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Standing Committee on Economics
18/03/2016
Australian Prudential Regulation Authority annual report 2015

BYRES, Mr Wayne, Chairman, Australian Prudential Regulation Authority

CHAPMAN, Mr Keith, Executive General Manager, Specialised Institutions Division, Australian Prudential Regulation Authority

LITTRELL, Mr Charles, Executive General Manager, Supervisory Support Division, Australian Prudential Regulation Authority

ROWELL, Mrs Helen, Deputy Chairman, Australian Prudential Regulation Authority

SMITH, Mr Neil, Special Counsel, Australian Prudential Regulation Authority

SUMMERHAYES, Mr Geoff, Member, Australian Prudential Regulation Authority

Committee met at 9:30

CHAIR ( Mr Coleman ): Good morning. I declare open this hearing of the House of Representatives Standing Committee on Economics. On behalf of the committee, I welcome the Chairman and other executives of APRA here today. I do thank you for taking the time to appear before the committee. You have very substantial responsibilities, and we appreciate you taking the time to appear. This is our first hearing with APRA in 2016. It is my first as Chair of the committee. At the last public hearing with APRA in October 2015, the committee sought information on property lending and capital requirements in the banking sector and also on APRA's oversight of the superannuation sector. The committee will examine some of these areas today and also focus on APRA's measures to reinforce residential mortgage lending practices, as outlined in its letter to all ADIs in December 2014.

The committee is particularly interested in APRA's benchmark of 10 per cent growth in investor landing by ADIs and the continuing impacts of this in the housing market. I do remind you that although the committee does not require you to give evidence under oath, the hearings are 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 contempt of parliament. Please be advised also that the House of Representatives may be sitting during this hearing. Should that occur, these proceedings will be suspended and will resume once the sitting of the House has completed. Mr Byres, would you now like to make an opening statement before we move on to questions?

Mr Byres : Thank you, Chair. Let me start by congratulating you on your appointment to lead the committee. On a similar note, I would like to introduce Geoff Summerhayes, who was appointed as the third APRA member from 1 January this year. Therefore, he is making his first appearance before this committee. Geoff will direct our work on insurance related matters—life insurance, general insurance, private health insurance—as well as have responsibility alongside Helen and myself for APRA's overall strategy and approach.

I thought I would start by briefly updating the committee on the position of the Australian financial sector in light of recent volatility in global financial markets. In short, and as I noted at our recent appearance at Senate estimates, Australia continues to benefit from a sound financial system. Financial market developments are certainly something we are keeping a close eye on. There are no grounds for complacency given the global outlook. But the volatility in equity markets and increases in credit spreads in recent months are well within the capacity of the Australian financial system to handle without any significant stress.

APRA's regulatory agenda for 2016 is heavily influenced by the recommendations of the Financial System Inquiry. In banking, an important focus will be on how we refine the prudential framework for the deposit-taking sector such that it delivers on the FSI's recommendation for 'unquestionably strong' capital ratios. In doing this, we need to be mindful of the still evolving international regulatory framework. But, as things stand today, we should be in a position around the end of the year to set out how an 'unquestionably strong' framework will be achieved. Actual implementation of any changes will occur in an orderly fashion over the following couple of years.

We also have important pieces of work underway in relation to securitisation and bank funding. We are currently consulting on proposals for a simpler regulatory framework for securitisation which we envisage will not only provide an appropriate set of prudential requirements but also help re-establish a more resilient securitisation market. In the next few weeks, we will commence formal consultation on the Australian implementation of a new regulatory requirement—the Net Stable Funding Ratio. The ratio is a new international standard designed, in simple terms, to discourage banks from becoming overly reliant on volatile short-term borrowing when funding illiquid assets. Australian ADIs—Australian authorised deposit-taking institutions—have necessarily strengthened their funding profiles relative to the pre-GFC period. To a degree, the NSFR will reinforce and continue this trend. It will also help contribute to the FSI's objective of 'unquestionably strong'.

Our supervisory work on lending standards for housing will continue in 2016. Housing lending continues to grow at a solid rate—around seven per cent per annum—but there is a compositional shift occurring as investors are less prominent and owner-occupiers account for a greater share of new lending. Importantly, from our perspective, serviceability assessment standards have improved across the industry, although we still have further work to do to ensure that improved lending policies are fully implemented, monitored and enforced.

