Senator SHERRY —We were discussing the supervision, surveillance, of the larger funds: do you have to hand the number of members and the total current value of assets in those 360 large superannuation funds?

Mr Chapman —Not precisely, but it is of the order of 90 per cent of members and 90 per cent of the assets of the non[hyphen]excluded sector.

Senator SHERRY —You said earlier that there was a reduction in surveillance; it has changed its focus. Have you considered whether in fact the reduction in intensity of examination will add to the possible risk? I ask that question given the growth in
superannuation moneys, the size of these funds and the possible loss to members if something should go wrong in even one of these large funds.

Mr Chapman —The answer to your question is yes. Obviously we would have regard to any change in regulatory approach and whether it would increase the risk. Ultimately, it is a balancing exercise, and what we decided to do was to trial this approach for the top 360 and see how it went. If we find, in looking at those funds, that there is a problem with one of those funds, it obviously gets examined more intensively. One of the reasons why we do what I indicated before, which is to have a look at a particular area in detail in most cases, is to test some of the assertions that might be made from what could otherwise be called a superficial look at the top level governance type processes within the fund operations.

To date, we have not seen any indication from our work that this approach is not a viable way to supervise those funds at that end of the market. Indeed, while we see some funds come out of the top 360 because we think they need more intensive examination, we see other funds outside that $60 million benchmark which are moving into that type of approach because, even though they are smaller, they have the same type of capacity that the larger funds usually have.

Senator SHERRY —Do you often get complaints which, on examination, are valid complaints about the administration of a particular fund?

Mr Chapman —I am not sure I can say whether we often get those or not. Certainly there are occasions when we get a complaint which is valid. Somebody might claim that, when the administrator sent out their annual statement it missed out some contributions from the employer sponsor on their behalf, and when we have looked at that we have found that, yes, there can be problems within the administration systems; that it is a systemic issue. By and large, what we find at the larger end of the market is that there are individual problems as opposed to systemic issues in the way the systems work.

Senator SHERRY —I appreciate the difference. Do you have any data on the number of complaints you receive about particular funds from members of the funds?

Mr Chapman —No. If you were to ask how many complaints there were in relation to fund X, we could determine that because all complaints would go onto the fund's specific file. However, we do not have data across the board on that issue. And I cannot tell you that, in relation to 10 funds, we received 100 complaints.

ACTING CHAIR —As a follow[hyphen]up question to Senator Sherry, what action, if any, would you take if a large fund starts to show poor returns. I presume you do get complaints on that basis. What triggers your action and what is your action, if any, under those circumstances?

Mr Chapman —It would depend on the reason that the returns were becoming poor. The SIS legislative framework provides the trustee with the discretion to determine appropriate investment strategy and so on and different trustees obviously will make different investment decisions. We do not actively monitor a hierarchy of returns to determine whether fund X is an outrider on the majority of funds in their class. If we received a complaint saying that fund X had a rate of return of two per cent, which the member thought was inappropriate, then the chances are that we would not actively investigate the issue. We would write back to the member and explain the framework and suggest they might wish to take it up with their trustee themselves. If we were to receive a lot of complaints about it, the chances are that we would look at it in the context of discussion with the trustee, but we do not aim to replace the trustee's investment making discretion.

ACTING CHAIR —Where you had, say, a fund that was very poorly performing, apart from discussions with the trustees, really there is nothing much more you can do—is that correct?

Mr Chapman —It is not a regulatory issue in that context, Senator.

Senator SHERRY —Just following on from Senator Parer's question, if it was a shocker—in the current environment, for example, a shocker would be a negative return—would that set alarm bells ringing for you to at least carry out some—

Mr Chapman —Yes.

Senator SHERRY —Because it may be an indication of something other than just poor investment.

Mr Chapman —The answer is yes precisely for the reasons you have outlined, Senator. If somebody is way out of the water, particularly in a negative return context, then the chances are that there is something else anomalous with the operations.

Senator SHERRY —Given SIS and given a trustee's obligations, if they spread the investment, which a large fund does—all funds should do that, but the reality is that large funds spread the investment—it would be extraordinarily difficult, I would have thought, to have a negative return in the current environment.

Mr Chapman —I would have thought so. The other issue with this, too, which could muddy the waters somewhat, is that, as investment choice comes in more prevalently in the larger funds, there will be differential earning rates within the fund. I am aware of one large fund where their high growth option has actually earned less in the last 12 months than their intermediate growth option. And I would expect that to create some enquiries and complaints, concerns, being raised by membership—particularly those in the high growth category—but there is nothing inherently wrong in the result.

Dr Roberts —Senator, we have also taken the view that, because superannuation is long term, a one-quarter or one-year return is not necessarily the issue and we require a five-year rolling average return on the annual statement. So because markets go up and down, I think you would be wanting to look at the average kind of result quite often.

Senator SHERRY —I think we would all appreciate the reason for that, but I am not sure some members do, and particularly in a phase[hyphen]in period, there has been a tendency towards investment choice spreading very rapidly. Certainly in the first couple of years, you do not have a five-year average return and it is quite possible, given what Mr Chapman has said, for a high return fund to actually return less in the initial stages than a so[hyphen]called lower risk, lower return option.

Senator Kemp —Just to clarify the point, if you think the performance of a large fund is completely out of kilter—to pick up Senator Sherry's point—and if it was making very poor returns in a market which has generally been a pretty buoyant market and good for investment, does that trigger a further inquiry or not?

Mr Chapman —It would trigger further inquiry in terms of whether the trustee has properly considered their investment strategy and whether they believe the strategy they have actually has the long-term benefits. Again, I have knowledge of one particular fund, using exactly the same strategy that they used last year. They are outperforming their cohort, whereas the strategy last year underperformed the cohort. It is simply the timing in the market. It is their strategy versus the timing and the movements in the investment markets. The answer would be, yes, we checked that back to the section 52 covenant in SIS: have you and the trustee both properly considered this and do you believe it is appropriate?

