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Standing Committee on Economics - 20/03/2015 - Australian Prudential Regulation Authority annual report 2014

BYRES, Mr Wayne, Chairman, Australian Prudential Regulation Authority

GLENFIELD, Mr Stephen, General Manager South West Region, Specialised Institutions Division, Australian Prudential Regulation Authority

LAUGHLIN, Mr Ian, Deputy Chairman, Australian Prudential Regulation Authority

ROWELL, Mrs Helen, Member, Australian Prudential Regulation Authority

Committee met at 09:33

CHAIR ( Mr Alexander ): I declare open the House of Representatives Standing Committee on Economics. On behalf of the committee I welcome the chair and other executive members of APRA here today. I also welcome members of the public and the media. This is our first hearing with APRA in 2015, my first as chair of this committee.

We look forward this morning to continuing our discussions with the chairman and his colleagues on current developments in prudential regulation in Australia and on some of the challenges facing APRA in its oversight of the banking insurance and superannuation sectors. When APRA appeared before the committee last November, a range of significant issues were discussed including governance and accountability in the superannuation industry, stress testing in the banking sector, the future of property lending standards and capital requirements for authorised deposit taking institutions.

The committee is keen to further discuss these areas with APRA today amongst others. It is significant also that the financial system inquiry released its final report shortly after our hearing with APRA last November and made a number of recommendations that would directly impact on APRA's activities if adopted by the government. The committee is also interested in discussing some of the potential implications of these recommendations this morning.

I remind you that although the committee does not require you to give evidence under oath, the hearings are legal proceedings of the parliament and warrant the same respect as proceedings of the House. The giving of false or misleading evidence is a serious matter and may be regarded as a contempt of parliament.

CHAIR: Mr Byres, would you like to make an opening statement before we proceed to questions?

Mr Byres : Let me begin by formally congratulating you on your appointment as chair of this committee. I would like to make a short opening statement to highlight a few important issues that are on our agenda. Given your opening comments, they will probably set the scene for many of the issues that you would like to raise this morning.

When we made our last appearance before this committee, we were still contemplating potential actions with respect to emerging risks in the housing market. Since then we have written to all of the authorised deposit-taking institutions, ADIs, encouraging them to maintain sound lending standards and we have identified some benchmarks that APRA supervisors will be using in deciding whether additional supervisory action such as higher capital requirements might be warranted. I would like to emphasise that in alerting ADIs to our concerns in this area, we are seeking to ensure that emerging risks and imbalances do not get out of hand. We are not targeting house price levels—as I said elsewhere, that is beyond our mandate—and we are not at this point asking banks to materially reduce their lending. We have identified some areas where we have set benchmarks that we think will be useful indicators of where risks could be building and in doing so will help reinforce sound lending practices amongst all ADIs.

We are currently assessing the plans and practices of individual ADIs and over the next month or so will be considering whether any supervisory action is needed. So far, our discussions with the major lenders have suggested they recognise it is in everyone's interest for sound lending standards to be maintained, but we shall see and we are ready to take further action if needed.

Beyond this immediate issue, we are also giving thought to the more fundamental issues in relation to ADI capital contained in the recommendations of the financial system inquiry. There are two key influences on how we will proceed on these issues: first, the submissions being made through the government's consultation process and, second, the work still underway on a number of related issues. In the international standard setting bodies, particularly the Basel Committee on Banking Supervision, helpfully, the FSI and the international work are pointing us in the same direction. There are, however, complexities in the detail that we need to work through carefully. In terms of timing, we do not need to wait for every 'i' to be dotted and 't' to be crossed in the international work before we turn our minds to the appropriate response to the FSI's recommendations. But it will be in everyone's interest if, over the next couple of months, we are able to glean a better sense of some of the likely outcomes of the international work before we make too many decisions on proposed changes to the Australian capital framework.

When we last appeared before this committee we spent some of our time discussing the management of conflicts of interest in the superannuation industry. Since the introduction of prudential standards for superannuation in 2013, APRA has been assessing how well trustees have adjusted to the heightened expectations placed upon them, with a particular focus on conflicts management. The main message from our recent review in this area was that while there have been improvements across the industry and some trustees have established quite good practices, others still have more work to do to meet the objectives of the prudential standard. Unfortunately we still see instances where actual and potential conflicts are viewed narrowly. A minimalist compliance based approach is taken to the design of conflicts management frameworks rather than an approach that seeks to meet the spirit and intent of the requirements. Some trustees also take a reactive approach to dealing with conflicts rather than ensuring regular and appropriate prior consideration of conflicts and a proactive approach to their effective management. APRA supervisors are engaging with the entities that were covered by the review to ensure that appropriate and timely action is taken on any specific issues that were identified. We are also issuing a general letter to industry—in fact, that was issued yesterday—providing the key findings from the review and identifying a range of specific questions for trustees to consider in reviewing and enhancing their conflicts management frameworks. APRA will continue to focus on conflicts management as part of its future supervision activities, and will continue to push the industry to meet the enhanced government's and risk management expectations set out in the standards.

Finally, let me make a quick comment on private health insurance. As you would be aware, APRA is not currently the prudential regulator of private health insurance—the Private Health Insurance Administration Council, or PHIAC, performs that function. But we are preparing to take on that task from 1 July this year, assuming the passage of relevant legislation. For our part, we are working closely with PHIAC and other stakeholders and will be ready to take on these new responsibilities. We are proposing only the minimum change necessary to the prudential standards and rules to align them with the proposed new legislation. In practice, health insurers should notice very little difference in their prudential arrangements from 1 July. Even though the impact of the change may not be particularly noticeable, we would stress that a lot of work has gone into the preparations and it is in everyone's interest that the momentum is not lost. APRA, PHIAC staff and the industry will all benefit from certainty provided by that. With those opening remarks, my colleagues and I are very happy to answer your questions.

CHAIR: Thank you, Mr Byres. Super funds generally report to members a lump sum admin cost. Why isn't there a better breakdown of these costs for members, and what can APRA do to improve transparency? What further powers could APRA have to force greater transparency in this area?

Mrs Rowell : I might take that one, Chair. There have been some changes in the reporting and disclosure requirements that have recently been implemented that will require more breakdown of expenses and publication of more granular information about expenses. Those requirements are relatively new and are still being implemented so at the moment they are not fully in force, but over time they will be. Primarily, disclosure by funds to their members is an ASIC issue rather than an APRA issue but, under the framework introduced from 1 July 2013, there are provisions for alignment between reporting to APRA and disclosure by funds, which is under ASIC's purview. Going forward, when we start publishing the more granular information that is reported to us and the trustees are also reporting that more granular information on their websites, then you will see more breakdown of the components of expenses by funds.

CHAIR: So you are satisfied with this—you do not need any further powers?

Mrs Rowell : That is correct.

CHAIR: Good. Does APRA have a view on how APRA funds are engaging members on retirement income issues; that is, lump sum versus pension?

Mrs Rowell : Again, it is not an area which would necessarily fall under our mandate as prudential regulator. Engagement with funds is really a matter for the funds and, again, to some degree falls into ASIC's purview under the general disclosure arrangements. Having said that, I think APRA's view would be that there is certainly benefit in funds and trustees engaging effectively with their members about the outcomes that will be achieved in retirement and portraying those in income terms. I think that would be beneficial.

Mr HUSIC: Chairman Byres, going to the issue of the macro prudential tools, I note that in early January there were reports that covered the data published by APRA in relation to the growth in bank lending. It looked like lending to investors to buy residential properties, based on what I have seen, jumped by 11½ per cent to $454.7 billion. If I understand correctly, you were calling for a 10 per cent cap on this type of lending and you had indicated that if this were to continue—and you reinforced this in your opening statement, Mr Byres—that there would be further 'supervisory oversight'. Is it fair to say that you are disappointed that the initial steps taken by APRA are not working in the way that you had hoped? Is it too early to make such an observation? If growth continues over the double-digit mark, can you give us a sense of how greater supervisory oversight will translate—because I do not think a lot of people in the general public know or appreciate this.

Mr Byres : There are a few questions there. I will try and answer them in a couple of ways. First of all, you used the phrase 'cap'. We have not used that phrase. It is a benchmark. What we have said is that that will be a trigger for our supervisors to think about whether additional supervisory action is required. Being above that cap is not a breach of prudential requirements in the same way. Other things would generate immediate supervisory action in someone breaching a requirement. It is really trying to be transparent about where our tolerance levels are and where institutions, if they want to operate in particular areas, are more likely to get more intense supervision. That more intense supervision could include a range of things. The issue that is most prominent in everyone's mind is higher capital requirements. That is certainly an obvious tool in the tool kit that we would have to use.

Mr HUSIC: When you say higher capital requirements, do you see that above what has already been flagged?

Mr Byres : Yes. What we are trying to do in our work at present is not just apply higher capital requirements to everybody. There are plenty of ADIs out there, who are lending for housing, who are using quite reasonable serviceability metrics. They are not growing at particularly rapid rates. There is not any obvious cause for concern in their particular business practices and their growth aspirations. It would not be our intent to load any additional regulatory requirements on those institutions for particular concerns in the housing market.

Mr HUSIC: Does that suggest that you would target those lenders?

Mr Byres : Exactly. This would be a bank-by-bank or an ADI-by-ADI type of response. This is not an across-the-board response. We are looking institution by institution at a range of aspects of their lending practices. We are in the process—we have not completed the process—of making an assessment as to how prudent or otherwise their current plans are.

The second point I would make is that I would emphasise the words: 'their plans'. Growth rates are necessarily backward looking. I am not quite sure of the exact source of the numbers you had or which publication they came from.

Mr HUSIC: The report I am referring to is from the article in The Australian entitled 'Surge in housing loans for investors' written by Andrew Main on 2 January this year.

Mr Byres : That was probably based on data that we had published. If it was being published in January, it was probably October or at best November data.

Mr HUSIC: So it was data that was published before our—

Mr Byres : Sorry, it was lending that had occurred before our letter had been issued. You would not expect to see any response in that data—even in the more recent data which has been published. I think the most recent data is the end of January numbers. Much of the lending that has occurred over the period from when our letter went out—which was 9 December—to the end of January—which I am pretty sure were the last public statistics—would have been loans that were approved well before our letter went out. There is a pipeline of lending, and banks cannot just, if—they have given someone approval, revoke that approval.

So what we have been focusing on is less what the current growth number is and much more on what their business plans say they plan to grow at over 2015. It is quite an important point, and it is important to bear in mind as you look at the published growth rates because they are—necessarily—backward-looking. If I use a very simple example: if you take a bank that may have been growing its investment lending 20 per cent last year—so it was growing very quickly—and it decides to only grow that at 10 per cent over the course of 2015, then by the middle of the year it will still be reporting a 12-month growth rate of around 15 per cent—because half of it is 2014 and half of it is 2015. So we need to be a little bit careful about responding to the growth rates that appear in the early part of the year as some indicator of success or otherwise of the discussions we have been having with the banks—because a large part of that growth is historical: it occurred well before we wrote our letter to the industry. Maybe I will stop there.