Turning to superannuation, there are three areas that will receive particular emphasis in 2016. Firstly, the robustness of strategic and business planning is being undertaken by boards. In a rapidly evolving environment, superannuation trustees do need to have in place robust processes for setting their strategic direction, establishing business plans and reviewing their operations, services and performance against appropriate benchmarks. This is an area where we observe industry practices can be improved.

Secondly, we will also be looking at board appointment renewal and performance assessment processes with a view to highlighting better practices as well as areas where improvements are required in line with accepted principles for sound governance. Thirdly, APRA will be following up on our 2014 work on conflicts management which identified oversight of related party arrangements as a particular area of weakness in the superannuation industry practices. Although it did not refer any specific matters to APRA, similar issues were identified by the Royal Commission into Trade Union Governance and Corruption. We will therefore be reviewing more deeply for a sample of funds across all industry segments, practices in relation to the management and oversight for different types of related party arrangements. This work will assess the extent to which the issues we identified in the 2014 review have been addressed and where further improvements in practices are still needed.

In the area of insurance, there are a couple of issues to note. The committee would be aware that we took over the prudential supervision of private health insurance from PHIAC, the previous regulator, in July last year. Internally, the integration of the two agencies is well advanced. We also plan by mid this year to release a road map to private health insurers for the alignment, where appropriate, of the private health insurance prudential framework with those that apply to other sectors that APRA supervises. That work will occur progressively over the next few years.

In general on life insurance, we are currently conducting stress testing with a selection of life insurance and, in a separate exercise, general insurers to see how the industry responds to a severe economic and liability shock. In addition to APRA's ongoing focus on the prudential soundness of the life insurance industry, following a period of underperformance, we have also engaged with the efforts to improve the standards, performance and sustainability of the industry. There has clearly been a gap between community expectation and industry practice that needs to be closed.

Finally, an issue that we have been delving into across all of the industry sectors that APRA supervises is culture. Our interest in culture reflects our prudential mandate. A good culture helps to protect against poor outcomes. Our work is primarily directed to detecting the potential for financial institutions that we supervise to be badly mismanaged such that they put their own viability at risk. We are not the lead regulator when it comes to instances of consumers being unfairly treated but we are very interested in what those episodes tell us about the culture within financial institutions and the extent to which incentives might be operating to encourage imprudent behaviour.

A little over 12 months ago we also instituted a new standard that, amongst other things, introduced an explicit requirement on boards to form a view about the risk culture of their institutions to assess whether it was consistent with their strategy and risk appetite and, if they felt change was needed, to ensure something was done about it. While we would observe that boards are giving more attention to issues of culture, I think it is also fair to say that they are still grappling with how to do this in a robust and systematic manner. So, with that overview of our activities, my colleagues and I would obviously be very happy to take your questions.

CHAIR: Thank you very much. I will kick off with some questions. Obviously something we have talked about a lot over the last year or so is the issue of mortgage risk weights and the changes that you announced last year that were put in place. I am just interested in knowing your view on the impact of those changes. Have they been what you would have foreseen; and have they achieved the policy objectives that you set out?

Mr Byres : There were two related issues we dealt with last year: one was housing lending standards and the other one was mortgage risk weights. They are often treated together but, to your specific question about mortgage risk weights, that was responding to an issue that was raised by the FSI. FSI recommendation 2 was that mortgage risk weights for the larger banks that use internal models to determine their regulatory risk weights should be higher. So we announced in July that we were increasing those risk weights to take effect from July this calendar year, so the change comes into effect July 2016.

Your question was: 'Did you get the expected impact?' I think it is fair to say, at least in the first round, yes. The requirement, in effect, asked banks to hold more capital. They did that and the major banks were primarily the banks affected. Those four banks all went out and sought to raise additional capital well ahead of the new requirements coming into force. So, as we sit here today, when that change comes into effect, the banks are well positioned to accommodate that without any further difficulty.

The issue that the FSI raised was a question of competitiveness between those large banks and the smaller institutions. It was always unclear how the smaller institutions would respond. The major banks responded to higher capital requirements by increasing their mortgage rates. That left the door open for the smaller institutions to decide whether they wanted to follow suit and improve their own returns or whether they would respond by trying to keep their mortgage rates as they were and pick up additional market share.