Senator SHERRY —We have had a discussion and questions about larger funds. In regard to smaller funds, you have mentioned earlier that resource allocation is being shifted to smaller funds. Why is that?

Mr Chapman —Because it is in the smaller funds we generally find greater weaknesses in terms of administration systems. You made a comment earlier about investment spread. You can get a decent investment spread in a small fund if you invest into a collective investment operation. However, a lot of trustees of those funds tend to want to do it all themselves. They tend not to be big enough to be able to afford full-time advice or appropriate advice. These are all broad sweeping statements, I realise.

Senator SHERRY —I understand that you have got to generalise.

Mr Chapman —They have more of a tendency to not be big enough to be able to run themselves as appropriately as the larger funds.

Senator SHERRY —Has there been a contraction in the number of smaller funds?

Mr Chapman —Yes.

Senator SHERRY —Since this has been in operation, given your shift in—

Dr Roberts —Can I just clarify that: small funds, excluding the under fives, because what we have actually seen is the growth of the rationalisation in the middle, not the tail. So the under[hyphen]fives are increasing; the large funds are increasing.

Mr Chapman —I am looking forward to 1 July when the really small funds hopefully go to the tax office.

Senator SHERRY —That is another issue. We have looked at it in another committee. We are talking about the middle range funds; let us use that terminology. This is perhaps a good point five years on from SIS and given your shift in surveillance. Could you provide us with a list of the number of funds where the trustees have had to be replaced, the number of members that either in part or whole lost their moneys or where there are still disputes going on about the outcome of what has happened to the moneys, and a very brief synopsis of the reasons for the fund failures?

Mr Chapman —I cannot answer the specifics, but there have not been that many. No, that is not true. There have been quite a lot because of the ASN situation. If we treat that as one group, off the top of my head, there have been less than 10 in total.

Senator SHERRY —Would you explain the circumstances in respect to ASN, so that the information you provide does not give a wrong impression? I do not know where this is and I do not want to be impractical in terms of loading you with work, but if you have any comparative international data with the UK or perhaps the US that is easily obtainable, I am interested in getting some international comparison of large[hyphen] and medium[hyphen]sized funds. We do have some problems, but fortunately very few in this country.

Dr Roberts —I do not think it is easily obtainable. The systems are highly different in every country, including the taxation and social security arrangements. The only area where there would be a figure, because it is such a well[hyphen]known case, is the pensions mis[hyphen]selling in the UK. That was really not a prudential issue; that was an advice issue. We have always been unable to make comparisons with other countries because the basic systems are dissimilar.

Senator SHERRY —I am familiar with the mis[hyphen]selling in the UK, but I think it is more the area of theft, fraud and fundamental failure of trustees. I think you are right that the UK is probably the only comparable country, putting aside the mis[hyphen]selling problems that occurred.
It is that theft, fraud and failure of the trustee system where it would be interesting to have some comparative data. I would understand that it would be difficult to obtain.

Switching to another issue, the Sunday Mail of 14 March reported that APRA had begun an internal investigation into the dealings of its Brisbane staff with a financial services adviser. Can you briefly outline whether there is any substance to the allegations made in the Sunday Mail and, if so, what aspects are being investigated?

Mr Karp —An independent investigation has taken place. We have given the staff involved, and the staff who are investigated, a chance to respond to that investigation. We are now in the process of making final decisions about the steps from here. Essentially, the outcome is that there are no major findings of any improper conduct from that investigation.

Senator SHERRY —That was carried out by Clayton Utz?

Mr Karp —Yes.

Senator SHERRY —Clayton Utz carried out the investigation. Were any other firms asked to carry out an investigation? Was there a tendering process?

Mr Karp —There was not a tendering process. A few other parties who do this type of work at relatively short notice were considered and approached. Clayton Utz were chosen because it was judged that they had the capacity to undertake the task, but they could also undertake it within the time frame we wanted. Some of the other parties that were approached could not undertake it within the time frame that we wanted.

Senator SHERRY —What was the fee paid to Clayton Utz?

Mr Karp —I would have to take that on notice. I do not know what it was.

Senator SHERRY —This investigation by Clayton Utz has been completed. You said there were no major improprieties coming out of the report. Were there any improprieties? If so, what was the nature of the problem?

Mr Karp —The nature of the problem was allegations of closeness between the Brisbane office staff and the financial service provider, as contained in the article. What did come out of the report was more along the lines of the processes for appointing replacement trustees to superannuation funds needing to be properly documented because there were not any documented processes and a particular process to follow in that situation. The report mainly hinges on recommendations in those areas.

Senator SHERRY —Just going back one step, was the approach to Clayton Utz and to other potential firms to carry out the investigation put in writing?

Mr Karp —I would have to check that myself. I was not personally involved, because it was my area of responsibility that was being investigated. Someone else from the organisation was actually handling that particular process. So I will have to get back to you on that.

Senator SHERRY —Take that on notice. Are new processes going to be put in place in the Brisbane office, or will this report of Clayton Utz be used in respect to the appointment of independent trustees throughout the country?

Mr Karp —We are looking now to reconsider our processes for appointing replacement trustees. We actually do not do it very often, as Mr Chapman's response indicated earlier, but we are looking at that and picking up recommendations out of the report. It is quite possible that we will actually come up with processes for the organisation to use right around the country whenever this need for a replacement trustee comes up again.

Senator SHERRY —Do you have any guidelines at the moment for replacement trustees?