Mr HUSIC: Following on from that then, Mr Byres: you made reference to looking at the banks; when you take on the individual banks and look at what they are doing, you are going to assess their plans and what they are intending to do in this space. Forgive me for asking the obvious question, but will that also include a review of performance against previous targets? Obviously, everyone's attention has been activated in this space, and you could imagine that there may be a different approach to targets post- your expressed interest versus how things have been managed in times past.

Mr Byres : Yes, that is true. And so it is not just a case of a bank saying to us, 'no need to worry about us; go and look elsewhere because we are going to grow at 9 per cent', or something like that. We are not just going to—obviously—take that, and that is where the matter ends. Obviously, we would be watching over the course of the year that people actually behave in accordance with their plans and expectations and, if there is any deviation from that, then we would be reopening discussions with them.

The other point to make is this is not entirely just about growth rates in investor lending. Also in our letter, we flagged, in particular, serviceability buffers, and making sure that banks are not lending, and customers are not borrowing assuming that current interest rates—which are at record lows—will stay where they are forever. I do not know where interest rates are going to go but the odds are, at some point they rise. And so it would be prudent for both banks and their customers to be factoring that into their planning when they think about what sort of housing loan they can afford. And so, as well as investor growth, we had also flagged serviceability as a key area of our assessment, and making sure that when banks were looking at the ability of customers to pay, they were allowing a reasonable buffer in those assessments so that, should interest rates rise at some point in the future, there is a degree of comfort that the borrowers will be able to meet higher repayments.

Mr HUSIC: In your comments, you indicated that rather than an entire-industry-wide approach, it would be very specific, looking at individual banks' performance. You flagged capital requirements, and I would like to come back to that particular tool. In thinking about this issue, my committee colleagues and I have also wondered about the ramifications for customers. You may impose a particular mechanism on banks, but then there is the flow-on effect of how that might be passed on to banking customers. Has consideration been given to that? What are some of the things that you would be thinking about in that area?

Mr Byres : Yes; certainly we think about those things, and think about what the implications are. Because we are talking about measures that are targeted at individual institutions, rather than across-the-board increases to everybody in the industry, clearly, there will be impacts. It is reasonable to assume they would prefer to avoid any increased capital requirements, if they could. As I said in my opening statement, most of the major lenders certainly agree that sound lending standards are worth maintaining, and so they approach their engagement with us in a fairly cooperative way.

If there were to be one or more institutions where there were higher capital requirements put on them, it would depend a little bit on the magnitude and the way that those requirements were applied. The potential for that to create a higher cost for the customer will depend on, first of all, how material the capital add-on is relative to how much buffer the bank currently has above its minimum requirements. It may be that the bank could absorb an additional capital requirement within its existing buffer, such that its overall funding did not need to change. It would be running at a slightly lower buffer, but it would not incur any costs.

If there were a need to change its pricing or to otherwise respond in that way then, yes, in theory that could be passed onto customers but, equally, there are 160 ADIs out there. It is a very competitive market. That is the whole point. We are paying particular attention to it because the competition is very hot. There would be plenty of choice for customers who were unhappy if any pricing became uncompetitive as a result of any action we took, but I suspect that would be fairly marginal. For most of the banks, given the competition in the marketplace, it would be very difficult for them to just say, 'We can just completely pass on any of this to our customers.'

Mr HUSIC: You are obviously very sensitive to flagging too much but, clearly, there would be acknowledgement of your attendance today and the likelihood that this would be raised. Is the regulator, APRA, only looking at—and I do not suspect you are, but I have to ask the question—capital requirements or are changed cap requirements, targeted on an individual basis, the main lever you seek to exercise? What are the other options, in terms of the suite of macroprudential tools that are attracting your attention, if I can put it in those terms?

Mr Byres : It is probably the main tool, at this point, that we would look at when we were looking at individual institutions. There are other things we can do—just maintain more scrutiny, get extra reporting from them or place some other sorts of requirements on them. The main tool we would use, in this particular instance, would be capital requirements for individual institutions. That is what we flagged in the letter that we wrote to the ADIs, that this would be a key tool in the tool kit.

When we were talking about this last time we appeared before this committee, we talked about this as another ratcheting up of the dial, in terms of supervisory intensity. We will just have to observe how things change and evolve to decide whether something firmer or higher or tougher is required at some point in the future.

Mr HUSIC: What is the time frame that you are looking at when you say you will observe?

Mr Byres : I do not think you can necessarily put a time frame on it. We and the other members of the Council of Financial Regulators are all talking about this regularly. In part it depends on our observation of how banks are behaving and how we see market conditions. If there is a moderation of growth in some of those areas that had been identified in the Reserve Bank Financial stability reviewas emerging imbalances, it may be that no further action is required. If, on the other hand, those imbalances and risks continue to grow, maybe some action is required. But I would be very reluctant to say we will make a decision at a certain point in time. I think it very much depends on observing how the banks and the market more generally respond to a changing environment—not just the regulatory environment but all the other influences on their business.

Mr HUSIC: Given some of the concerns expressed publicly about the recent reduction in interest rates by the RBA and the flow-on effect in particular housing markets—and I note that it is only some of the major cities; this is not a uniform effect across the country—is there a concern that you would need to have your considerations conducted in a much more concentrated time frame?

Mr Byres : No, I think it is helpful that we had done our work—that we had issued our letter in December. Our letter essentially said growth of 10 per cent, which was roughly the rate at which the market was growing at the time we issued the letter. We also suggested that banks should lend with a minimum interest rate in their serviceability calculation of seven per cent, with a buffer of 200 basis points over the current loan rate. That was broadly where the market was operating. We were not really trying to constrain the banks or force them to significantly pull back from the sorts of positions most of them were already in. What we were trying to do was, in a sense, put a floor under lending standards and put some degree of moderation on growth so it did not accelerate. We did not want growth to accelerate or standards to erode any further. It was about reinforcing existing practice. That means, for example, when the Reserve Bank recently cut interest rates, we were effectively saying to banks, 'That will mean your borrowers, on a day-to-day basis, can more easily meet repayments, but you should still be assessing loans on an assumption that interest rates will trend back up at some point.' Yes, perhaps it does add an additional sense of importance to what we are doing, but I am not sure it would necessarily immediately change the timetable we are working on. In fact we have not changed the timetable we are working on.

Mr HUSIC: My last question is a two-pronged one. When you made reference then, and in your comments earlier, about emerging risks, is serviceability one of the emerging risks you are considering in this space? Secondly, are there others that have equal or similar weight in your mind? Finally, in this targeted institution-by-institution approach you have just briefed the committee on, how do you see the notification process working? I imagine that the first bank that gets notified of these changes, once you decide to go down this path, would have a fairly significant look—because the first one out is always the toughest one. How do you see the notification process working where APRA is signalling its preparedness to move on a particular institution? Or will you just do it suddenly?

Mr Byres : No, no, no. There are two questions there. Let me go to your first one, about issues. So, in our letter, I would say we flagged four issues. We flagged serviceability as quite important, and that is clearly important because we are in a very low interest rate environment. Interest rates are historically low, and it is important that people recognise—that both banks and customers remember—that they are historically low and it is highly unlikely that they will stay that low forever. That was a key one. Obviously, we also flagged the strong growth in investor lending as an area where we needed to watch carefully what was happening. The other two which we mentioned in our letter as areas we were watching, because they are traditionally going to be loans of higher risk, are high loan-to-value ratio loans and high loan-to-income ratio loans. In those particular cases, we did not set any specific benchmarks; we simply said we are going to be watching what is happening there. But the high LVR lending, in recent times, has actually come off a little bit. It is not trending up, so it is not obviously a source of concern at present. But we keep a watch on it because, all other things being equal, higher LVR lending will tend to be higher risk. So that was your first question.

The second question was: how are we notifying banks? We are going through a process now where we have collected a lot of information from them. We have a team internally that is coordinating the assessment process because the last thing we would want would be for the results to depend on an individual supervisor acting in isolation. Obviously, we are looking across all ADIs. We are providing them with feedback along the way about whether they have given us plans that we are comfortable with or we have some questions about. So there is an iterative process here. If we get to a point where we are talking to a bank about additional capital requirements, it will not be a surprise to them. The whole point of writing our letter in December and then saying we would be thinking about this in the second quarter of the year was to give them plenty of time to think through their plans, think through their lending policies and make any changes they want to make. It was not going to be a spur-of-the-moment thing that caught them by surprise. There is quite a deliberate process here of allowing us to talk to them, them to talk to us, go through all the nuances and then decide something.

Mr HUSIC: But, while they will know, obviously the market will not. These conversations are clearly happening behind closed doors. It is a different thing once it steps into the public domain.

Mr Byres : When we deal with individual banks, it tends not to get into the public domain. What we are doing here is something that, in this case, is a little more transparent because we think that it is important that all the banks know they are being treated on a level playing field, that everyone is being held to the same standards, and they have visibility up-front about some of the key benchmarks that APRA is going to use in making its decision. But it has been a routine part of our tool kit since APRA has been around that, for individual institutions that have, for whatever reason, higher levels of risk, we have always reserved the right and regularly applied additional capital requirements—to individual banks or other ADIs. That is not unusual and it is not in the public domain. So, in this particular case, this whole exercise is a little bit more transparent because we think there is value in being a bit more transparent about it, but not to the point where we would be telling the market, 'X bank is getting X capital add-on.'

Mr HUSIC: Thanks, Chair.

CHAIR: Thank you. Peter?

Dr HENDY: Thank you, Chair. Sticking with the same issues, if I could, Mr Byres, could we just go back to tors on one thing. Given that we have not had many hearings with APRA, with respect to the housing market could you briefly outline the difference between the RBA's responsibilities and yours, just to get that difference on the record?

For example, in the discussion you just had you talked about the RBA's Financial Stability review and things like that. I just pose that question to you.

Mr Byres : It is probably also worth adding ASIC into this answer, if you do not mind, because I think there are responsibilities of all three agencies. Clearly, the RBA comes at this issue from very much a macroeconomic perspective, as one would imagine. Their responsibility is for the broader Australian economy and, obviously, their interest in issues of financial stability. Our interest comes from the perspective that if they have a top-down perspective, we have more of a bottom-up perspective. So we are looking at individual institutions, at their soundness and, ultimately, their ability to, in the case of banks, meet their obligations to their depositors. We are interested in lending standards because it is very important to make sure that they maintain prudent lending portfolios in making use of depositors money.