I think the results were fairly mixed across the board, to be honest, and the response was a bit of both. There were clearly increases in rates that followed the major banks by the next tier of institutions but, in many cases, they were less than or at least no more than the increases that the majors had instituted. So I think where we ended up was that the change certainly does improve the relative competitive dynamics of the smaller banks versus the larger banks but, in many cases, it has allowed those smaller banks to improve their returns.

CHAIR: Just taking a step back on that: obviously, the underpinning idea here is that you have the small number of banks that can effectively comply with the IRB rules and, consequently, adopt this lower risk weight, although the gap has narrowed a bit. If you were to go right back to first principles and ask: is that reasonable, in your view; and is it, from a prudential perspective, necessary and appropriate that the smaller institutions that do not comply with the IRB rules should be required to hold materially more capital against mortgages?

Mr Byres : There is a question about whether there should be a gap at all and then there is a question about how big the gap should be. In response to the first question about whether there should be any difference, I think there is a case to say there can be a difference for banks that have invested in advanced risk management. Certainly, the philosophy of the Basel framework was that, where banks had advanced risk management techniques that enabled them to manage their risk better, diversify their risk better and price their risk better, that should be rewarded in some sense by the regulatory framework or recognised by the regulatory framework. That is essentially the principle that says maybe there can be a difference.

What the FSI called out was that, in practice, that difference had got too large and was having an adverse competitive impact. The steps that we took last July were designed to respond to that. The other thing that I should just say is that it is not the end of the story. We have said that the steps we took in July were an interim measure. As I said in my opening statement, all of this work—both the standardised approach risk weights and the internal model risk weights—is currently subject to review by the Basel committee. They are in the process of being recalibrated and reset. We will need to come back to this as part of looking at how we take that work forward at the end of this year. It may be that the gap is narrowed further.

CHAIR: How does it compare to other countries? Is it a similar situation in other countries?

Mr Byres : Charles might have a view on this, but I would have thought that the gap here is less than that which exists in many other jurisdictions. We have done things here to raise the IRB risk weight above what just a strict implementation of the Basel framework would look like. Is that a fair?—

Mr Littrell : The global minimum at the moment is the IRB risk weight at 10 per cent and the standardised 35 per cent. We are running currently a bit over 25 per cent and a bit over 40 per cent so, relative to the Basel minimum, we have a narrower difference—different countries have different approaches. We are not uniquely hard on our standardised banks by any means.

CHAIR: On the work that you are doing now in response to the FSI recommendation about ensuring the system is unquestionably strong, you have mentioned that there is a lot of work going on there and you will have more to say on that later in the year. Is there anything, at this point, that you want to say about any direction you might be heading in or anything that you think is appropriate to share publicly at this time?

Mr Byres : No, not particularly and not because I am seeking to avoid saying anything publicly. The things that we said last year about how we see things playing out remain. One of the advantages of responding to the mortgage risk weight issue that the FSI raised and that caused the larger banks to raise some new capital was that it did improve their capital position relative to the rest of the world. That was one of the FSI objectives.

As we sit here today, we are reasonably well positioned to accommodate whatever comes out of the international review and consultation that is currently underway. We are not sitting here with a banking system that is a long way away from where it needs to be. That is why we feel it can take longer than everyone might like. I am sure that the banking industry would like more certainty but it is worth us just taking the time to see how the international framework settles and then think about what we need to do to make it work well here.

CHAIR: On another topic, you mentioned again in your remarks your concerns about governance of superannuation boards or certainly identifying room for improvement. I know that is something that you, Mrs Rowell and Mr Byres, have both commented on in the past. You seem to suggest that there is further work you are doing in that space and things you are looking at. Would you like to expand on that or any recent developments in that area.

Mrs Rowell : Certainly let me respond to that question. Last year we consulted on some possible amendments to our prudential standards and guidance in relation to governance for superannuation. Some of that was related to the government's proposals around independent directors on boards but other aspects of it were focused on our view that there needed to be some strengthening of approaches around board appointment, renewal, performance assessment and ongoing effectiveness of governance.

We had a number of responses to those consultations last year and in December we released a letter which indicated the likely changes that we would make to our prudential standards in response to the consultation. In essence, industry was quite supportive of our proposals, because they were principles based and essentially said that: boards had to have appropriate governance charters with rigorous appointment, removal and nomination processes that looked at getting the right skill sets and capabilities on boards.