Mr Karp —We do not have any specific written guidelines as to what they should do. The difficulty in this particular arena is that the reason that you want to remove a particular trustee and put another replacement in usually varies quite a bit, depending on the particular circumstance, and you do not do it very often. So it is not that easy beforehand to lay down particular criteria that you want them to meet. For example, if you are looking at a situation where the fund has got into major problems and you really are looking at a wind[hyphen]up liquidation exercise, then you are looking at for the trustee a set of skills that would be different from what might be the case in some other situations.

Senator SHERRY —Can the Clayton Utz report be made available to this committee?

Mr Karp —It was a confidential report to the APRA organisation.

Senator SHERRY —Can it be made available to this committee on a confidential basis?

Mr Karp —I will look into that and take advice on it.

Senator SHERRY —Could you also let us know what the actual improvements in the changes to procedures will be? It may be some time before you finalise that.

Mr Karp —Yes.

Senator SHERRY —Can you advise us as to how the financial services adviser who was mentioned in the Sunday Mail article was appointed as a replacement trustee to the three superannuation funds?

Mr Chapman —I am not quite sure precisely what your question is, Senator.

Senator SHERRY —He was appointed by APRA?

Mr Chapman —Yes.

Senator SHERRY —Who within APRA took that decision?

Mr Chapman —Me.

Senator SHERRY —You did. What process did you go through? Would there have been a recommendation from officers on the ground?

Mr Chapman —When Mr Karp said there are no procedures, there are no procedures specifically for replacement trustees. We do have a formalised enforcement committee procedure which flows up via a recommendation from the officers on the ground. Our legal people get involved in the process, and then the committee considers it and makes a recommendation effectively to me, as the decision maker for most of these things, as to the course of action they believe should be taken. That enforcement committee procedure was followed in this case as well. We identified the problem. We needed to replace the trustee of these particular funds. The people on the ground looked at the options that they believed viable from their knowledge of the local industry. It flowed up through that process and a recommendation was made, which I then adopted.

Senator SHERRY —I can understand that you have got the formal sign[hyphen]off on this. Is it correct that a staff member of APRA resigned after the Sunday Mail article was published? Was it in connection with this matter, the appointment of a trustee?

Mr Karp —A staff member did voluntarily resign after the article came out, and it was in connection with the substance of the article.

Senator SHERRY —Do you know why they resigned?

Mr Karp —They admitted to leaking the information to the press.

Senator SHERRY —Do you believe that the information contained in the press article had substance?

Mr Karp —No.

Senator SHERRY —No substance at all?

Mr Karp —No.

Senator SHERRY —The three superannuation funds included Lifespan Superannuation Fund. At what stage of the process of recovery of moneys involving Lifespan is APRA at?

Mr Chapman —I will have to take that one on notice, Senator. I actually have got a briefing on the three funds concerned. I just cannot recall the details off the top of my head.

Senator SHERRY —If you could take on notice the question in respect to Lifespan. I do not know the name of the other two super funds.

Mr Chapman —Mackay & Allan and Divteed.

Senator SHERRY —Is it the same trustee in all cases?

Mr Chapman —No. It is the same replacement trustee.

Senator SHERRY —Yes. I understand that. They were interconnected in some way, were they?

Mr Chapman —The funds were not connected.

Senator SHERRY —Totally different?

Mr Chapman —Yes.

Senator SHERRY —As you normally get but also, I think, in part because of the publicity in the Sunday Mail , we have had a number of very worried members of the funds contact our offices.

Mr Chapman —I would probably mislead you if I made some comments about individual funds but I know that at least one of those funds has a significant problem in that there are not sufficient assets in the fund to at least pursue recovery. I will provide an answer to the Lifespan question on notice.

Senator SHERRY —And on the other two funds as well. I appreciate the difficulties, but could you indicate some sort of time frame, whether there are legal actions being pursued in respect to the former trustees or administrators, some likelihood—I know this is difficult—of the sorts of moneys that will be recovered, and those types of issues. That concludes my questions. My other colleagues had some questions for APRA after lunch.

Senator Kemp —I think we might as well break for lunch now.

ACTING CHAIR —Yes.

Proceedings suspended from 12.58 p.m. to 2.02 p.m.

ACTING CHAIR —We are considering the estimates for the Australian Prudential Regulation Authority. Are there any further questions?

Senator GEORGE CAMPBELL —Given the passage of the recent legislation in respect to these financial sector reform provisions, what does the APRA board now intend to offer employees coming across from state fiduciary bodies?

Dr Roberts —APRA is currently undergoing an internal restructure into what we call the new APRA. At present the people in the state bodies are entitled to apply for positions in new
APRA—the same as people are who already have transferred. If they get offered a position in new APRA, they will be offered an AWA.

Senator GEORGE CAMPBELL —They would be offered an AWA.

Dr Roberts —Yes. They will be made an offer, and the form of that employment arrangement will be an AWA.

Senator GEORGE CAMPBELL —And that is the only form of employment contract that will be offered?

Dr Roberts —Except for the very senior staff who are on contracts.

Mr Karp —If they do not want to sign up to an AWA, they will be offered the same terms and conditions under a common law type of contract.

Senator GEORGE CAMPBELL —The same terms and conditions that they currently are under, or ones that you have drawn up for the new APRA?

Mr Karp —We are going to be offering people the terms and conditions under the new APRA. If they do not want to accept that, they will be able to remain under the terms and conditions they are currently on, in accordance with the legislation.

Senator GEORGE CAMPBELL —What if a majority of those employees want the certified agreement?

Dr Roberts —The employment conditions in APRA subject to the legislation are a matter for the APRA board, and the APRA board has decided it prefers to have more direct relationships with its staff.

Senator GEORGE CAMPBELL —Who is advising the APRA board in respect of its industrial relations issues?

