needed, the industry has responded by adjusting the way it operates so that the need for regulatory intervention has been quite limited.

Concluding remarks

The three topics that I’ve talked about today are ultimately focussed on one underlying purpose: strengthening the resilience of the banking system. Whether it is in bank capital, the quality of loan portfolios, or promoting better governance and accountability, the objective is to ensure banks are well-governed, prudently managed, and financially sound. Banks that have these characteristics are most likely to meet the needs of the Australian community, through good times and times of adversity. So we see APRA’s ongoing intensive efforts in all these three areas in the year ahead as a very necessary investment for us to make.