So, at an appropriate time, which we have not yet settled on, we will implement those indicated changes into our prudential standards and guidance, if you like, to assess the response of industry to what we have signalled is the direction we think the industry needs to go. We will undertake some thematic work over this coming calendar year to actually look at practice in the industry around nomination, appointment and removal; and how they undertake performance assessments of the boards to determine that the governance of boards is actually effective and achieving sound outcomes. We will use that thematic work to provide some feedback both to the individual funds but also to the industry more broadly about where we see that there are good practices and where there are areas that need improvement.

CHAIR: When there are those bad practices or ones that need improvement, why is this important? What are the potential consequences for investors of suboptimal governance processes?

Mrs Rowell : At the end of the day, I think our focus is on making sure that the decisions made by boards are robust, rigorous, well founded and primarily focus on members' best interests. The manifestation of where poor practice could emerge can be quite many and varied, because it depends on the particular decisions that are being made. It can influence decisions about mergers between funds. It can influence decisions on investments and whether they are going to achieve good outcomes for members. It can manifest through fees, costs and services that are being provided. Some of it can be more qualitative in terms of overall member service and support and some of it can be more quantitative in terms of actual financial outcomes for members.

The question that I often get is: where are the really material egregious issues? We certainly have seen some of those; however, what we also see is the accumulation of lots of small things that can over time add up to poor outcomes even though it is only a small decision here on expenditure or a poor decision there on a particular investment. Our view is that overall we want to make sure that all decisions are being made robustly. It is difficult to point to that having a particular quantitative outcome over time, but we think that having good decision making in funds is critical.

CHAIR: Last question and then I will pass over to Mr Husic. You make some comments, Mr Byres in your statement about securitisation and regulation of securitisation. That is not something that has come up a lot before the committee but it is, obviously, an important area and was partially involved in some of the financial issues of some years ago. Could you just expand a bit on what you are looking at in that area and why it is a priority for APRA.

Mr Byres : I might ask Charles to take that because he has led much of the work and the thinking.

Mr Littrell : The issue globally was much less relevant in Australia. Securitisation and derivatives were combined in ways that made it very hard for the investors to understand what they had bought. In our market the issue was: securitisation was conceived in the 1990s as both a funding and a capital concept. Over the years the concept of securitisation for funding, but without any capital relief, developed prominence, and our rules do not particularly support that. As an aside, one of the permanent prudential issues in Australia is: we do not have a lot of government interference in funding the home loan market, which is the case in many of our peer countries—which generally is good but it has the effect of saying the banking sector funds the entirety of the home loan business, which tends to make them less liquid than their international peers. We had two broad views in our reform. One is that we wanted to create a much more explicit environment for funding-only securitisation. For the more substantial banks that is essentially a way to offer secured term funding to investors they cannot reach very easily right now. That is mainly about our strategy about improving the banking sector's liquidity.

The other issue is capital relief securitisation where we were not requiring originating ADIs to continue to hold capital on their home loans. That structure had become overly complicated and, in all honesty, overly gamed by the industry. We are proposing to reform that so it is still possible to get capital relief, but some of the structures that achieve capital relief without actually relieving the risk will be done away with.

At the end of the day we expect we will have a much bigger, much safer and much simpler securitisation market where what happens now in capital relief will probably be outstripped in volume terms by funding based securitisation.

CHAIR: Is a fair summary of that that you have had some concerns that there has not been enough underlying capital behind the various products that are securitised and you are seeking, through various means, to address that?

Mr Littrell : There are two concerns. One is that we would like the securitisation market to be bigger in asset securitised terms, which means we were looking to reform the regulations to make that work better. The other thing is that we were seeing structures where you would go into the structure with, for argument's sake, $5 worth of equity in the banking system and you would come out with 50c, but all the risk was still in the banking system. From our point of view that is not a good outcome. We are trimming some cut corners back to being sharp corners.

CHAIR: Thank you. Mr Husic.

Mr HUSIC: Thank you, Chairman Byres, for your appearance and the appearance of other representatives from APRA, and congratulations to Mrs Rowell on your deputy chair appointment, and Mr Summerhayes. Chairman Byres, in relation to the whole rebalancing of investor loans versus owner occupied, my recollection is that you—and by 'you' I mean APRA—wrote to the ADIs in about December 2014 saying—

Mr Byres : Correct.

Mr HUSIC: It was roughly about a benchmark of 10 per cent growth.