Dr Roberts —I think the APRA board takes whatever advice it needs from whatever sources. That would be an internal matter for them.

Senator GEORGE CAMPBELL —Is it receiving advice from Mr Ian Douglas QC, for example?

Dr Roberts —I myself am not aware of where they have got advice from but I am aware that APRA has complied with all its obligations with respect to employment under the Workplace Relations Act and the APRA Act.

Senator GEORGE CAMPBELL —That is not quite true. We have had this argument before. I recall in a hearing of the Economics Legislation Committee that we pointed out to you what the workplace relations minister said when the Workplace Relations Act was introduced, in terms of the right of employees to choose what form of contract of employment they want to be under. You are denying the right to choose. I understand that 68 per cent of the employees at APRA have made a decision that they want a certified agreement but that you are refusing the offer to them.

Dr Roberts —We have not seen that petition, Senator. We only have the CPSU's and the FSU's account of that.

Senator GEORGE CAMPBELL —Have you asked them to provide you with evidence of that?

Dr Roberts —We would have expected that, if they thought it was as significant as they apparently do, they would have provided it to us. But we have not seen it.

Senator GEORGE CAMPBELL —Why would you assume that? They stated to you that is what they had. I do not recall seeing anywhere any rejection of APRA of that.

Dr Roberts —The employment arrangements, subject to the Workplace Relations Act and the APRA Act, are the responsibility of the board, and the board has decided that it wants to enter into direct agreements with each staff member. If a staff member does not sign an AWA—and they are not required to—they will be offered the same equivalent conditions under a common law arrangement.

Senator GEORGE CAMPBELL —Explain the difference between the two.

Dr Roberts —The difference would simply be the legal clothing of it.

Senator GEORGE CAMPBELL —It is a bit like saying to a person on Death Row, `You can hang or you can go to the electric chair,' isn't it?

Senator Kemp —No, it is not, Senator.

Senator GEORGE CAMPBELL —The result is the same.

Senator Kemp —It is not the same as that at all—offering somebody a job under certain terms and conditions.

Senator GEORGE CAMPBELL —Tell me what is different, Minister?

Senator Kemp —If you are on Death Row, you are about to be hung. What we are talking about is actually employing someone and providing them with a job—

Senator CONROY —And being hung out to dry.

Senator Kemp —There is nothing like that, Senator.

Senator GEORGE CAMPBELL —Tell me the difference between—

Senator Kemp —I have explained to you the difference.

Senator GEORGE CAMPBELL —the offer that has been made to them, that they can have either an AWA containing certain terms and conditions of employment or exactly those same terms and conditions of employment under a common law contract.

Dr Roberts —My understanding is that there are obligations on the board in the APRA Act and in the Workplace Relations Act, where that applies. In addition, the CEO has signed a note saying that he will comply completely with the letter and spirit of the transfer agreement with the states in regard to the state employees. So APRA is complying with all those obligations. In terms of the kind of agreement it has with the staff, its preference—and the board has a responsibility to determine some preference in these matters—is to have direct agreements with the staff and that they be AWAs. There is a process, via a staff consultative committee, of engaging in discussions with the staff on the content of the AWAs. We understand that—

Senator GEORGE CAMPBELL —Can you explain what the process of discussion is on the content of the AWAs?

Dr Roberts —APRA has a staff consultative committee to handle staffing matters between the staff and the management. That consultative committee has had discussions on AWAs and how they work, what the content should be. APRA is also consulting with the unions on the content of the AWAs. Some modifications have been made as a result of those discussions. So there is consultation with the staff through both the consultative committee and through the unions.

Senator GEORGE CAMPBELL —Can you detail what the nature of the consultation is? Has APRA provided a draft AWA and said, `This is our proposal.'

Dr Roberts —I am not a member of that consultative committee myself. But I understand there have been discussions on the content of the AWA.

Senator GEORGE CAMPBELL —Has Mr Douglas been involved in drafting the AWA?

Dr Roberts —I do not know what advice the board and APRA have had. I think Mr Douglas might be the person who has represented APRA in the commission, but the employment policies of APRA are determined by the board.

Senator CONROY —Can I just return to the point that Senator Campbell asked you about earlier as to who was providing the advice. Has the board been given free advice?

Dr Roberts —I do not know what advice the board has had. My impression is that they have purchased advice from a number of sources.

Senator CONROY —That is a purchase with Commonwealth money, right? This is the Commonwealth parliament. We get to ask questions about where Commonwealth money is spent.

Dr Roberts —We are funded by industry levies.

Senator CONROY —So you do not believe you have to answer a question about who the board is employing—

Dr Roberts —We are accountable to the parliament, which is why we are here. APRA is required under the Commonwealth Authorities and Companies Act to meet a whole range of accountability requirements, including the way in which it spends some money that it uses for operations. APRA is complying with all of those requirements and APRA will produce an annual report.

Senator CONROY —And so, when we ask you who the board is getting advice from, you feel that you are in a position to say, `We don't have to tell you.'

Dr Roberts —I will have to—

Senator CONROY —I am happy for you to take it on notice if you do not know. I am just uncomfortable with the answer `We don't have to tell you.'

Dr Roberts —We can take it on notice.

Senator Kemp —Senator, the officer is unsure.

Senator CONROY —I am happy for him to take it on notice if he does not know, but that is not what he actually said.

Senator Kemp —I think it is fair that if the officer needs to seek advice, particularly as it relates to a board matter, he is quite entitled to do that and he has taken it on notice.

Senator CONROY —And I could not agree with you more. But that was not actually the answer that Dr Roberts gave Senator Campbell initially.

Dr Roberts —I will take it on notice.

Senator GEORGE CAMPBELL —Can you also take on notice whether he has given you advice on the employment framework of the organisation?