Both agencies have a financial stability mandate. The APRA Act says that, amongst all of our various responsibilities, part of our job is to promote financial stability. We do that by, in a sense, making sure that individual institutions remain sound and robust and that, as we spot emerging risks across the industry, we try and respond to them. But there are obviously different perspectives. ASIC does not have a financial stability objective, but ASIC is still interested in these issues because they have responsibility for the legislation in relation to responsible lending. You may recall that the same day we issued our letter to industry on lending practices, ASIC also announced that it was undertaking a review of certain aspects of housing lending with respect to their responsible lending mandate. They were looking particularly at interest-only lending. From a slightly different perspective, we all have an interest in this issue.

Housing is very important for financial stability in this country for the simple reason that the housing loan portfolio is far and away the biggest portfolio on the books of the Australian banks, and the Australian banks are at the core of the financial system, so we all have an interest in this. The work that we are doing is very much coordinated through the Council of Financial Regulators, which, in itself, does not have any authority or powers but is an important vehicle for making sure that the various actions that the regulators are undertaking are coordinated and consistent with the objectives that we all have. Treasury is also part of the council, and so it contributes to those discussions as well. Does that answer your question?

Dr HENDY: Yes. That is very useful. I think it is very useful to get those sorts of things out on the public record. It might have been said in the past, but it can be reiterated. For example, when we have similar public hearings with the Reserve Bank Governor, almost always there is a question about the Reserve Bank's views about a potential for or their perspective on whether there is a housing bubble in Australia. So I will just put that question to you. Does APRA have a view about that from the prudential perspective you have, compared to the RBA?

Mr Byres : I do not know how Glenn answered those questions. I should have read his transcript.

Mr BUCHHOLZ: Very cagily.

Mr Byres : Yes. I can imagine he did, and I will try and do the same.

CHAIR: We want full disclosure.

Mr Byres : Yes. I am not trying to avoid answering the question. Housing price bubbles are actually very hard to define. It is always hard to spot. If you look at the conditions we are in at present where we have very low interest rates, very high household debt, subdued income growth, rising unemployment, very high house prices and a very competitive financial market in terms of housing lending with a lot of people competing for the business, there is lots of potential for risk, and risk is probably higher than it might otherwise be. That is why all the agencies are paying particular attention to it at present. I do not know what a bubble is and I do not quite know how you spot it, but I think all the regulatory agencies are looking at the current condition and saying, 'There is certainly the potential for higher levels of risk in the current environment that we have and so we should be paying extra attention to this issue.' That is effectively what we are doing.

From our perspective, the best way we protect the financial system and the broader economy from any issues in the housing market and any correction in the housing market is to make sure that the banks have been lending on a sensible, prudent basis and are able to deal with any volatility that might occur, be it in house prices, be it in interest rates, be it in whatever it might be.

Dr HENDY: So sometimes you might not know whether there has been a bubble until it has burst?

Mr Byres : Unfortunately, that is true. If these things were easy to spot and define, almost by definition, regulators could deal with them. The fact that they are very difficult to identify—the drivers of economic conditions are always very difficult to be precise about to design regulatory tools to respond mean is that, inevitably, there is a degree of caution about how you jump into these issues.

Dr HENDY: Yes. I would surmise that your December letter is an indicator that there are issues and you have obviously written to ADIs because you want to stay ahead of the curve on this.

Mr Byres : Yes.

Dr HENDY: Following on from what the deputy chair said regarding this issue of transparency and the public interest balance between disclosure of where there might be difficulties. You were discussing your policy of dealing with banks and ADIs, which is that there are capital requirements and, if you see a problem, there is more intensive supervision. I think you described it as notching up the dial. You also said in answer to the deputy chair that, if you did require higher capital requirements—I suppose you would define it in a problem case—you would not disclose that to the market. I think that is what you said. Is that correct?

Mr Byres : Correct.

Dr HENDY: How does that balance work? I want to tease that out.

Mr HUSIC: Especially if you are listing and they have to report. Sorry for jumping in.

Dr HENDY: Say, in ASIC terms, they have to report concrete changes to the market. So there is an actual conflict there.

Mr Byres : There are some competing objectives that have to be balanced here. Prudential regulators are traditionally the people who try to operate behind the scenes—below the surface, below the radar. Financial institutions survive and thrive because they have confidence and the community has confidence in them, and you are happy to put your money into the bank, you are happy to take out your insurance policy and you are happy to invest your superannuation money because you have confidence that, when the time comes, you will get your deposit back, your policy will be paid and your super money will be there.

Unfortunately no institution is perfect, and sometimes issues arise. Prudential regulators tend to try to operate behind the scenes to get issues fixed and to avoid them becoming a source of concern to the community. If we can do that well and head off problems before they become serious problems, that is actually reinforcing of financial stability, because it is preserving the confidence that exists in the system.

As I said in my answer to the earlier question, a tool in our toolkit that we regularly use for banks and insurance companies as well is the capacity, if we see higher risk in an institution—it could be higher business risks or higher operational risks such as shortcomings or weaknesses in their processing capacity or their business continuity plans or whatever it might be—we have the capacity to, and we regularly do, apply some higher capital requirements. We do this for two reasons: one, the basic foundation of capital requirements is that where there is risk there should be capital to support risk, so if we observe higher risk than the general setting of the capital framework, we want to apply some extra capital to compensate for that. Also, the extra capital acts as an added incentive for the institution to fix the problem, because once they fix it we can take the extra capital requirement away again.

We do that; we have done that regularly; but, consistent with the fact that we do not wish to advertise that any financial institution may have some issue that requires our intervention, we do not disclose those things, and within our powers we have the capacity to tell regulated institutions that they should not disclose them as well. We do use that power. We give our regulated institutions some information—for example, our risk rating. Leave aside capital requirements for a minute. We have a risk rating system, where we assign everyone a rating. In the interests of transparency between us and the institution, we tell them what our rating is and why it might be high or low or whatever. We also tell them that that is not to be disclosed to the market, because that is a helpful discussion between us and the institution, but it is probably not helpful if that became generally part of public knowledge.

I recognise that that is something we have to balance with the broader objectives to have transparency. Over the years we have had many discussions with ASIC about how to get the balance right on these things; but we find that our capacity to do these things behind the scenes is a very effective way of getting things dealt with without causing undue angst more broadly.

Dr HENDY: My observation would be that the system has been working very well in Australia, so whatever that art is that you have there, rather than the science, it is working well. That risk rating that you were just talking about that is supplied to the institution—would it be supplied to ASIC, the RBA and Treasury?

Mr Byres : Not in the normal course of events.

Dr HENDY: Just the institution?

Mr Byres : Just the institution. I would not rule out that in a particular case where, for example, we exchanged some information with ASIC on a particular case, that rating might be part of that information exchange. But it is not information that is routinely exchanged.

Dr HENDY: I had the opportunity of talking to some representatives of the banking community recently. They were talking about Basel IV. I do not know if that is an official term or not. We know Basel III, and we talked about that at our last hearing. But is Basel IV something that is actually happening?

Mr Byres : No, I think there was a consultant that started this term, Basel IV. Unfortunately, the phrase has caught on. You will not find anyone from the Basel committee talking about Basel IV. As I said in my opening statement, there is a lot of work still in the international standards setting bodies to deal with refinements to the bank capital framework. As I said, many of these issues being grappled with are not dissimilar to the issues that had emerged in the FSI. So one of the tasks we have is to try and work out how we take these two influences and work out something sensible for the Australian framework.

Dr HENDY: So it is an extension of the same discussion?

Mr Byres : Yes.

Mr CRAIG KELLY: I have just a few questions on the subject of superannuation investment in housing. Do we have a total dollar figure of the investment by superannuation funds in Australia in the total property market?

Mrs Rowell : We do have asset class information, and that would include the allocation to property—both indirect and direct. I do not have that information with me, but that information is available.

Mr CRAIG KELLY: Perhaps, you can take that one on notice. Also, is there a break-up between commercial property and residential property in that figure?

Mrs Rowell : We will take that on notice. I do not believe there is but I will take that on notice and confirm.

Mr CRAIG KELLY: The other thing that you might also want to follow up on that: of the residential property, is there a component of how much is actually being borrowed by certain super funds to purchase additional residential property? Are there additional borrowings against that? Is there any leverage in that? Or is it all owned outright?

Mrs Rowell : APRA-regulated funds are not allowed to borrow other than for short-term cash flow purposes. In the APRA-regulated space, there would be no leveraging of those properties.

Mr CRAIG KELLY: That would only be in the self-managed area?

Mrs Rowell : Correct.

Mr CRAIG KELLY: Also, is there any break-up of the investment in the residential properties between states and also regional areas?

Mrs Rowell : We would not collect that level of granularity for the super funds, no.

Mr CRAIG KELLY: In percentage terms, I think Mr Husic mentioned it is around 11 per cent in total funding for housing. Was that a correct number that he used?

Mr Byres : No. That figure of 11 per cent was, as of roughly the end of last year, the growth in lending by banks for the purposes of investment property.

Mr CRAIG KELLY: As it was a total amount, is there a percentage of the APRA-regulated super funds that is actually invested in residential real estate?

Mr Byres : I think we would have to take that on notice, unless Helen can quickly find it as she looks through the documents.

Mrs Rowell : No. The summary I have here does not have that.

Mr Laughlin : It would be fair to say though that in the APRA regulated space the amount invested in residential property would be quite low.

Mr CRAIG KELLY: Is it substantially higher in the self managed—

Mrs Rowell : As of December 2014, the asset allocation of super funds with more than four members—so that is excluding the self-managed funds and the small APRA funds—the total is eight per cent. I only have that split between listed and unlisted. I do not have it broken down by residential versus other.

Mr CRAIG KELLY: Just as a rough, back-of-the-envelope, ballpark figure, if that is eight percent then what is the total pool of funds at the moment?

Mrs Rowell : The total assets that is based on is $1.2 trillion—so eight per cent of $1.2 trillion.

Mr CRAIG KELLY: So what is that? Who has a calculator? I would say that is about—

Mrs Rowell : I can tell you what the—

Mr CRAIG KELLY: One hundred billion—

Mr Byres : One hundred billion, yes.

Mrs Rowell : Yes, it is just over $100 billion.

Mr CRAIG KELLY: Do you have any concern that it is $100 billion invested in residential real estate, that it is having any upward effect on prices in the housing market?

Mr Byres : Sorry—just to clarify: Helen's point is that that was total investment in property, which would include—

Mr CRAIG KELLY: Property—okay.

Mr Byres : any residential. But I would hazard a guess that the bulk of that was commercial property—

Mr CRAIG KELLY: Would you?

Mr Byres : because those figures were from the APRA-regulated funds, and they tend to invest in commercial property rather than in residential property—unlike the self-managed super funds.

Mr CRAIG KELLY: So if it is $100 billion all up it could be that 20 per cent of that would be residential, at a guess?

Mrs Rowell : I do not know. We would need to look into it.

Mr CRAIG KELLY: But, either way, it is a substantial sum of money that would be invested in residential real estate from managed funds?