Mr Byres : Correct.

Mr HUSIC: Could you remind the committee—not going through everything that has happened since then—of the circumstances that led to APRA issuing that letter in December 2014? What were the industry conditions, the markers, that you took note of that required you to intervene in that way back at that point in time?

Mr Byres : I took up my current role on 1 July 2014, and when I arrived back into the job there were discussions amongst the financial regulators, the Council of Financial Regulators—the RBA, Treasury, ASIC—about very strong lending growth in the housing sector and the environment in which that was occurring.

The environment in which that was occurring in many parts of the country was rapidly increasing and high house prices, high household debt levels, historically low interest rates and subdued income growth. Those four factors put together suggested that a degree of caution was needed. At that same time, in its Financial Stability Review in September, the Reserve Bank explicitly called out the very strong growth in lending to investors as leading to—and I cannot remember the quote, so this is not a quote—emerging imbalances in the housing market.

These issues were discussed among the Council of Financial Regulators, and we talked about what potential things we should be doing to reinforce the safety and stability of the banking system. That effectively resulted in two pieces of work that kicked off in December 2014. We wrote to the banks and said, 'We're going to be very intensely focusing on lending standards,' and we called out a couple of things in particular. The rate of growth in investment housing lending was particularly strong, and it seemed to be where competitive pressures were leading to particular erosion in standards, but I think it was not exclusively investment lending. We talked about the 10 per cent as being a benchmark that we saw as one that might warrant or suggest that higher risks were being taken. We also put out some benchmarks on interest rates that banks should be thinking about in their serviceability assessments. Given that we were operating in an environment of historically low interest rates, we did not want banks or other lenders making credit decisions based on an assumption that interest rates would stay as low as they are today forever.

We wrote to the banks in December. At the same time, ASIC also launched a piece of work about responsible lending, because they have responsibility for the responsible lending obligations. They undertook a piece of work in conjunction with us, but they were the leaders of that work, looking at whether banks were meeting their responsible lending obligations. Your question was: what was the environment? It was this environment of high—and in some cases rapidly increasing—house prices, high and increasing household debt, historically low interest rates, subdued income growth and this sense that there were very strong competitive pressures that were causing an erosion in the lending standards across the industry.

Mr HUSIC: Flowing from that response, there are three measures in particular that I am interested in. One, how you got to 10 per cent growth as being something that merited attention by APRA. Two and three are related. Are you saying now that APRA has in its tool kit a figure that says that if house prices grow at a certain rate, or if debt levels exceed a certain figure, you will, basically, employ macroprudential tools to manage the response?

Mr Byres : No, not in the mechanical sense that I think your question might be implying. There is no specific threshold that says, 'If household debt gets above X, we will do action Y.'

Mr HUSIC: In a range of interpretations based on what you have indicated to the committee—chiefly, the rate at which house prices increase and the level of debt that would be worn by households to finance home purchase—can you see how it could be drawn or inferred from those points that there is a threshold at which APRA will act and that once it crosses a certain mark, you guys will act?

I have to say that that is how I interpreted your response.

Mr Byres : Yes, but I did not put any figures on my response. I said, what prompted this work was a discussion amongst the council agencies to, in a sense, look at these various issues and say, 'Put together, it is an environment of heightened risk.' It is not a formulaic assessment that says that if you cross this threshold or that threshold, you must act in a particular way. We have been very keen, and when I say 'we' I think there is agreement at the Council of Financial Regulators, that those sort of formulaic approaches are not ones that we want to pursue. But, clearly, if we had called out those trends and said, 'These factors, taken together, have caused us concern,' and, if those trends had continued, then it is reasonable to say that we would have had to act further.

Mr HUSIC: Would it be safe then to say, if you do not have that figure, that if someone were to go back and basically chart over a 12-month period leading into December 2014—when you issued your letter saying, for instance, 'If investment loan growth goes over a rough 10 per cent benchmark, we will act'—and looking at the stats then, is that what someone should take out; that that is the point at which APRA may act?