Dr Roberts —Yes.

Senator GEORGE CAMPBELL —And whether or not he has a contract with APRA to provide industrial relations advice?

Dr Roberts —Yes.

Senator GEORGE CAMPBELL —Are you aware, Dr Roberts, of any discussions with the Department of Workplace Relations in respect to the employment contract that has been offered in APRA?

Dr Roberts —If there were, I think that would be a matter for Treasury.

Senator GEORGE CAMPBELL —You are not aware of any discussions between the department of workplace relations and the APRA board in relation to industrial relations matters within APRA.

Dr Roberts —I will have to take it on notice.

Senator GEORGE CAMPBELL —You will take that on notice.

Senator CONROY —I understand that APRA will receive a loan of $4 million to cover the cost of integrating the financial institutions scheme that currently provides supervision of credit unions, building societies, and friendly societies at the state level. Can you tell me exactly what is involved in this process and why it costs about $4 million?

Dr Roberts —The $4 million loan here is akin to the $16 million loan which APRA got last year for establishment purposes. It is essentially to integrate the operation of the existing state schemes into APRA, so it is not for anything other than establishment type purposes. It is a loan. Levies from the industry sectors will be used over a three[hyphen]year period to repay that loan. It is meant to be separated out from the intended long[hyphen]term running costs of APRA.

Senator CONROY —Is there an interest figure on it?

Mr Karp —There is, but I will have to take it on notice.

Senator CONROY —Is it correct that, on 1 July 1999, the responsibility for the supervision of excluded super funds comes across to APRA?

Mr Karp —If the legislation gets passed, it will move from APRA to the tax office.

Senator CONROY —From you?

Mr Karp —Yes, from APRA to the tax office.

Senator CONROY —Dr Roberts mentioned APRA gets its money from levies, and you gave us some information on that at the last hearing, so thank you. You gave us some figures on that. Under the new public accounting regime, will these fees when collected go to the government or Department of Finance first before they come back to APRA, or do you keep them direct? How does that work?

Dr Roberts —Because it is technically or legally a tax, the intention was that it would come straight to APRA, but because it is technically or legally a tax, the mechanism, as I understand it, goes straight into consolidated revenue and straight out to APRA.

Senator CONROY —Does APRA expect that it will be able to maintain its level of revenue from fees or levies over the next two to five years? Is it predicting an increase, a decrease?

Mr Karp —The Treasurer or delegated minister determines the levies each year. So there will be an annual process of consultation with industry about the proposed levies or possible levy structures to recruit APRA's costs. Then there will eventually be a final determination by the Treasurer or the delegated minister each year.

Senator CONROY —In the PBS, APRA revenue from sources other than the government shows a decline from about $3 million in 1998[hyphen]99 to about $1 million in 1999[hyphen]2000. Can you give me a bit of run down on what has happened there?

Mr Karp —There are two main reasons for that. The first is that those statements are predicated on an assumption that the government actuary's office which is currently part of APRA would move out of APRA. That has not been finally determined as yet, but that is the base on which the statements are predicated. So there is fee income from the government actuary's office which currently is in that figure.

The other major component is that APRA does have the initial $16 million establishment money and, in the first year of APRA's existence, the initial funding from APRA came from government and the levies went straight back into government, which meant that APRA started up a large bank account and earning interest on the money. With APRA's operating costs during the year and with some repayment of the loan, that bank balance has basically reduced and the interest on that has come down. So that is the other big component in that reduction.

Senator CONROY —Thank you. Going back to clarify a question I asked earlier, I understand the administration of the excluded funds is staying with Tax or going to Tax?

Mr Karp —Going to Tax.

Senator CONROY —The legislation for the second round of Wallis reforms has passed through federal parliament, and complementary legislation is, I understand, on its way through state and territory parliaments? Will building societies and credit unions be transferred to APRA's regulation?

Dr Roberts —Yes, Senator.

Senator CONROY —On 1 July? Is that all on track?

Dr Roberts —As far as I know.

Senator CONROY —I understood there might have been a small hiccup here in the ACT, ironically?

Dr Roberts —We are working to 1 July.

Senator CONROY —Are you ready for the transfer? Is all in place?

Dr Roberts —We are actually attempting with building societies and credit unions, and friendly societies for that matter, to have a staged transition. On the transfer date on 1 July they will come across to APRA—the building societies and credit unions under the Banking Act and the friendly societies under the Life Insurance Act—but there will be mechanisms to essentially preserve their existing rules for the initial period. So while they will come across to our legislative framework, they will continue basically with the same prudential requirements. Some time over the period ahead, in the next two or so years, there will be a process of harmonising the banking, the credit union and building society standards with the banking standards on that side and the friendly society standards with the Life Insurance Act standards. That is a complex exercise, so we did not want to actually do that on 1 July when there will be all sorts of other changes occurring.

Senator CONROY —Are there any specific organisational changes? You have mentioned the new APRA and whatever—how are you bringing it together? Are you just putting it there and restructuring over here and then bringing it in?

Dr Roberts —I do not know. Les might want to talk about our new divisions.

Mr Phelps —Senator, we are moving ourselves into a new structure. At the moment, my banking supervision people from the Reserve Bank stay together and Mr Karp's insurance and superannuation people stay together for this first year. But from 1 July or soon thereafter, as we get people into their positions, we will have a division which looks after conglomerates
and internationally operating organisations. That will be across banking and insurance and superannuation. That is the division which Mr Karp will look after; I will look after the other division which will be essentially organisations which are only in deposit taking, only in general insurance and only in superannuation. They will essentially be large numbers of smaller domestic institutions. Everybody in the organisation will have to think across banking, insurance and superannuation. There will not be any splits along those lines, except in the policy areas where the different acts will continue to be the cornerstone of what we do. So they will have to have banking experts and insurance experts in the backroom, if you like. But the people on the ground will be going and visiting a superannuation fund one week and a credit union the next week, and they will become experts in inspection.