Mr Ian Laughlin : This is a subjective comment, just based on experience: the amount of that sum—that $130 billion—being invested in residential property would be very low.

Mr CRAIG KELLY: Okay. Maybe you could just take some of those numbers on notice?

Mrs Rowell : Yes.

Mr CRAIG KELLY: My other question is about some of the risks to the banking sector. There has been a series of recent court cases involving unfair penalties—that is where some of the bank fees have been deemed in the past to be illegal penalties in common law. There is the potential for the banks to have to refund those amounts. Is that something you have looked at as a potential risk to the banking system, that they may have a substantial liability to refund unlawful penalties to customers?

Mr Byres : Certainly, we are aware of those issues. The amounts that have been discussed thus far, and the claims that are being made thus far, are clearly substantial. Obviously, they would have an impact on the profitability of the banks. But they are not of particular concern to us in terms of their overall safety—

Mr CRAIG KELLY: Even though they are substantial by themselves, in terms of the banks' net assets they are not something that would have any concern?

Mr Byres : Correct. They would be material in terms of profitability—in terms of their annual profits. But their net assets are much larger, and so it would not be an issue of concern for us.

Mr CRAIG KELLY: Just going back to the housing issue: would you have a concern if there were some change in the superannuation regulations where people were able to use their superannuation savings in some way for a deposit on a house? Do you see that that would have any substantial effect on the current superannuation system?

Mr Byres : Sorry, I am not quite sure—

Mr CRAIG KELLY: It has been discussed through various media outlets, by various commentators and by various members of parliament, about assisting young people to get into the housing market by being able to use some part of their superannuation as a deposit for a house. I understand it is done in a couple of other countries, or that there is some type of system for it. If that were done here in Australia, or something along those lines, would you have any concerns that that would adversely affect the current superannuation system?

Mrs Rowell : I will take that one. It is not strictly a prudential issue per se, it is more of a retirement income policy issue. I think that the concerns which have been raised by some commentators here around its impact on the total accumulation over time for retirement need to be considered. If you allow funds to be drawn out early then they are not in the system accumulating towards retirement and the end retirement goal. And so those issues need to be weighed up, I think, in making any decisions there.

The other point to make would be on the international comparison point of view. Some of the other jurisdictions that are referred to when this is floated are places like Singapore. You need to bear in mind that in Singapore, the total contribution that is being put away into the central provident fund is something of the order of 30 to 35 per cent. Of course, it is there to fund retirement, health and housing, but you are starting with a much bigger contribution compared to where we are, with 9½ going to 12 per cent. And so there are a number of factors needing to be considered in heading down that path.

CHAIR: Would that be addressed—that the super funds that go into the purchase of the home remain the property of that person's super? So it is not taking money out. Instead of having it in shares it is represented by a part ownership or the capital in the home.

Mr Byres : One of those things that is not clear in the discussion thus far is exactly how the framework would be applied. Clearly that is one option: to, in a sense, make sure that the funding is in some way preserved or earmarked for superannuation. I do not think there is anywhere near enough detail on how you would make that work to be able to comment on it.

Mrs Rowell : The sole purpose test at the moment constrains some of those structures, and we have certainly had issues around some schemes to facilitate members in effect putting their money into a super fund and then being allowed to use that to borrow and buy housing, which we would say at the moment contravenes the sole purpose test for superannuation funds, which is around provision for retirement.

CHAIR: So as long as it is quarantined for retirement, I guess it is one of those situations where it is often said that the devil is in the detail but here the heavenly result might be in the detail.

Mrs Rowell : Yes.

Mr CRAIG KELLY: My other question is on some of the competition issues in the banking sector involving lending to small business. If I look back at some of the historical tables in the Australian Bureau of Statistics and look at the comparison of the lending rate to small business where it is residentially secured as compared to the discount variable rate for housing and we go back to December 2000 we are looking at a spread of about 85 basis points—less than 100 basis points—between the small business lending rate and the variable housing rate. But if we look at it today, with the latest numbers, the spread is close to 300 basis points. It seems that the spread for small business seems to be increasing all the time. Is that something that you see as a result of a lack of competition in the banking sector? Do you see a greater risk of banks lending to small business?

Mr Byres : The fact that there is a premium is a function of the evidence that says that banks do lose more money on small business lending than they do on housing lending. That tells you that there should be a premium.

Mr CRAIG KELLY: How about where that is residentially secured?

Mr Byres : That probably reduces loss rates, but I think it is the case that, even in those cases, there are more defaults in small business lending secured by housing than housing loans secured by housing. So there are still more losses that come through the system. It is probably less than lending to small business without the benefit of that.

Mr CRAIG KELLY: So there is a reason for the spread there. My question is more about the spread over the last 15 years, which seems to have opened up substantially. Is that opening up of that spread because of competition in the banking sector or the greater risk of lending to small business?

Mr Byres : I have to say that we do not have a firm view on that or a clear picture on that. I think it is fair to say that there is more competition in the housing market than there is in the small business market. To the extent that that greater competition in the housing market is keeping housing lending rates lower, that is obviously a good thing for retail customers and housing loan borrowers. That may be a factor in that the competition in housing has been greater than it has been in small business lending. But I could not really give you any answer as to what precisely has driven that 85 to 300 figure that you quoted.

Mr COLEMAN: I wanted to ask about interest-only loans. You mentioned them earlier in response to one of the other questions. Could you just explain the responsibility for monitoring of interest-only loans? There does seem to be a significant rise in them in the mortgage market.

Mr Byres : The volume of interest-only loans has grown quite strongly, and their proportion of the total housing portfolio of banks has grown. So they are taking up a greater share of the portfolio. In one sense, that is not necessarily surprising, because investor loan growth, as we have already talked about, has been growing quite strongly, and the tax system provides incentives for investors to borrow interest only, because they want to maximise their interest deductibility. So it is quite common for investors to borrow on an interest-only basis. The issue that we have been more alert to is the fact that there seems to be an increasing number of owner-occupiers who are borrowing on an interest-only basis. The traditional owner-occupier has borrowed for 25 years, with an amortising loan, repaying principal and interest—fairly conventional lending. But there is an increasing portion of owner-occupier lending that seems to be occurring on an interest-only basis.

There are a range of reasons why that might be occurring. Some of them are quite legitimate. For example, a number of banks have product offerings where they will offer an interest-only loan side by side with a mortgage offset account, and they will still be expecting the customer to make a normal principal-and-interest payment into the offset account, but it obviously gives the customer capacity to redraw if they need those funds in the future. But our concern is the potential for there to be borrowers who cannot meet the bank's serviceability requirements if they borrow principal and interest and so, in their determination to get a loan, are resorting to interest-only loans, which obviously have a smaller monthly repayment than something where you are repaying some principal as well. Those loans are obviously of a higher risk, because, first of all, the fact that a borrower might be forced into that situation tells you that their capacity to meet the debt is fairly marginal and, secondly, it means, should something happen in the future such that the customer defaulted, or house prices fell or whatever it might be, the potential for the bank to be exposed to loss is greater because the borrower has not built up equity over time in the property.

So, for that reason, we are looking at what banks are doing in that area. It is also one of the things that ASIC is doing in their review of interest-only lending. They are looking at it in the context, as I said, of responsible lending and whether there is any evidence—and it is very much an open question—that very marginal borrowers are receiving loans that are probably not consistent with the responsible lending obligations. But that second bit is something you should take up with ASIC at some point.

Mr COLEMAN: When you are assessing institutions and their relative risk profiles and so on, does the proportion of loans within their books which are interest only become a factor that you consider?

Mr Byres : Yes. It is one of those things that go into our judgement. The statistics will tell you which banks have more of this business, and that is a useful starting point. But then we need to talk to them about what is generating this trend. Is it because you have product structures where, yes, it is recorded as an interest-only loan but the customer is still repaying on a principal-and-interest basis? That is a very different proposition from someone who simply making interest-only loans to owner-occupiers.

Mr COLEMAN: What is the default rate on interest-only loans relative to principal-and-interest loans?

Mr Byres : I could not tell you off the top of my head. I would have to take that on notice.

Mr COLEMAN: Is it materially higher?

Mr Byres : I do not know whether it is materially higher. One of the problems we have more generally is that we are lucky that we have not had a housing problem. Default rates and loss rates across the board are quite low, but that does not mean that will always remain the case. I will take your question on notice for actual figures.

Mr COLEMAN: I have another question around mortgages. I notice one of the FSI inquiry recommendations is about mortgage risk and the methodologies used to determine those. As I understand it broadly, to some of the banks you apply an objective test, so to speak, and some of the banks make their own internal calculations as to the relative risks of different types of mortgages. Looking at that from the outside, it does appear to be somewhat inconsistent. Is that your view or do you think the existing system is working well?

Mr Byres : You are right; there are two approaches within the capital framework. One is, if you like, the default approach, which says there is a fixed weight rate that APRA determines. Then there is the capacity for banks, if they prove they have good enough risk management and data and meet various other requirements, to use their own estimates of risk to input into a supervisory formula to spit out a risk weight. At least in the context of Australian housing lending, the model based approaches will tend to produce lower risk weights than the standardised numbers that most of the small ADIs are using.

The fact that the numbers are different is a well-recognised and desirable outcome of the system. You would not go to all that effort if you were going to get exactly the same number as the standardised approach. The fact that they are somewhat lower than the standardised numbers is a deliberate calibration decision designed to provide incentives to banks to invest in better risk management, better data, better collateral management, et cetera. If they make all those investments and can prove to us that they have better measures of risk than the standardised approach, then we are prepared to consider using those for capital purposes.

The issue the FSI has raised is whether the differences that have emerged are too wide and whether that is creating a competitive imbalance in the market. It is a legitimate question to be asking, and it is an issue that is the subject of some of the discussions going around internationally. One of the lessons from the crisis was that banks' risk models were not necessarily as robust or as good as we might have liked them to be or hoped they were. The reliance on these model based approaches is very much up in the air at present. All of that is to say: yes, it is a legitimate issue that has been raised and it is one that we are looking at. But, as I said in my opening statement, we are not making any decisions on how to proceed on that until we see what comes through the consultation process on the FSI report. That consultation process finishes at the end of this month. We know all the banks are making submissions on this issue. We will get a better sense over the next couple of months of some of the international developments and how the broader Basel framework might be modified. When we have those two pieces of information, then we can think about how to proceed on that recommendation.

Proceedings suspended from 10:49 to 11:04

CHAIR: Before we recommence, I ask that those present stand in silence as a mark of respect for Mr Malcolm Fraser.

Honourable committee members having stood in their places

CHAIR: Thank you. We will recommence.

Mr COLEMAN: I have a couple of different questions on superannuation. I had a little discussion at the last meeting more generally about SMSFs and the regulation of them. My basic question is: are you comfortable with the existing arrangements through the ATO with SMSFs and do you feel that there are any areas at all where regulation should be changed or do you think that the current system is working well?

