REDESIGNING FINANCIAL REGULATION:
DO WE HAVE ALL THE NECESSARY INGREDIENTS?
WAYNE BYRES
Executive General Manager, Diversified Institutions Division
Australian Prudential Regulation Authority
Paper prepared for the CEDA seminar
Assessing responses to redesigning financial regulation
Tuesday, 22 February 2011, RACV Club
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REDESIGNING FINANCIAL REGULATION:
DO WE HAVE ALL THE NECESSARY INGREDIENTS?
Good afternoon everyone. It is a pleasure to have been invited by CEDA to speak
at an event such as this, and to join two such distinguished speakers in talking
about what is a very important topic.
When I was invited to speak today, CEDA asked me to reflect on a two-part
question:
what initiatives are required to fix and avoid past errors?
and
what initiatives are now required to ensure stable financial markets and sound
regulatory processes in the future?
Now that the worst of the crisis appears to be behind us – albeit that the clean-up
in many countries will be protracted and painful, and we can‟t discount the
possibility of further significant volatility – the latter question is clearly more
important than the former. But on the basis that those who cannot remember the
past are doomed to repeat it, let‟s first consider what‟s been done to try to avoid a
repeat of recent years. Before doing so, however, let me stress that my comments
should be viewed in an international context: they refer to the international
experience of the crisis, and to the shortcomings of the global regulatory
framework. The Australian experience has been a little different, and I‟ll make
reference to issues closer to home towards the end of my remarks today.
Responding to the past
Perhaps needless to say for a crisis of the size of the GFC, there was no single
cause. Rather, a combination of factors came together - gradually and subtly - to
create, and compound an increasingly unstable and unsustainable situation.
Broadly speaking, these factors were:
1.
Misaligned incentives. These were primarily created in the private sector
(eg rewards for volume rather than quality of loan underwriting), but some
emanated from the public sector too (eg incentives to provide finance to those
who had previously been, and in many cases still were, unable to afford it).
2.
A failure of market discipline. Markets failed to keep the incentiveencouraged poor behaviour in check: even with incentives to write poor loans,
they could not be written in such huge volume unless investors agreed (due to
ignorance, greed, and the opacity of structures) to keep funding them.
These two failings allowed the heart of the problem – poor credit underwriting
standards – to take root.
3.
Weak regulation. Regulation did not manage to fill the gap create by the
absence of market discipline; indeed, in some areas effective regulation was
dependent on market discipline working.
Amongst other things, global
minimum capital requirements were set too low, and global liquidity
requirements were non-existent.
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4.
Poor supervison. Notwithstanding (or perhaps because of) the weaknesses in
regulation, many supervisors did not detect - or if they did, chose not to act on
- the build up of risks in the system.
5.
The absence of robust bank resolution regimes. This was certainly not a
cause of the crisis, but there is no doubt that the inability of regulators in
many jurisdictions to remove a bank from the system in an orderly fashion
exacerbated the crisis when it was near its peak.
So, in examining the regulatory response to the crisis, our first step should be to
see how well we have responded to these five factors.
Most obviously, there has been a major reform of the regulatory framework for
banks. The simple term 'Basel III' belies the breadth and depth of the regulatory
reform initiatives. Given the time available, I won't say too much more about
Basel III, other than to outline its key features:
a substantial increase in minimum capital requirements (minimum equity
requirements are being increased by a factor of 3-4x in many countries);
a considerable strengthening of the quality of capital (which has the effect of
increasing the minimum requirement even further);
introducing a formal corrective action regime into the capital framework (in
the form of the capital conservation buffer);
introducing a macroprudential component into the framework (in the form of
the countercyclical buffer);
introducing a simple leverage ratio as a backstop to the risk-based regime;
and
(last, but definitely not least) introducing the first global liquidity and funding
standards.
It is, by any measure, a substantial set of reforms which will significantly
strengthen the financial soundness of the banking industry. APRA is committed to
implementing Basel III in Australia, at least as quickly as the international
timetable provides for.
But with all the focus that is currently on Basel III, it is important to ask what else
is happening, since we can't and shouldn't rely on capital and liquidity regulation as
a panacea for all ills.
Supervisors are now putting much more effort into the development of recovery
and resolution plans (or so-called „living wills‟) by banks. These plans force banks
to face up to the potential for their own demise, and to ensure their break-up and
wind-down can occur in a (relatively) orderly manner. Banks that are unable to
demonstrate such a plan face higher prudential requirements, or even potentially
forced restructures.