Senator CONROY —Is it possible to get a flow chart or a breakdown? Not right now, but just on notice, and if you can forward it to the committee. Also on notice, would APRA provide the committee with the list of the new bodies coming under its prudential legislation. I am sure it could be quite long.

Mr Karp —Sorry—new institutions?

Senator CONROY —Yes, new bodies coming under its new prudential regulation—the life insurance ones coming across. If it is huge, like thousands and thousands, let us know.

Mr Karp —It is hundreds—

Dr Roberts —We will provide it, Senator. As a result of the negotiations over the legislation in the Senate, they will actually be published on transfer date or the day before transfer date. I think broadly there are around 270 credit unions, around 20 building societies and around 80 friendly societies that will come to APRA. It is a bit of a moving feast until closer to the transfer date; but we will provide those names.

Senator CONROY —When do you anticipate entering the MOU with the ACCC?

Dr Roberts —In the next few months, I would say.

Senator CONROY —You can take this on notice, if you like. I was interested in which issues it will cover. If you are able to rattle them off, go for it; but if you want to take it on notice, please do.

Dr Roberts —I think the major issue following the transfer of business legislation will be the basis on which the ACCC would like to be consulted from its merger point of view when there are proposed transfers of business arising. There may be other issues that arise as well. Generally, the MOUs that we have with other agencies in the portfolio—ASIC and the Reserve Bank—pretty much follow a standard form of setting out the respective responsibilities of each agency because they have changed post Wallis slightly, and then the processes by which the agencies will exchange information and liaise. So I expect it will follow that kind of format.

Senator CONROY —Are they public documents?

Dr Roberts —Yes.

Senator CONROY —When you get it signed in a few months if you could forward the committee a copy, out of interest, that would be helpful.

Dr Roberts —Yes.

Mr Karp —They are on our web site, if you want access to them directly.

Senator CONROY —Yes. Tragically, I am computer illiterate. I am sure someone in my office would be able to access your web site, but I would not.

Senator Kemp —But you can read and write though.

Senator CONROY —I can count, which is the most important thing.

Senator Kemp —I had heard that is the one thing you have going for you.

Senator CONROY —When does APRA anticipate finalising the transfer rules required for voluntary transfer from the financial sector transfers bill?

Dr Roberts —In the next couple of months. There is a draft that I think you have probably seen, and we are getting comments on that draft. It is something that ASIC also has an interest in. Building societies, credit unions and friendlies were entirely—both from a corporate governance and a prudential aspect—run under the same state scheme, but now that has being split. After transfer date the corporate governane aspects corporation will go to ASIC, prudential elements go to us, and some of those elements are a bit along the blurry line. The transfer rules are in that category, because they are dealing with the just terms of the transfer and ensuring that there are just terms. I think ASIC has an interest in those, as well as us. There is a draft that is around at the moment that we are really waiting to get comments on before we finalise them.

Senator CONROY —Last month at the launch of KPMG's financial institutions performance survey, Mr John Buttle, who is chairman of the KPMG financial services' industry group, was reported in the press as stating that the booming Australian banking sector has built its remarkable growth on fragile foundations. He added that:

Australia's banks had become reliant on asset growth and credit quality for sustained performance and that any significant rise in interest rates would pose a serious challenge to banks' outlook.

Do you share this concern?

Mr Phelps —No, I would dispute that. Asset growth has been around the nine per cent or 10 per cent per annum mark in the last few years. There has been, in the last year or so, quite a strong growth in personal loans for reasons other than housing. It is a bit hard to disentangle how much of that is being encouraged by credit card bonus points and all this sort of thing, but we are watching that closely. The ratio of impaired loans to total assets was, at the peak of our worries in 1992, about six per cent and it is now about 0.6 per cent, which is quite low by international standards. On our visits to banks we have something to nag people about—their credit processes, and whether they could be improved in this direction or that direction—every time we visit somebody. Banks complain that we keep moving the goal posts. There is nothing coming through which suggests that there is a fragile situation there or that credit standards are being reduced.

Profitability and return on equity has many facets to it. Capital is being very tightly managed so the equity part of the return on equity is not any bigger than it needs to be by our standards and by the banks' own judgments. There has been some growth in non[hyphen]interest income which gets reported on quite widely every time banks publish their reports—that their income from sources, other than interest income, is growing quite solidly. That is coming from their funds management activity and partly from their fees and charges on their accounts, which we all follow personally. It is not our prudential job to follow that particularly. There are many sources for the strong profitability of the Australian banks but we do not judge that taking risk on credit is a part of that.

Senator CONROY —There are a lot of critics around in terms of the banks' profits. I think I have probably been one of the voices occasionally talking about the levels of bank profits. Would you agree it is only loan growth and the focus on the fees and charges area that have enabled them to increase or do you think it is broader than that?

Mr Phelps —Their international operations have varied. Two of the banks now receive half their income from outside Australia. The ANZ actually reported some losses with its trading activities but international operations seem to have been quite profitable in the last year or so. It is too varied between banks to generalise. Banks that can return 17 per cent on equity are doing very well.

Senator CONROY —They are doing very well by any historical standard, which is a point I make each time I meet with them, and they regularly complain to me about making that comment. It is fairly well known around the market that St George's merger with Advance Bank has not proceeded quite as smoothly as they would have hoped, particularly when it came to the IT integration. There were some instances where cards of St George Bank customers were captured by ATMs. When a situation such as this occurs does APRA seek an explanation from the bank as to the progress?