Mrs Rowell : I think the comment that we made at one of our first sessions of this was that it was appropriate that there were different oversight arrangements for SMSFs than for APRA-regulated funds, given their nature and the fact that the trustees are also the members and so there is an alignment of interests, if you like, which is not necessarly there in the APRA-regulated space. I do not think we have any observation beyond that. It is clear that the SMSFs do play a significant role in the retirement income system and so there needs to be appropriate oversight, which is currently provided by the ATO, to make sure that the objectives of the super system are being met through SMSFs. Beyond that, I do not think it is really an area that we can comment on.

Mr COLEMAN: Another matter you mentioned earlier was the broader requirements for super funds related to disclosure, the use of members' funds and so on. I understood from what you said that there are some new regulations in that area. I was just wondering if you could just touch on those in a little more detail, as to what the new requirements are. Secondly, if there are any specific examples you have become aware of regarding a lack of disclosure that have given you concern.

Mrs Rowell : With the implementation of the Stronger Super reforms, which started from 1 July 2013, there were some enhanced transparency requirements introduced for superannuation. Some of that related to the information that trustees themselves needed to disclose to members, either through their website or by other means. Some of them relate to the information that is reported to APRA and that we ultimately may publish. From an APRA perspective, the reporting standards were progressively implemented and so we had some introduced from 1 July 2013 and others took effect from 2014; there are still some to coming into effect from 2015. They have been gradually increasing the amount of information that is reported to us at a fund-specific level and at an investment-option level, giving us more of a breakdown on around fees and costs, performance and some of the attributes of the particular products that are offered.

We have tried, in developing our requirements, to liaise with ASIC so that—for example—the information that is reported to APRA about fees, costs and investment objectives is consistent with the information that the trustees have to disclose on their websites. There are ongoing consultations happening with industry at the moment. APRA and ASIC are working together to refine some of those requirements, particularly in the areas of fees and costs. Whilst we do have trustees at the moment disclosing information to members at a much more granular level than they may have in the past, not all of those requirements are fully implemented and providing the level of transparency that we will ultimately get to. That is so that it is very clear, for example, what the investment return is; what the nature of the expenses are, broken down by direct and indirect administration and investment expenses; what the insurance costs are and those sorts of things. That last little piece is something that is still not fully in place.

We have also been progressively publishing more of the information that we have been collecting, but we have had to go through a process of consultation with the industry about the confidentiality of that data and whether there would be any commercial sensitivity about some of the information that would be disclosed. Again, we have not completed that process, but we expect to do that very soon and we would expect to be publishing, in particular, more information about fees and costs in the coming quarters. That is a broad answer, which is really trying to say that we would expect over the next 12 to 24 months for there to be much more information available at a much more granular level about the funds, their investment performance, their fees and their other product features than has been the case in the past. It is still a bit of a work in progress.

The other area that has been covered by the reporting and disclosure obligations is in relation to remuneration. The first time that the new requirements for reporting applied were for the last financial year. That information had to be reported to us and also disclosed in October last year in respect of the 2013-14 financial year. I made some comments at a conference earlier this week; we did a little bit of a review to assess the quality of that reporting and in particular the consistency of the information that was on websites versus reported to APRA. We found some significant gaps. In terms of areas where we have found examples where the reporting and disclosure perhaps are not up to scratch, remuneration of directors and responsible officers would be one area where we think there is room to improve.

The expense area is another one where, again, getting funds to actually properly allocate costs and disclose costs between direct and interact administration and investment expenses is proving to be a bit challenging for the industry, because it is not something that they have had to do before. They have had to change their systems and make sure that they have got the proper allocation processes in place to be able to do that properly.

Mr COLEMAN: Where you have found the disclosure to be inadequate, what occurs? Presumably, you speak to the relevant fund. Do you publish that information about those breaches as well? How does it work?

Mrs Rowell : We do not publish specific information that says that these particular funds have not reported correctly. We would typically go back to the individual funds, raise those issues and ask them to correct the reporting. That is certainly what we have done as an introductory process through the implementation of the new reporting requirements where we see that there are anomalies or errors. Our preference is to just go back to the funds and ask them to correct and resubmit, which most of them would normally do.

Mr COLEMAN: Why is that your preference? Particularly if it is serious—I can understand if it is something very minor—why would you not publish that information?

Mrs Rowell : Our view is generally that with the implementation of new reporting requirements we have to accept that there is a transitional period. It takes some time for the industry and their service providers to actually implement and go through a quality assurance process to get the reporting up to scratch. For the first year or two of new reporting, we will take a facilitative approach. As long as we think they are making genuine efforts to meet the requirements, then we will give them some time to make sure that they get their reporting up to scratch. If we do not feel that they are cooperating or if we do think that the issue is more material, then we will escalate our response.

Mr BUCHHOLZ: Thank you for being here. I truly believe that the dialogue that is entered into here has benefits for a number of stakeholders. I look forward to ongoing engagement in this format. Thank you for your appearance today. I just firstly want to start with a couple of questions from Mr Byres' opening comments in and around the area of liquidity. The questions do not need to be specifically answered by you, Mr Byres. Anyone on the panel who feels like it can offer commentary. On the extra liquidity arrangements, in particular for banks, would be a by-product of some of the Basel III recommendations, I am interested in your commentary as a regulatory authority on what the cost associated with the extra liquidity will mean and then how that potentially will flow through to the consumers.

Mr Byres : As a result of Basel III there were some new liquidity requirements introduced in the regulatory world—this is known as the liquidity coverage ratio, or the LCR. In really simple terms, the LCR says that banks need to have enough liquidity to be able to survive a 30-day period of stress. There is a test in which they calculate what is likely to happen in a period of stress, what sorts of outflows they are likely to have, and they have to show they have enough liquid assets to meet those outflows. One of the difficulties we have in Australia is that because we have relatively low levels of government debt and certainly relatively low levels of government debt relative to the size of our banking system, the sorts of liquid assets that the international framework envisaged banks would hold are not available here. In most other jurisdictions banks would be holding more government paper, but there simply is not enough government paper in Australia to meet the needs of the banking system. As part of the Basel framework there was an option negotiated into the agreement by the Australian representatives at the time to allow for the central bank—in our case, the Reserve Bank—to provide what is, in effect, a secured line of credit to the banking system to help fill that gap.

As part of our implementation of the LCR the banks have made arrangements to sign up to these agreements and establish these agreements with the central bank. The aggregate amount of those lines of credit with the RBA are about $275 billion across about 14 banks. They pay an annual fee for that of 15 basis points, so in dollar terms it turns out across the banking system in total as a little bit over $400 million per year that the banks pay to the RBA in return for that liquidity line. That is a cost that the banking system obviously did not have to incur before Basel III came in and before the Global Financial Crisis, but in our view it is a worthwhile insurance policy for banks to have the additional liquidity. It was pretty clear in the financial crisis that banks around the world did not hold enough liquidity for market turbulence and for significant shocks, and that was the case right around the world. It was a necessary investment in making banks hold some additional liquid assets. There is a way, and I just described it, that gives you a sense of what the cost is—it is in that order of magnitude across the banking system.

Mr BUCHHOLZ: Including ADIs?

Mr Byres : Yes. The LCR primarily is applied to the bigger end of the bank, to the ADI sector. For the smaller ones, particularly the credit unions and building societies, we have a simple long-term measure that we have held, and we thought it was perfectly fine. So we did not seek to impose the LCR on the smaller end of the ADI sector—the credit unions and the building societies. There is a cost—that is right. That cost, when you look at it in terms of the aggregate balance sheet of the banking system, is actually very small. You look at it in terms of the aggregate profitability of the banking system it is very small and, as I said, when we looked at it and we worked through the process we thought it was a worthwhile investment in strengthening the liquidity of the system.

Mr BUCHHOLZ: Whether or not it was coincidental that the second tier banking sector, or the ADIs, I think there was a connection between the extra liquidity rates. There seemed to be a greater noise or traffic coming out of that sector about the inequities of liquidity ratios for the second tier operators compared to the banks. Can you offer some commentary as to how the Basel changes will affect the inequities that already exist in the sector—if you listen to the second-tier operators?

Mr Byres : I am not sure I would agree there was a significant inequity, but what I would say is that, if there was, then the introduction of the LCR to the larger banks certainly would raise the requirements of those larger institutions—and, as I said, we have not applied it to the smaller ones. So, to the extent there was a difference that was generated by the two different regimes, certainly there are now much stronger requirements of the larger banks. If there was an inequality, it would have been reduced, if not removed, by that change.

Mr BUCHHOLZ: Did the Murray report make any recommendations about closing the gap between the requirements for the first and second tiers?

Mr Byres : Not on liquidity. Obviously, as we have discussed, they made a recommendation in relation to mortgage risk weights on capital. But there certainly was not a recommendation in the report and, in fact, there were very few comments in submissions on issues of liquidity.

Mr BUCHHOLZ: Yes, my apologies. It was risk weighting. Another point you made was about the very competitive nature of ADIs—that there was fierce competition. Do you think that, in that space of competition, the market is aware of the ownership or the shareholdings of some of those? What are APRA doing in that space to make consumers aware that, at face value, it would look extremely competitive, with over 160, but not when you look behind the balance sheets at where the ownership sits. Does it truly reflect what your comments alluded to with regard to competition?

Mr Byres : Yes, that is an issue, and I guess there are a number of institutions that use multiple brands. In terms of owners of ADIs, there may be fewer than that; but many of those brands are actually conducted under a single licence, so it does not materially reduce that number. We have thought about this and keep a watching brief on it, but it is not clear to me, to APRA, at this point that there is a significant issue that we need to intervene on. There is nothing in the legislation or our standards that discourages people from having different brands. When you look at the different brands, if we take housing, for example—which is the area we have been focusing on—the different brands do offer different product features. It is not as though it is exactly the same product, just with a different brand on top of it. These are offering different features to customers. As I said, it is something we watch, it is something we are mindful of, but it is not something that, I would observe, we feel the need to intervene on at this point.

Mr BUCHHOLZ: I will take that on board. The same or a similar situation would extend over into the insurance market as well, when you look behind those brands. I would be interested in your comment on that.

Mr Laughlin : That is true, when you look at the online aggregators and so on. Often there are a number of brands but there is only one owner structure behind them. If you look at the wider market and you get away from those online aggregators, there is generally quite a good deal of competition, and it is reasonably fragmented. So, again, it is not a pressing issue in the insurance market.

Mr BUCHHOLZ: Maybe not a pressing issue. I will leave that line of questioning there other than to suggest that I will continue asking into the future whether there is a comfortable understanding, with the consumer, before making a choice. Are they aware of the structure of whether or not it is in the super sector or the banking sector?

Mrs Rowell : To a degree, that disclosure piece is an ASIC responsibility, more particularly, than an APRA responsibility, in terms of whether there is sufficient transparency around the way those brands are presented in the market to consumers.