But recovery and resolution mechanisms are not just being left to the banks.
Policymakers are, for example, examining the merits of so-called bail-in
mechanisms for senior debt holders. Bail-in would operate in a similar fashion to a
debt-for equity swap: at times of extreme stress, the bank could be recapitalised
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by writing down, in full or in part, the claims of certain debtholders and providing
them with equity as compensation. Clearly, the mechanics of such an arrangement
are complicated to make work correctly, and there are a range of potential
consequences that need to be carefully thought through, but this concept is
certainly on the work agenda of international policymakers at present.
Higher requirements for capital and liquidity, plus recovery and resolution plans
and bail-inable debt will all go some way to reducing the risk of failure and the
need for taxpayer support. But they cannot guarantee that failure cannot occur,
so work on failure management powers for supervisors and resolution regimes
for banks also remains a high priority reform initiative. Many countries are
rethinking both their deposit insurance and resolution regimes, with major
shortcomings identified during the crisis. In a number of countries, for example,
deposit insurance did not serve to prevent a run on a bank, as it theoretically
should. Depositors felt, quite naturally, that it would be better to have their cash
now than rely on any scheme that did not guarantee immediate and seamless
access to their money. Supervisors also found themselves without an adequate
legal framework for the orderly closure of a failed bank, particularly where that
institution operated across national borders. So work in both these areas is ongoing to see how these shortcomings can be addressed.
The GFC highlighted clear deficiencies in remuneration practices and incentive
arrangements within the financial sector. As I have noted in other fora, some
incentive structures delivered substantial rewards to managers that have not
reflected returns to shareholders. In some cases, taxpayers have been forced to
bail out failing banks, only to see the bailed-out bankers continuing to receive
substantial bonuses.
Clearly, this quickly becomes an untenable situation
politically.
Ideally, the finance industry would have reflected on its own shortcomings and
produced sensible and sustainable remuneration practices for the future. But no
one felt this would occur and so regulators felt the need to step in. And while
perhaps more difficult to engineer than a change to global capital and liquidity
standards – it will be more evolutionally than revolutionary – I don‟t see any
reluctance amongst international regulators to achieve changes to remuneration
practices.
Market discipline has also been recognised as an area for improvement in the
reform agenda. Disclosure requirements are being increased. And regulators are
also discouraging a blind and unquestioning adherence to the opinions of rating
agencies. At its extreme, the Dodd-Frank Act requires the US regulators to remove
all references to rating agencies from their regulatory framework. Elsewhere, the
response is less severe, but directionally the same. The objective of this work is to
promote sound credit analysis by investors, by reducing or removing incentives
within the regulatory framework for the use of ratings as a substitute for proper
risk assessment.
As for the final contributor to the crisis that I mentioned earlier – poor supervision –
it is harder to detail specific improvements. There is no doubt the quality of
supervision has been recognised as an important issue to be addressed in the
aftermath of the crisis.1 But the quality of supervision is extremely difficult to
1
The G20 Toronto Summit Leaders‟ Declaration said “We agreed that new, stronger rules
must be complemented with more effective oversight and supervision” (paragraph 20).
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define and measure, and therefore it has been difficult in the response to the crisis
to recommend specific supervisory responses, other than to urge „more‟ or „better‟
supervision. More to the point, the response to the crisis so far has emphasised
rules over improved supervision, partly on the basis that it is difficult for countries
to police each other‟s supervision of their financial institutions, whereas consistent
rules are relatively simple and transparent to observe. (And making a rule is
relatively costless to government budgets, whereas new supervisory resources have
a clear bottom line impact.2) Overall, this area can probably best be described as
still work in progress, and I will say more about it shortly.
So a lot has been done to strengthen the regulatory system in the face the
shortcomings that the financial crisis revealed. From an Australian perspective, we
do not see there are any major deficiencies within the regulatory framework that
require major domestic policy initiatives over and above that which is being driven
internationally. But, of course, the generals are always said to be ready to fight
the last war: the real question is whether we are ready to fight the next one?
Preparing for the future
The difference between a problem and crisis is often the time you have before it
arrives. If Brisbane had had four months notice of its recent flooding, rather than
four days, there‟s no doubt the city would have been more prepared and the
damage from the floods would have been reduced. Financial crises are, almost by
definition, hard to see coming. Obviously, if we saw them coming well in advance,
the authorities could act to reduce their likelihood and impact.