Mr Phelps —Yes. That is part of going into a merger. There have not been that many of them in Australia but when a merger like that occurs our level of reporting increases, our level of contact with the institution increases. It is quite usual for us to say that during a period in which you may be vulnerable to systems and problems you should maintain a minimum capital ratio which has a bit of a buffer above the eight per cent which normally applies in general circumstances. We get reporting on each step of the way in that integration process.

One of the problems was that the Advance Bank had the Bank of South Australia merger not long prior to that, so there were essentially three systems within the organisation to be put together. When the first two of the three were put together there were some problems in St George branches and we received a very thorough briefing on how that was going to be done better the next time. While some cards were swallowed this time, there certainly was not the disruption there was the first time around.

Senator CONROY —Does APRA actively seek information when banks lose significant funds due to exposure from failed projects such as Loy Yang A investment in the Latrobe Valley?

Mr Phelps —We would normally seek comment and be closely involved in anything that was material. Defining where materiality is in, as we have just discussed, banks that make over $1 billion a year, how much has a loss got to be before it is something which the supervisor—

Senator CONROY —The Macquarie Bank and ANZ Banking Group underwrote Horizons $335 million investment in Loy Yang B. The Loy Yang partnership, which is 25 per cent owned by the Horizon group, last month missed a payment for its subordinated debt.

Mr Phelps —As I understand it, that is not a default situation.

Senator CONROY —I do not think I was suggesting a default.

Mr Phelps —It is a situation which would go into close watching and it is certainly something which I have had reports on from my staff.

Senator CONROY —That is what I am trying to ascertain. That is the sort of level we are talking about where you guys would be getting extra contact, getting extra details.

Mr Phelps —Yes.

Senator CONROY —Obviously there are two banks there with some exposure to that transaction. What is the likelihood that this investment will remain a cause for concern? Have you got any indications?

Mr Phelps —No, I do not—

Senator CONROY —If you do not want to comment, that is okay.

Mr Phelps —I do not think I can comment on that.

Senator CONROY —I am not sure if you would have any of the information that I am after, but do you know the nature and level of borrowing by the major banks from overseas sources?

Mr Phelps —There are two components to it. Their overseas activities are essentially financed overseas, so a big chunk of their balance sheet is financed in that way from foreign borrowings. But there is also information collected from banks and published in the Reserve Bank bulletin each month of the level of foreign currency liabilities to non-residents. That is something which is in a series which we follow. It is of the order of $90 billion out of a total Australian balance sheet of around the $600 billion mark.

Senator CONROY —Last month, as Dr Roberts and I briefly discussed, you hosted a conference of financial supervisors?

Dr Roberts —Integrated supervisors. With the formation of APRA combining banking, insurance and superannuation, some other countries have done something similar, and the chairman thought it would be interesting to have a conference of these newly integrated supervisors—

Senator CONROY —So it was not a worldwide international conference?

Dr Roberts —No. There are about 13 in this category, essentially defined as a `supervisor' that covers banking and insurance. Out of that 13 there are some quite big countries and quite small countries.

Senator CONROY —Is it possible to get a list?

Dr Roberts —Yes, certainly.

Senator CONROY —I am happy for you to take it on notice.

Dr Roberts —Yes. But it includes the UK, Canada, Korea.

Senator CONROY —What were the key issues that came out of the conference?

Dr Roberts —The issues were partly to get together with the other supervisors and to see what common problems and common interests people have and how they have handled those challenges. Some of it was on internal organisational matters—how you structure the organisation—

Senator CONROY —Lots of advice on AWAs, was there?

Dr Roberts —No, I do not think there was any discussion of industrial relations. There might have been passing references from time to time from some countries about the extent to which unions influence their recruiting, but it was not a major topic.

Senator CONROY —What were some of the major problems that others advised you of, other issues that you guys perhaps are going to face?

Dr Roberts —One of the big issues was how do you integrate the various cultures you inherit and how long should you remain with a sort of silo structure that most integrated organisations start with where you have everyone under the one banner or shingle but, within that, you have the banking people separate from the insurance people separate from the pensions people or whatever—the difficulties of how you go about merging those cultures and practices. There were issues about recruiting and issues about harmonising legislative prudential standards.

Senator CONROY —Is there a summary being prepared? Is there a summary that you would be able to supply to the committee—just out of interest?

Mr Phelps —Yes, a summary is prepared.

Senator CONROY —If it is confidential, that is okay. If there is one that is able to be released to the committee—

Mr Phelps —It is being prepared for our board with a recommendation that it should be made public.

Senator CONROY —If the committee could be forwarded a copy, that would of value. Where are we at on the debate of regulation of hedge funds? Where has that got to?

Mr Phelps —Various international groups are looking at the subject from the perspective of how disruptive hedge funds can be to domestic financial markets and the fact that they are able to gain so much leverage encouraged by the fact that banks were willing to lend them money without applying the same strict conditions that they might apply to others. Various papers have come forward on the question of banks, particularly US banks, being excessively generous in their lending habits to these organisations. They really boil down to: if they had obeyed their own rules, they would not have done it. So it is essentially about not falling for the halo effect of these customers. They might seem to be very clever, but you need to apply the same rules to them as you apply to anybody else. So that is the sort of message which is coming out on the banking side. But the question of whether hedge funds should be controlled because they have an unfair ability to damage local foreign exchange and interest rate markets is one that is still being actively pursued in the international arena.

Senator CONROY —What is APRA's position?