Mr BUCHHOLZ: Earlier in the week you gave a good speech, I thought. You stated that around a third of the approximately 40 funds reviewed were found to have conflicts with management frameworks that were assessed as vulnerable or weak. This falls within your purview. I am interested in teasing that out. What are the current requirements for super funds, in relation to conflict management and the frameworks surrounding those?

Mrs Rowell : We issued—and it took effect in July 2013—a number of prudential standards. One of them was specifically targeting management of conflicts of interest. That prudential standard effectively requires trustees to have in place a conflicts-management framework, to have in place registers of conflicts of duties and conflicts of interest across the institutions. They might pertain to directors, to responsible persons within the organisation or at the entity level itself. Those conflicts registers need to be publicly disclosed.

The framework means that the trustees have to have a robust process in place for identification of conflicts and appropriate management of those conflicts of interest. We have been looking over the last little while to make sure that funds are meeting those expectations in the prudential requirements. They are new. The comments I was making at the CMSF conference on Wednesday were to say, 'We did this review in 2014. We found some areas where improvements need to be made and we will be expecting all of the industry to have a look at their frameworks and make sure that those improvements, in practice, are implemented.'

Mr BUCHHOLZ: In that review, did you cite any instances where there were exceptional frameworks in place?

Mrs Rowell : There were certainly some good practices. It is probably fair to say, though—we looked at a number of elements of the frameworks and the processes that were in place—that some trustees or funds would be strong in some areas but not so strong in others, and others were more adequate to poor across the board.

Mr BUCHHOLZ: Do you want to give anyone a plug?

Mrs Rowell : No; I think that would be inappropriate. The point I would like to put on the record is that the review covered all of the industry. We looked at a segment of industry fund, retail funds, corporate funds and public sector funds and there were strengths and weaknesses in all of those segments.

Mr BUCHHOLZ: Moving to related party arrangements, in that speech you also said you will be taking a very close look at industry practices, in this area, and across industry and retail funds. What processes do you expect to follow, to pursue that?

Mr Glenfield : There are a number of routes that we take, in terms of looking at related parties. The first is probably like the Helen type speeches, where we get out into industry and talk to industry in general. APRA has expectations around related party transactions, which are documented in the prudential standards, and if you look at not just the conflicts of interest but also fit and proper and outsourcing—about how you have to assess whether it meets almost an arms-length type transaction.

On an individual institution basis, APRA conducts on-site reviews of institutions on a regular basis. Wayne talked a bit about our risk assessment. So what we would look at is, what do we see as being higher on the risk profile for superannuation funds? At this point in time, we have identified conflicts of interest and related-party transactions as something worth looking at. So when we go on site, we look at not just their documented policy—which you would expect to meet this—but how it is actually employed in action. So you have two arms to it: it is not just the documented part; it is what they are actually doing in practice. And we would discuss those findings with the board and with senior management and, in events where we think they are not doing enough, or they are not disclosing enough, or they are missing potential conflicts or perceived conflicts, we would go back and report to them, saying, 'hey, look: you need to do more in this area'. And that is then followed up in subsequent reviews. So what you would see over time, I would think, is an improvement across the industry, which is what we have traditionally done with most prudential standards. These are fairly new. They come out, they have some time to gestate with the funds, and for the funds to make their endeavours to comply, we then have a look and say, 'well, look; we are seeing better practice here—you should think about that' or, 'yours is missing the point here; you really need to fix that'.

Mr BUCHHOLZ: Are you comfortable with the sufficiency of the powers that exist at the moment under your current review structure? Are they adequate? Or would you like to have greater authority to request change?

Mr Glenfield : No, I have done it long enough to be comfortable with what we have got.

Mr BUCHHOLZ: Okay; and that was genuinely an issue for you guys. Do you have enough powers to compel third parties that are not super funds, where their investors are super funds? I am talking about that third party link.

Mrs Rowell : Our obligations rest on the trustees, and we put requirements on the trustees in terms of how they manage their relationships with third parties. Part of that includes giving us access to the third parties if we need it, so we would require, under our outsourcing standard, effectively, that the contractual arrangement needs to provide for APRA to have access to the third parties if we feel that we need to. And so we have actually been and undertaken on-site reviews of some of the custodians and some of the administrators for the super industry, to satisfy ourselves that those third parties do actually have sufficient processes and controls in place themselves. To date, we have not had a problem in relation to third parties. But the way we do that, as I said, is by having the obligation on the trustees to make sure that they get the information they need from the third parties and provide that to us when we need it.

Mr BUCHHOLZ: Does APRA have the authority to disqualify a trustee or a director in that instance?

Mr Byres : Sorry, when you say in that instance—what instance is that?

Mr BUCHHOLZ: Where we have gone back and had a look at either a body or a related body that would have an underlying investment in it. How far is your reach?

Mrs Rowell : To formally disqualify somebody, there would need to be a demonstrable breach of a law, and we would need to put together a case, and have that taken through the court system to achieve a disqualification. We have a process of entering into enforceable undertakings and so, again, if we found egregious behaviour and clear breaches of prudential or other legislative requirements, then we might use that as an avenue to have someone agree to not participate in the industry for an extended period. We can also issue directions to institutions to comply with prudential standards as well. They are powers that we rarely need to use and they are usually when there are very, very serious breaches. Most of the time, we get the outcome that we are looking for by providing recommendations and following up on those, and having the trustee respond properly.

Mr BUCHHOLZ: Okay. So they exist there for years. As I said in my opening question, you said that the funds that you looked at were 'vulnerable or weak'. Given that they manage a fair portion of people's life savings, how does APRA relay those concerns about vulnerability or weakness in that governance space to the market so that it can make a judgement or decision on whether or not they stay?

Mrs Rowell : Similar to the comments that our chairman made earlier, we seek to operate behind the scenes and have the issues addressed. It is probably important to say that, when we rated conflicts management frameworks, for example, as being weak or vulnerable, that just means that they fell well short of our expectations of better practice. It does not necessarily equate to us having a fundamental concern about the risk of any particular fund in terms of outcomes for members. Our view is that, having made those observations and put those to the funds, we expect those issues to be addressed so that they move up to at least an adequate if not a sound standard; and, if they do that within a reasonably short time frame, then there are no concerns that really would warrant more public disclosure of the issues.

Mr BUCHHOLZ: Public disclosure from you—I understand that. Is there any compulsion, from APRA's perspective, for the fund to then disclose their risk to their members? A shareholder could be completely oblivious that their investment is being managed by someone with a report card of 'weak or vulnerable'.

Mrs Rowell : In one specific area of our requirements, we cover a range of attributes.

Mr BUCHHOLZ: Sure. We all understand what a report card looks like, and I think industries would be proud to produce a good report card; it would be very useful marketing tool. I just wanted to get your opinion on those that have a poor report card in particular areas; they might be outstanding in others. How does that information get demonstrated? Why assess someone if you are not going to report the results of your review to anyone? In particular, the person who should have complete transparency on this is the person who has their life savings invested in that fund. Help me build that bridge.

Mrs Rowell : There is a difference between weaknesses in operational processes that might lead to a problem and a crystallised problem. The challenge for us is when we move from being concerned about a problem that might emerge to the fact that there is a problem here and now, and I think it is very much in that latter stage where the issue around public disclosure and the timing of public disclosure is much more critical, and when we would need to have some serious conversations with the trustee and also with ASIC about what should be disclosed to the market and when. Again, if we had a concern about the security of members' investments or assets, we would take steps to have that dealt with very, very quickly and we would, in those circumstances, be able to use a number of mechanisms, including replacement of the trustee, transfer of the funds to another trustee, those sorts of things, to ensure that the members' retirement savings were protected well ahead, ideally, of any losses emerging.

Mr BUCHHOLZ: I will be interested in having ongoing conversations with you as to how that area improves, for the benefit of consumers.

Mrs Rowell : Sure.

Mr BUCHHOLZ: Finally, your comments earlier on in the week in relationship to governance in super funds, you said there were 'a wide range of skills and capabilities on boards'. In general terms, does APRA have an opinion on whether or not there are any skills that are lacking from boards in the current system?

Mr Glenfield : I do not think you would say that there is a skill set lacking across the board. Our provisions under the prudential standard are that the board will have the relevant skill and expertise for the complexity of the fund that they are supervising. We look at each board individually. We look at their skill sets, their assessments of their own skill sets and their outcomes. We ask them: 'Are there parts of a skill set that you are missing; how will you get skilled up to it; or, how will you get someone in who has that skill set?' I do not think it is possible to say that there is a particular point across industry that would be lacking.

Mr BUCHHOLZ: What about when you look at the same skill sets that make up other sectors, like the banking sector or even a superannuation set at board level, and then cross analyse that against the super sector? Are you comfortable that there is the same maturity of capability and skill sets across those three sectors?

Mrs Rowell : Our view would be that there would be room for the skill sets around superannuation boards to be enhanced relative to what we see in the other industries. I think many boards are responding proactively to this by bringing in people with industry expertise, financial expertise, marketing expertise and other relevant expertise so that they do have those skill sets around the table. It is an evolution that is occurring.

Mr BUCHHOLZ: I am sure that there are many who would agree. The current legislative definition for an 'independent director' in the superannuation industry does not exclude someone who was a service provider to a fund. Is that correct and, if so, is that a concern for APRA?

Mrs Rowell : It is correct. The definition of 'independent director' is historical and is probably in need of review. Having said that, there are no requirements at the moment for the superannuation sector to have independent directors. So I guess it has not had the focus that it might have had in some of the other industries.

Mr BUCHHOLZ: Thank you.

Mr HUSIC: Mr Coleman and I have touched on this issue, and I just want to confirm whether my understanding is correct. Chairman Byres, if you change capital requirements for individual banks as part of the macro prudential reforms, if I can put it that way, did I hear you correctly when you said that APRA does not believe that it is a market reportable activity?

Mr Byres : No, I didn't say that.

Mr HUSIC: Okay. That is why I am asking the question. I just want to know.

Mr Byres : Just to be clear about what I said: there is no obligation or requirement on APRA to disclose. Our history and practice—

Mr HUSIC: So you do not need to disclose?

Mr Byres : Yes.

Mr HUSIC: But it is up to the bank—

Mr Byres : We can and regularly do choose to instruct institutions that they do not need to disclose either.

Mr HUSIC: When you instruct them that they do not need to disclose, is that instruction backed up by powers within legislation or regulation?

Mr Byres : We have the statutory power that we can use to enforce that instruction.

Mr HUSIC: To cover them from not reporting to the market?

Mr Byres : That is right.

Mr HUSIC: I have not heard this before; others may have. What is the rationale? No doubt our predecessors had some rationale to allow that legislation to give you that power, but could you explain to us what the rationale is to provide the cover for listed organisations that are affected by your capital requirement decisions not to report that to the market?