So in asking whether we are prepared for the future, we need to ask about what
sorts of crises might challenge us. On the one hand, banks conspire to lose money
quite regularly the same old way: pursuing growth and market share by lowering
credit standards. Unfortunately, they often find new means to do it, so it isn‟t
easy in advance to see the same old habits being repeated. And there is always a
cheer-squad telling us “this time it‟s different”.
Keynes noted that a sound banker “is not one who foresees danger and avoids it,
but one who, when he is ruined, is ruined in a conventional and orthodox way with
his fellows, so that no one can really blame him”.3 More recently and more
succinctly, a now ex-banker famously said that „as long as the music is playing, you
have to get up and dance.‟ Unfortunately it is rare, in the bullish environment that
often precedes a crisis, to hear too many people saying „thanks, but I‟ll just sit this
one out‟. That is where prudential supervisors come in. Central bankers are often
This led to the issuance of the Financial Stability Board‟s “Intensity and Effectiveness of
SIFI Supervision: Recommendations for Enhanced Supervision” in November 2010.
2
That is not to say rule-making is necessarily more cost-effective than employing more
supervisors. For example, the Basel Committee‟s Quantitative Impact Study estimated that
the world‟s largest banks would need an additional €577 billion of equity, over and above
that which they held in 2009, to meet the new Basel III capital requirements. Assuming a
cost of capital of 12 per cent, this imposes an additional annual cost on the global industry
the equivalent of asking it to fund an extra 800 APRAs!
3
Keynes (1931) "Consequences to the Banks of a Collapse in Money Values", Essays in
Persuasion, Macmillan, London
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said to take away the punch bowl just as the party‟s getting started. Supervisors
have a similar role: reminding, cajoling and badgering institutions to hold firm to
sound risk management principles and a long-term perspective, despite the
seductive music and attractive opportunities that may be on offer on the dance
floor.
APRA has long been of the view that good regulation and good supervision go side
by side, and that both are necessary for good outcomes. Good supervision, in my
view, involves a high degree of judgement. And exercising good judgement, in
turn, relies on two key attributes: foresight and gumption.
A large amount of work is going on to improve the foresight of supervisors. This is
occurring in both the traditional field of microprudential supervision
(i.e. examining the health and resilience of each individual institution via scenario
and stress testing, improved data collections, increased focus on market-based
information) and in the emerging field of macroprudential supervision (i.e. a more
structured examination of the build-up of vulnerabilities within the financial
system as a whole).
All of these initiatives are designed to give supervisors more foresight: to
understand the vulnerabilities in individual institutions and in the system as a
whole, and to identify from which directions, and in what magnitude, the next
problems might emerge.
But it‟s all very well to spot potential problems – we also need to do something
about them. Here is where a healthy dose of gumption is needed. The definition
of gumption, to me, sums up what every supervisor needs to possess: shrewd
practical common sense, spirited initiative, resourcefulness, fortitude and
determination. In the years leading up to the crisis, it is clear these attributes did
not exist in sufficient qualities within the world‟s supervisory community. For
example, the US Financial Crisis Commission, which recently issued its majority
report, found:
“The captains of finance and the public stewards of our financial system
ignored warnings and failed to question, understand, and manage evolving
risks within a system essential to the well-being of the American public.”4
Of greater note was the specific criticism of those tasked with supervising the
system:
“we do not accept the view that regulators lacked the power to protect the
financial system. They had ample power in many arenas and they chose not
to use it. …. And where regulators lacked authority, they could have
sought it. Too often, they lacked the political will – in a political and
ideological environment that constrained it – as well as the fortitude to
critically challenge the institutions and the entire system they were
entrusted to oversee.”5
I make these points not to blame the crisis on the failings of US supervisors. These
failings would appear to have existed in many jurisdictions. And I certainly
acknowledge that they were, a decade ago, the failings of APRA that were
4
Final Report of the National Commission on the Causes of the Financial and Economic
Crisis in the United States (January 2011), p. vii
5
Ibid, p. xviii
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highlighted by the HIH Royal Commission. Rather, I wanted to make the point that
successful supervision – heading off problems before they become crises – requires
courage and conviction. As the International Monetary Fund noted:
“regulatory reform legislation will not be effective by itself and will require
on-going vigilance and „the will to act‟ on the part of those tasked with
supervising the …. banking system”6
The financial system is weakest precisely when it looks at its strongest: when
credit is flowing, liquidity is abundant and asset values are high. Standing against
the tide in such an environment is difficult: it is often said, and I think it true,
that good supervision is most valuable when it is least valued.