Mr Byres : If someone wanted to ask whether, if those circumstances came to pass again, the regulators would probably do the same thing,' then that is probably an assumption to make. But the situation has evolved. So what has happened? House prices have cooled—they are not increasing in the double-digit rates that they were—and, on the other hand, household debt is still rising. So these things are going in different directions. Interest rates are still at historically low levels, and we need to be cautious of people assuming that that lasts for ever. Income growth is still relatively subdued. So a number of these factors will stay the same. What has changed, though, is we have forced lending standards to a higher level. That builds resilience into the system. And we have also, through other means, including the risk weight change that we talked about a little earlier, generated some extra capital in the system. It is necessarily judgemental but, if those circumstances emerged again—to go back to your point—and we did not act, it would probably be reasonable for you to ask us why.

Mr HUSIC: Understood. It is just more understanding of at what point you act.

Mr Byres : It is not that we have not published it; it is just that we do not have a mechanical, 'If this threshold is crossed we will do something.' It is judgemental.

Mr HUSIC: Can you recall any other time in which a regulator of your type, either you or your predecessors have employed these types of macroprudential tools?

Mr Byres : I think these tools have been used increasingly around the world. They have been used in slightly different ways. For example, our colleagues in New Zealand have put more prescriptive rules in place about maximum LVRs, and they have even got to the point of having differential regulatory requirements if you are lending to Auckland versus the rest of the country. In the UK, they have limits on the amount of bank lending that happens at very high loan-to-income ratios. So, if you are borrowing a very large amount, as a multiple of your income, there are limits that they have imposed. So I think there is a raft of these measures that are emerging around the world. Some jurisdictions, particularly in Asia, have gone a different path. They have made changes to stamp duty and other things as their way of dealing with some of these issues.

Mr HUSIC: But what about in the Australian context? I take on board the international jurisdictions you are referring to. Has there been application of macroprudential tools, that you recall, in the Australian environment in recent history?

Mr Littrell : The most relevant would probably be that we were in a similar situation in the early 2000s. The confluence of the RBA thinking was that the macroeconomy was getting a bit overheated and that overheating was concentrated in the home lending sector, and APRA supervisors were observing steadily notching down credit policies and actual implementation of policies, so we decided in 2002 to 2003 that we would tighten the markets. In fact, we turned out to be one of the global pioneers in stress testing. We did an industry stress test and we used that to demonstrate to the more exuberant of our flock that they could be less exuberant. We changed the rules on how to apply lenders mortgage insurance, we steepened the capital curve for higher loan-to-value lending and we strongly discouraged lending to individuals who could not normally afford a loan in other ways, otherwise known as subprime. This is not a unique thing.

Mr HUSIC: I want to ask some quick questions triggered by Mr Summerhayes's appearance. Mr Summerhayes, what are your responsibilities now within APRA? What is that policy regime or area that you will be focused on?

Mr Summerhayes : My responsibilities as an APRA member are life insurance, health insurance and general insurance.

Mr HUSIC: I am trying to ask this as sensitively as I can, which is uncommon for me. You are ex-Suncorp, and you were there at a time when there were particular challenges for life insurance. Obviously, companies in your space, like Suncorp, were under particular pressure. Given you have come from that sector, what assurances can you give? Obviously, as a regulator now you have to wear a completely different hat. What are the high priorities for you now in this new role? If I may ask, and this will potentially give you the opportunity to send a signal broadly, how do you see your role now as a regulator differing from that of a CEO in a sector where they obviously had specific challenges?

Mr Summerhayes : Thank you for your question. It is a different role for me, and there is obviously a period of adjustment in coming to grips with that different role. Mr Byres can comment on the logic for my recruitment and looking for somebody with my capabilities, but what I bring to APRA is a commercial perspective. One of the important things that we do in engaging with our regulated institutions is to try and understand the context in which those institutions operate, and having some commercial experience is valuable in that regard. At the end of the day, what we are doing is assessing business strategy, assessing risk and governance and assessing that those organisations have adequate capital to pursue the strategies they undertake. A commercial perspective and a commercial overview is beneficial in that regard.

Mr Byres : Could I jump in in response to that?

CHAIR: Yes.

Mr Byres : I just want to respond to Geoff's point. When Helen and I talked about what would be our ideal candidate to replace Ian Laughlin, who, you will recall, was the previous APRA member, we were actually looking for someone with similar experience to Ian. Ian had come from the industry and brought invaluable experience to APRA, as did Ian's predecessor, John Trowbridge, who had come from the general insurance sector. Ultimately, it is not our decision to make the appointments; the appointments are made by the Treasurer.

Mr HUSIC: But you recommend them to the Treasurer, correct?