Mr Byres : The rationale is simply for the same reason that we do not allow institutions to put out a positive report card. It is a general approach we have to work behind the scenes, without publicity, and because of the concern that a lot of what we do is judgemental. It can be subjective. It can have significant commercial detriment if it is not very carefully managed. So we do have that authority. Particularly, you can envisage situations where the disclosure of a problem, even if it is very readily fixed, might create unnecessary concern and exacerbate the problem rather than—

Mr HUSIC: How would it exacerbate? You are acting because you have outlined—and I am actually going to ask you a question on notice to outline the housing risks that you have identified on the public record previously. Sorry, you have called them risks, but I would be interested to get the classification of what you are considering in that mix. Putting that aside for the moment, you have identified some risks and you are starting to take action to deal with those risks, but you believe that the public disclosure of action on banks that, you believe, are acting in a way that may be is not cause and effect but contributing to problems in the housing market—you are more concerned that the revelation of that might impact on the company as opposed to dealing with the risks that you are dealing with? Can you appreciate that, in my mind, I am just trying to reconcile those two points.

Mr Byres : I understand the issue that you are raising. As I said, our general approach has been to work behind the scenes and to work on a confidential basis. Our capacity to deliver is significantly enhanced by our ability to do that. Institutions give us information because they know that there is a statutory obligation on us not to disclose it. So we do get a great deal of information that is confidential and commercially sensitive. If there was a sense that APRA might disclose or disclose its actions as a result of receiving that information, I think it would significantly impair our ability to do our job. Then there is the issue that a large part of our job is trying to identify small problems. These are very big and complex organisations that we grapple with. But our task is to try and identify small problems, or potential problems, and have them remedied before they become a real problem. Our concern is always that the disclosure of the fact that there is a regulatory intervention, or there is a problem that is being dealt which may not have any reason to cause immediate concern but might well inadvertently do so because of the disclosure, is often going to be unhelpful to getting things fixed.

Mr HUSIC: I understand there are some tensions here that I tried to get across in my last question to you. And I take on board the things you have said. With increased capital requirements—so above and beyond what comes about as a result of a combination of Basel III and FSI outcomes, and, if I understand from your earlier remarks in this hearing, you said that the cap requirements would be above those two matters I have just mentioned—at what point do shareholders and consumers know that the changes, potentially, of an individual bank to the products that they are offering have resulted from your increased capital requirement expectation.

Mr Byres : They may not because, partly, the bank may not—if you take this example of adding some extra capital to a minimum requirement, there are two relevant numbers that we have to think about: the minimum capital requirement that the bank has and how much they actually have. Clearly, to meet our requirements they must have some buffer over and above. If our minimum capital requirement is being raised somewhat but is still well within the amount of capital that the bank holds, then there is no obvious reason why that would become apparent to anybody. If, of course, we said to a bank, 'Actually, your minimum capital requirement is now going above the amount of capital that you actually have,' and that bank would be forced into some kind of capital raising, then the bank is taking public action. It would obviously need to think about how it explained why it was raising capital or doing what it was otherwise doing.

Mr HUSIC: But of those two scenarios, the first one is small enough that they absorb it. If I am incorrectly characterising what you describe, feel free to correct me. If it is too small but it is absorbable and it is not noticed or it is big enough that it does get noticed, I imagine that in the first scenario you would not be undertaking this action if it was not noticed. You would want to take this action because you flagged that this is a concern and you have tried to get them to act through the letter that you issued to ADIs late last year. The jury still out; we are still waiting on it. But if you get to the point where you are now having to ramp up your supervisory oversight to the extent that it allows you to exercise these capital requirement demands, you are going to want that to have an impact. It is really more the case that scenario two is what you are after.

Mr Byres : You certainly wanted to have an impact, or else why would we bother? As I said, the history of our experience is that it certainly has impact by generating the attention of the management and board of the institution. I am yet to come across an instance where we have instigated some sort of capital action and the management of the board have said, 'So what? We don't care. We're going to carry on regardless.' These things have an effect, they work and there is a strong incentive in them.

When we are dealing with problems, we would like to go about our business in a way that does not risk instability and does not cause unnecessary commercial detriment to the organisations concerned. Often, these issues are complicated and nuanced. The reason you have a regulator like APRA is because you need expertise to respond to and deal with these issues. Market discipline, in and of itself, is not enough. As I said, we think we have had a successful track record in being able to achieve good outcomes for the community—because that is what it is all about: outcomes for the community—by working in this behind-the-scenes kind of way.

I am not in any way trying to dismiss the importance of disclosure and transparency, but disclosure and transparency are not an end in themselves. They are means in which you will hopefully generate good outcomes for the community. One of the things that we have to make a judgement about is what is the best way to operate—in public or behind the scenes—to generate the best outcomes for the community. As I said, I think our track record shows that a lot of the time operating behind the scenes, getting things fixed and allowing things to move on relatively seamlessly has been in the community's interests.

Mr HUSIC: My questions are not a criticism of APRA, per se. I certainly appreciate the massive challenges in trying to embark down this path. The RBA has signalled them previously. Over two hearings now, we have explored some of those difficulties. I think there is a very public policy, set of policy objectives or economic rationale behind what is being done; there is also your balancing out the impact on individual firms. It is just something to reconcile.

I will move on, because I suspect there might be other questions on this. There are some questions that I want to put on notice because I simply will not have time for them. I was very concerned about a report by Adele Ferguson in early March about bank bundling, the offering of super products and, in particular, the suggestion that inducements were being provided by banks to go into retail funds. I understand that Industry Super Australia wrote to you, raising these concerns. They had undertaken a survey of about 550 SMEs, which revealed 'widespread systematic breaches'. It said, if I can go to it:

… 25 per cent of businesses had been approached by one of the big four banks in the past year about switching their staff's default super to the bank's own retail super fund. … The most popular inducements included discounts on fees within the superannuation (38 per cent), lower insurance premiums for their business (37 per cent), free financial advice (32 per cent) and discounted interest rates and fees on business banking products (25 per cent).

I do not have a problem with competition between retail funds and the like, but I am concerned that the competition is not on equitable grounds. It does not appear right. I understand that the legislation actually prohibits this type of behaviour. These have landed on your doorstep and you have been asked to look at them. Can you give some sort of indication about where things are at? I also know that ASIC has been approached on this too. I appreciate that there is another regulator in the mix.

Mrs Rowell : This is an issue on which ASIC and APRA are actually working together. The information from ISA was provided to both APRA and ASIC at the same time. We have taken a coordinated approach. In essence, there is not enough information in the material that has been provided by ISA to assess whether there have actually been any breaches of the relevant provisions in the legislation. What we are doing is approaching the relevant institutions to get some more information about their practices and the nature of the arrangements that they are offering. We will then form a view as to what further action might be appropriate in any of the particular cases.

I would note that it is a complex area and there can be a fine line between something that is just genuine marketing and within the parameters of the law versus tipping over into something that might be viewed as a breach. I think probably for today the best I can say is that we are alert to the issue. APRA and ASIC are working together to delve into this a little bit more and determine what follow-up action is needed.

Mr HUSIC: This may be too broad and I accept advice on this. Could you brief the committee at some later point in writing about any updates on this front?

Mrs Rowell : Yes.

Mr HUSIC: I asked you a question last time about unlicensed foreign insurers. I understand my colleagues from Northern Queensland have a legitimate concern about accessing insurance products, because actuaries have made decisions about at what price insurance should be to be covered for those areas. I am interested from a Western Sydney perspective, because—particularly with development occurring the it is—developments are going into areas that sometimes have previously been classified as flood prone. The practice of allowing more UFIs to offer products is attracting greater attention. I understand that in Queensland some brokers have met during February to consider this matter too.

Last time, Mr Byres, you indicated that the powers are already there, there is not really much that needs to be done and they can operate here as they wish. If that is the case, why aren't they writing home insurance on a larger scale now? Secondly, given the potential risks, has the regulator provided advice to the federal government about the lack of protection for consumers if they do buy home insurance from UFIs?

Mr Laughlin : We are a prudential regulator, of course. This is about avoiding prudential regulation. At first blush, we are obviously not keen on this idea. The government also is grappling with these sorts of problems.

Mr HUSIC: It is a tough issue.

Mr Laughlin : It is a tough problem. It is not open slather. There are constraints. On this particular issue, there is a regulation that allows the use of unauthorised foreign insurers where the risks cannot reasonably be placed in Australia. That is the short qualification. That means that an unauthorised foreign insurer cannot just go, hang up their shingle and start selling to anybody. What does that actually mean? It means, for example, that there is no Australian insurer that will insure against the risk. If in theory all of the local insurers in North Queensland just left the market, which is theoretically a possibility, then it would be appropriate to use an unauthorised foreign insurer if they were willing to provide the cover. Another example is where the terms, which includes the price, are substantially less favourable to the insured—that is from a local insurer—than they could get from an unauthorised foreign insurer. One of the underlying points here is: why would an unauthorised foreign insurer offer cover that, in other respects, is equal at a lower price than a local insurer? Why would a sensible UFI offer cover at a lower price? It is pretty unlikely.

Mr HUSIC: Sometimes they could be pursuing market share and have decided to take a greater level of risk to achieve that.

Mr Laughlin : They could. That is exactly right. And a local insurer could do the same time. So there are possibilities. Another possibility is they come from a jurisdiction where there are very low capital requirements and they do not have to service that capital. But that comes at a price. That means that the security of the policy is lower than what it would be with a local insurer. When the initial sale is made, that may not be a big issue. The real concern will come when there are significant claims—for example, if there were to be a cyclone to go through North Queensland and cause a lot of damage, that is when this will become a real issue. Will there be the feet on the ground to process claims? Will there be resources to pay the claims? And so on and so forth.

Mr HUSIC: From my perspective, I can definitely see the benefit of UFIs putting competitive pressure on existing insurers. The only issue is—and you just touched on it then—if an event occurs, will they be able to actually meet the expectation of the consumer and fulfil what is reasonably required? Can I—

Mr Laughlin : Sorry, it is worth just making one point, too. This has to go through a broker, and they have certain obligations, as well.

Mr HUSIC: Understood. I just want to put these questions on notice, as I am conscious of time. The first question on notice is: in your 9 December 2014 statement, 'APRA outlines further steps to reinforce sound residential mortgage lending practices', you make a reference to addressing 'current risks in the housing sector'. Can APRA provider an outline of what it perceives these risks to be. Second, in reference to the flagged reforms to the regulation of private health insurance, or the oversight of private health insurance, can APRA provide written detail about the following: how you are preparing for this and, by that, the resources that you have set aside to achieve the transition to this new set of regulatory arrangements, the key milestones you have identified in preparing for this and, finally, the extent and method of industry and stakeholder engagement and consultation to support the transition. I will just put those on notice. Thanks for your indulgence, Chair.