In APRA, we view strengthening supervision as just as important as strengthening
the regulatory framework. Maintaining an interventionist supervisory culture does
not come easily: it requires the right resources, as well as hard work and diligence
by the supervisor, a clear and unconflicted mandate, an acceptance by industry of
the role good regulation plays, and political support for the job being done. In the
post-HIH world, those are things that APRA, thankfully, has not lacked. The
G20 Leaders have now endorsed this sentiment.7
This is important because, notwithstanding the strengthened regulatory
environment, our supervisory mettle will continue to be tested. The likely
operating environment at least for the next few years will likely be different to
that which existed for more than a decade pre-crisis. The danger will be that not
everyone will adapt, or that some will seek to recreate the past, since this will
only be able to be done via increasing risk levels. In Australia, we still see
instances of ambitious return targets and growth aspirations that don‟t seem to
match the underlying environment. We see instances of banks with business plans
founded on market share targets rather than risk-return trade-offs. We see
instances of credit standards reduced because to not do so would cede business to
a competitor. These are, of course, the workings of a vibrant and competitive
market place, but taken too far they are also symptomatic of Keynes‟ sound banker
– if we are ruined, we won‟t be alone. So the supervisor‟s job goes on,
notwithstanding the significant regulatory change.
But in examining the global response to the crisis, and the capacity for the system
to respond better next time around, it is important to ask what exactly has been
done to strengthen the hand of supervisors more broadly? If they failed to act, or
felt unable to act, last time, why will they be able to do so next time around?
What has been done to give supervisors a clear mandate, and strong powers? Is
there political support for the supervisor‟s role as chaperone on the dance floor?
And even if there is now, what ensures it survives once the music starts up again?
There are lots of rule changes being debated and implemented, but it is less easy
6
International Monetary Fund (2010), „United States: Publication of Financial Sector
Assessment Program Documentation - Detailed Assessment of Observance of Basel Core
Principles for Effective Banking Supervision’, Country Report No. 10/121 , p6.
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“ … we endorsed the policy recommendations … on increasing supervisory intensity and
effectiveness. We reaffirmed that the new financial regulatory framework must be
complemented with more effective oversight and supervision. We agreed that supervisors
should have strong and unambiguous mandates, sufficient independence to act, appropriate
resources, and a full suite of tools and powers to proactively identify and address risks,
including regular stress testing and early intervention.”, paragraph 33 of the G20 Seoul
Summit Leaders‟ Declaration, November 11-12, 2010.
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to see how the role of supervisors is being supported and strengthened. This is
something that needs on-going attention in the global debate.
Concluding remarks
Global leaders and international regulatory institutions have spent much of the
post-crisis period devising a new regulatory framework to respond to the
shortcomings identified by the GFC. But strengthening the rules will not be enough
to prevent another crisis. We know that in something as complex and potentially
unstable as a modern financial system, no set of rules – no matter how well
designed – will be sufficient to contain risk to prudent levels at all times. The
mistakes of the past are quite often repeated by the banking industry, but in new
ways and in new forms that rule-makers cannot predict. Supervisory oversight – an
independent pair of eyes focused on long-term institutional soundness – is also
necessary to apply the rules and make judgements about whether risk levels are
within community tolerances.
Efforts are being made within the community of prudential supervisors to improve
the quality of supervision. At its heart, this needs to support two key attributes
that supervisors need to have: foresight and gumption. At this stage, most work is
occurring in areas that will improve the ability of supervisors to see crises coming
and understand their impact, e.g. the emerging field of macroprudential
supervision, and in improved microprudential techniques (e.g. increased focus on
stress testing, better data, and a broader focus on market-based information).
However, while this will take extra resources and skills to put into effect, the
lessons of the crisis are as much about culture and attitude: the key question
remains as to whether supervisors have the gumption to do their job as the
community expects? If not, then not only will we not be prepared for whatever the
future may hold, but we are also destined to repeat the mistakes of the past.
Thank you.