Mr Phelps —APRA had no reason to believe that Australian banks had any large exposures in this area but did very quickly check with them all to see what their exposures were, particularly to long[hyphen]term capital management, and found that the exposures were generally zero to small in the context of banks which have nearly $10 billion capital each. There were numbers around the $50 million mark. But my understanding is that those exposures have now been reduced. They were only short[hyphen]term exposures anyway, and they are back to near enough to zero. Any new facilities to hedge funds are really being put through the wringer to make sure they comply. So it was not really the issue, as the US banks had, that some of them were so exposed that the decision was taken to rescue this hedge fund for fear of what it might have done to the market if they had been to forced unwind their positions. We never really had anything approaching that here in the first place. But, still, the opportunity was taken to share the international experience with our banks to make sure that they got the good advice that if at some stage in the future they were tempted to relax standards for these types of exposures they should not do so.

Senator CONROY —The Australian newspaper last Thursday reported that the group of eight leading powers will be agreeing to implement laws regulating hedge funds. This report will be released on 12 June, I think. It suggested that a first step would be to force hedge funds to improve disclosure of their finances. Did you see that article at all? If you did not, it is okay.

Mr Phelps —No, I do not recall that particular one, but that would be consistent with the sorts of discussions that have been held. Various international fora have looked at this.

Senator CONROY —You are saying it is consistent. Are we going in the same direction?

Mr Phelps —The Reserve Bank of Australia is a member of one of the more important of those fora, yes.

Senator CONROY —Are APRA directly involved?

Mr Phelps —No, APRA have not been directly involved. The hedge funds which are causing the international concern are essentially very large ones that tend to be registered in places where there is no supervision. We have some funds in Australia which on some definitions could be called leverage funds or hedge funds, but they are not rampaging around the world destroying other people's markets, so they are not in the focus of these sorts of groups. What people have been trying to think is how can you control somebody who is registered in some very small place where they do not have any supervision, and these are the sorts of suggestions that have been put forward.

Senator CONROY —The ASX has been reported as supporting improved company reporting requirements to ensure that the activities of highly leveraged institutions, such as hedge funds, are more easily monitored. The ASX has been quoted as saying that `more detailed and frequent reporting creates a significantly better informed market'. They added that when funds change their investment positions frequently, less frequent financial reports can mislead rather than inform if investors assume that the report reflects the future intentions of managers. Does APRA agree with the ASX in this regard?

Dr Roberts —That probably might be best directed to ASIC, who I think are on after us.

Senator Kemp —They are waiting to come on. So if you can finish your questions here, we can get them to the table.

Senator CONROY —I do not have the source here, but I read recently that the US pension funds are increasing their investment in hedge funds. Have we detected similar behaviour here? Is that something we should worry about?

Mr Chapman —The answer is no. We have not detected similar behaviour.

Senator CONROY —Does it ring a bell with you as well about the US pension funds?

Mr Chapman —I have seen the article, and there have been a few articles also suggesting that some investment consultants in Australia are promoting hedge funds. In the last few months we have made that a mandatory part of our review work for individual funds to actually ask them the question. We obviously ask more than that because a hedge fund can mean lots of different things. The structure is something like: do you use hedge funds and what did you understand by the question? We have not found any evidence that people are investing in leveraged funds of any ilk along the lines of long[hyphen]term capital management.

Senator CONROY —I do not want to suggest that you are complacent in monitoring in this area. I just got the sense from the discussion we have had that we are not really looking to do anything in particular. I am not trying to be unfair.

Mr Phelps —Hedge funds themselves are essentially investment funds. As Dr Roberts just said, we do not have the responsibility for protecting investors' we have only got depositors. From the point of view of regulating hedge funds themselves, to the extent that they exist in Australia, that would be ASIC territory. Our responsibilities then are to look into superannuation funds which might be taking a risk they do not understand by investing in a hedge fund or by a deposit taking institution making loans to or entering into agreements with these hedge funds and not understanding the risk they are taking. We have certainly explored this issue with banks and found no evidence that their exposures to hedge funds were—

Senator CONROY —I appreciate banks saying, `Look, we haven't done anything wrong. Why are you going to give us an extra survey of paperwork or level of complexity to deal with?' I guess we are lucky we lived through the 1980s and hopefully, from the sound of it, banks certainly seem to have learnt their lesson in some ways. But there are always newer and trickier and spivvier ways to try to sell products like these.

Dr Roberts —We have requirements in both banking and superannuation that seek to limit market risk, and derivatives would be an example and it would be similar to where banks are trading over the counter in those markets and where superannuation funds are engaging in derivatives or other products where you can have a lot of risk very quickly. There are already systems in place that we have in the banking system—market risk capital standards, which involve calculations of how much exposures banks should limit themselves to, and risk management statements in the superannuation system. So in a way I think it falls into that generic kind of issue. A couple of years ago it was derivatives; now it is hedge funds. There will always be some sort of exotic or complicated investment avenues where we say to our superannuation funds, `The basic requirement we have is that you shouldn't speculate with other people's money and you shouldn't leverage other people's money and you shouldn't borrow.' Keith might have more to say on that, but that is just one aspect of that.

Senator WATSON —Why don't you have a numerical amount that you limit your derivatives to, as you do in the other areas?

Dr Roberts —On the banking side it is quantified in the sense that we have capital that needs to be held against market risk—being part of the bank's trading book exposures, the losses that could generate. In superannuation, I think the answer to having an amount is that—

Senator WATSON —Or a percentage?

Dr Roberts —One arm to that is not borrowing. The highly leveraged funds are just another example of that, I think. What we really do not want superannuation funds to do with people's money is use it to borrow and leverage up, gear up. So we have a prohibition against that. But we also have a requirement that they have an investment strategy, and the investment strategy should have regard to diversification and diversification means you do not have the fund totally exposed to one investment avenue. I think that is the way we would handle it in superannuation for those two elements—diversification and no leverage.

Senator WATSON —Thank you.

ACTING CHAIR —That completes the Australian Prudential Regulation Authority. We now move to Australian Securities and Investment Commission.

[2.51 p.m.]