CHAIR: I will just go back to a comment that Peter had made earlier—this area of notification to banks and the other groups being an art form. I would understand that your comments, Mr Byres, of judgemental combined with subjective views that you bring when you are discussing these issues equate to an art form and that, when you break things down into cold hard numbers, you lose some of the nuance and some of the art. Pursuing that, what happens with a bank when you meet and you have concerns of the level of their capital reserves and they do not comply with your advice? What is the next stage that you can take it to?

Mr Byres : Thankfully, with the banks and otherwise—insurers and super funds—there are, ultimately, some big sticks that we have in our back pocket in terms of the powers that exist in the act to enforce compliance. We have direction powers, disqualification powers. We have a range of quite strong powers to deal with institutions who wish to not engage and constructively seek to resolve issues that we identify. Thankfully, because we have that big stick and it is visible to everybody we actually do not need to use it very often. But it is there and it is a good reserve power to have.

The answer to your question is we have a range of escalation powers where we can commence formal action. But by virtue of having those powers we rarely need to use them because people know they need to engage with us constructively or else we resort to more formal enforcement. It is in everyone's interest to try to avoid those. They are just costly and time-consuming and, as I said, ultimately we have the power there to use.

CHAIR: When that big stick is brought out, is that publicly disclosed?

Mr Byres : It can be—it depends on what the action is. Obviously if we were, for example, disqualifying individuals then, yes, that is a very public process because, as Helen said, we would mount a case and that goes through the court system. If we were to remove trustees in a super industry because we were thought they were not looking after the interests of members, then again, that is very public because, most obviously, we notify the members that the trustee has been changed. When we get to that extreme, strong and very firm intervention then yes, not in all cases but in lots of cases, it would tend to be done in a way that the public can see.

CHAIR: My thoughts are that if we were considering a transition to greater transparency, obviously if we get to this point with the shareholders being kept in the dark there is a major disruption and a destabilisation at that point. It does seem an unusual power to be able to instruct a bank or an ADI to not to disclose something that would be of concern to the shareholder, albeit is at very early stage and may be only a minor disturbance. But it would be my understanding that the higher the level of capital held would equate to a more stable share price but a lower dividend. The more capital deployed would result in a higher dividend. Therefore, that disclosure at very early stages just empowers a would-be shareholder or buyer of shares to go for a dividend knowing there is a slightly higher risk or a safer share with a lower dividend. I can clearly see it is not your responsibility to disclose. But in every other area, it is a public company's responsibility to disclose anything regarding share prices that might mitigate—

Mr Byres : Yes, so this is a judgement. As we have said in other forums, we pride ourselves on being a supervisor as much as a regulator. We do try to use judgement in these things. I do not know that I would necessarily call it an art; but there is a degree of judgement involved in these things and the need to intervene early. If everything that we did had to be disclosed, even at a very minor level, I suspect it would actually severely impede our operations in two respects. It would discourage intervention early, which I think would be a bad thing. It would discourage institutions from sharing information with us about their problems. That would impede our effectiveness as well. I am not suggesting that there are not trade-offs to be made here. I understand fully there are trade-offs to be made and how do you maximise the cost benefit to the community is the sort of thing we have to think about. I do not think APRA's practice is different to practices that exist in other agencies around the world working on the sorts of things that we do. There are many times when things are best done behind the scenes.

CHAIR: I guess the trick is at what point of this threshold is there an obligation for a bank or an ADI to disclose. But it is informing the nature of the business, I would venture.

Mr Byres : I make one quick clarification. When we talk about things that we tell institutions they can or cannot disclose, it is about APRA actions, APRA views or APRA ratings. That does not absolve them from their more general obligations to report about their business. If there were some event that happened in a particular institution that would, in the normal course of events, be required to be disclosed, we do not prevent them from disclosing that. The issues that we are saying we tend to avoid disclosing and would prefer institutions did not disclose tend to be the specific actions that APRA is taking at a point in time. But that does not stop them disclosing about their business activities and about their financial position more generally.

CHAIR: Your subjective judgement of their risk profile is then asking an institution to increase their capital reserves.

Mr Byres : It may.

CHAIR: It may. But an institution still would, notwithstanding your advice, need to be disclosing what their capital holdings reserves are and—

Mr Byres : Yes, that was my point before. If an institution chooses to cut its dividend, raise some capital, do whatever it might do—it is impossible to do those things without it being transparent. We would not stop people from disclosing the fact that they were doing that. If an institution had incurred a loss from some of their business activities and needed to raise capital to deal with that loss, that is a business activity. They should disclose that to the market. We would not be preventing any of that sort of thing from being disclosed. As I said, the things that we are concerned about are the disclosure of specific actions that APRA may or may not be taking.

CHAIR: In your meetings with each bank individually and each ADI individually, what assurance do these institutions have that they are each being dealt with equally, fairly and by the same criteria? How is that advertised?

Mr Byres : There is a range of features, quality assurance mechanisms for want of a better term, that are producing what we think are consistent outcomes. First of all, all of our actions are founded on Prudential Standards and requirements that we have. These Prudential Standards are public requirements. Everyone knows what they are. To the extent that we require action of an institution, it is typically founded on some aspect of the standard that is not being dealt with and everyone knows what those standards are. Within APRA, we have supervisory teams and teams of experts who are looking across institutions. We have a common group of people looking at issues across the industry and providing good benchmarks and consistency in the views that we are forming about different aspects of the way organisations operate. Then at the heart of our system we have our risk rating framework which is a common risk rating framework for all organisations. We have quite detailed assessment criteria that our supervisors use to provide and develop an overall risk assessment to the organisations that we supervise. That provides a strong framework in which we are able to compare and contrast and make sure that we are treating people in accordance with their risk in a consistent manner.

Mr Glenfield : As part of that, we do have significant benchmarking exercises within APRA, whereby we have a consistent set of risk assessments and we then have presentations across offices, across regions, showing that we have rated someone this way in front of an APRA internal panel to see that they would have been rated the same way across APRA. In that way, you can get a measure of consistency in the approach of all the analysts across the board.

CHAIR: I want to move to the other issue that we have spent some time on, in regard to property and the high level of investment. There are a number of factors when we are trying to determine what the risk level is and whether we are approaching a threshold where we could conceive of a bubble bursting, with low interest rates, a high price of housing, large household borrowings and high household debt too, if I can read my handwriting. We will obviously have investors at a time when low interest rates and reasonably high rental returns create this lineball which does not even necessarily result in negative gearing because the property is washing its face of its cost of interest.

It appears that there is a real spike in investor activity. There are homebuyers entering the market with interest only products. We have absolute historic low interest rates and the general feeling is yes, they might go lower, but if they return to traditional levels this will pose a problem to the investor. We often just concentrate on the homeowner, but the investor who does not have the income to take advantage of negative gearing in the event of interest rates going up and anyone with a home loan is going to suffer hardship. To me it would appear that there are a number of factors in place that are building pressure and increasing risk and we are getting to this threshold. How can we take action to mitigate this?

Mr Byres : I think all of your observations are consistent with the comments I made in the opening statement. There are a range of risk factors at present—very low interest rates, very high house prices, high household debt, rising unemployment—that suggest that the current situation has somewhat heightened levels of risk to it and we should make sure that everyone operates with a healthy degree of common sense and does not get too carried away just because of the fact that, at present, interest rates are low and prices are growing quite strongly, at least in some cities. But this is a situation that has been emerging over time.

As I have discussed in previous appearances before this committee, we have been slowly turning up the dial of our supervisory intensity. Our letter in December was only the latest step that we have taken. Previously we had issued some guidance to institutions on sound lending standards. We sought assurances from boards of banks that they were focused very much on the risks in their housing books.

Just as we think the risk or the potential risk is rising, as I said, we have been turning up the dial on our supervisory intensity. I am not sure who posed the question before about what we would do next, but the answer is that to some extent we have to see what 'next' looks like. But, if risks continue to grow, then clearly we will need to think about how else we respond to that to make sure that the banking system remains stable and able to absorb whatever happens in the marketplace.

CHAIR: I have reflected a little on that often the Reserve Bank talks about the blunt instrument, that their only tool is controlling the interest rate. I think, Mr Byres, you made a somewhat similar comment that your blunt instrument is to do with capital reserves.

Mr Byres : Capital is one part—we do have some other tools in the toolkit. Our tools are obviously much less blunt than the Reserve Bank, because an interest rate is an interest rate; it applies to everybody and everything. It covers the economy as a whole. The sorts of tools that we are talking about at present, which are capital related tools, nevertheless, we are able to target them much more precisely at the risks. In this current exercise, we are going through, we are targeting those ADIs that are pursuing the most aggressive lending strategies and, to the extent there are additional capital requirements imposed, they will be imposed on those housing portfolios where the risks are and not on the other lending books that banks have.

You are correct in saying that the interest rate tool that the Reserve Bank has is quite a blunt tool for dealing with something specific like housing risk. We have tools that are not perfect by any means, but they are able to be much better targeted at either individual lenders or individual markets in a much better way than the Reserve Bank can possibly do.

CHAIR: I will not tell the Governor that he has got a blunt tool.

Mr Byres : No, I am sure he would say the same thing.

CHAIR: The point I was getting to is: it would appear to me that it is incumbent on government to be able to develop policy that gives much finer control to preserve market stability and property values through somehow being able to give incentive or take incentive away from the investor and the homebuyer to maintain a balance through finely adjustable mechanisms. There are some things that you cannot do and there are some things we cannot do but, if we worked harmoniously in that area, it could make your job much easier.

Mr Byres : Yes. If we are talking about housing, there are a whole raft of issues that influence housing markets. Some of them are bank lending practices, and we clearly have a significant ability to influence those, but there are many things that are outside our control, the Reserve Bank's control, ASIC's control—we obviously do not have any control over tax policy; we do not have any control over land supply policies—a whole raft of things. To really think about some of the issues in housing markets, they are well beyond just APRA or the RBA.

CHAIR: Not to put you on the spot but would you support an inquiry that was expansive and looked at all of those things? So often it appears that, when one issue is raised, it can be knocked on the head; however, if it were raised in a suite of strategies, a raft of policies, to address this very, very large issue of homeownership and property in Australia that affects every single person—with the exception of those who we are concerned with, who are homeless—it would appear to be a very worthwhile inquiry.

Mr Byres : I would agree with you; it is a very important issue for everyone to think very hard about. There have, though, been a number of inquiries on this or related issues in the past. I am not quite sure what the new ground would be but, clearly, it is an important issue. If that is the most effective way to look at it, then by all means.

CHAIR: This should be done with full engagement with your good selves and others.

Mr Byres : To the point I made before, our issues and the Reserve Bank's issues in housing are primarily driven from a financial stability perspective. There are a whole raft of other issues on affordability and other things which are not things that we can deal with or respond to.

CHAIR: Thank you for that, and thank you for your time. I declare the public hearing closed, and thank you again for your time.

Resolved that these proceedings be published.

Committee adjourned at 12:25