Mr Byres : We work with Treasury to put forward names to the Treasurer, yes. We were particularly focused on making sure that we had someone fill the role who had strong commercial acumen and good senior executive experience within the insurance sector, because we thought that was valuable to the balance of perspectives within APRA. It was actually an important and, in our view, positive aspect of Geoff's appointment.

Mr HUSIC: I totally understand that and I think a lot of us—regardless of politics—value being able to tap into industry expertise, as to what Mr Summerhayes would bring to APRA. As a CEO, your primary responsibility is—there are a number of stakeholders, but I imagine shareholders are one, customers and employees—to work out who you need to attend to. In your role—given the pressures within the sector; this has been well documented—the key is to get a sense of, in your mind, who you see you are primarily representing in this role within a regulator space as opposed to your previous responsibilities.

Mr Summerhayes : The APRA mandate is very clear, and I am there representing and overseeing it, which is about prudential safety, contestability in the system and competitive fairness. We are doing that in the interest of policy holders of insurance companies, depositors of banks and members of superannuation funds. My mandate is through that lens.

Mr HUSIC: Good answer.

Mr BUCHHOLZ: Mr Littrell, can I continue a discussion you were having with Mr Husic about macroprudential settings and the macroprudential tools, and ask you to expand on what other tools are available to APRA in addition to the levers that have been pulled more recently?

Mr Littrell : This would probably be a good time to interject that 'macroprudential' has become something of a global buzzword and we, and the RBA, believe in prudential supervision—ideally, good prudential supervision. That is actually APRA's job. There is a difference between the global application of this and a local application. APRA has always benefited from having a highly competent central bank, giving us their view of the macroeconomy and how it is moving. However, we have always taken the responsibility of: what do we do about that in the context of the banking, insurance and super sectors? The sorts of tools we have available, broadly speaking, break down into regulation and supervision on the regulatory side. We can talk about different industries, but let us talk about banking. To an extent, we are ensuring that the banking industry is well capitalised, is managing its capital to its risk and is soundly funded. That, in itself, is a macroprudential tool even though it is focused on helping each bank be sound.

Broadly speaking, if the banking industry can only grow with a concomitant increase in appropriate capital and funding, and if it is being supervised in a way that the lending decisions it is making on average are pretty sound, then that, in itself, is generating a macro as well as a micro effect.

Under the Banking Act and the prudential standards, we have a broad range of powers in theory we could pull out. We have not, typically, felt it necessary to extend beyond what we do now, which is conservative regulation, proactive supervision and quite often focusing the attention of the industry on what we think are emerging risks. We could, for example, become more prescriptive about higher loan-to-value lending or loan-to-income lending, but we have not had to do that. We have these conversations, but it is important to remember that the Australian home loan portfolio is generating very low loss rates and very low default and late payment rates. It is a quite sound business now, so we are not trying to constrain it unduly. If we see an individual institution following a reckless path there is no need to pull macroprudential tools. We have supervisory tools to constrain that institution, and we do that fairly often. We could give you a list of the available macroprudential tools in the world. Fundamentally, good, proactive supervision is the best macroprudential tool. Preventing industry from going crazy is much better than having rules in place to deal with the craziness.

Mr BUCHHOLZ: In the conservative regulatory framework at the moment your recent actions in and around the implementation that you just put—was it just purely as a result of the Basel reforms or a growing concern of increase in the investor sector of more interest-only loans?

Mr Littrell : You are talking about the 2014-15 interventions?

Mr BUCHHOLZ: Yes.

Mr Littrell : What happened during calendar year 2014 was that we were getting steadily increasing signals from the RBA. There was concern of the macroeconomy overheating, with that being concentrated in home lending and particularly concentrated in investment property. We were also seeing in our statistics, our supervision and on-site visits more interest-only loans and more unusual loans being made. We were seeing policies being chipped away—things like minimum interest rates, interest rate buffers, how much would be lent against rental income and things like that. So there was this aggregate conclusion forming that was saying, 'We need to act more proactively to constrain an industry that is overgrowing a sound asset class.' Again, in terms of the constraints we are talking about, we are talking about an industry that is still growing this business quite a lot faster than nominal GDP. We have constrained the acceleration of something that we thought was getting a little bit reckless at the margin. So there was a combination of more capital and much more supervisory focus on lending policies. There was this one-off tightening, if you will, of the expectation about how fast investment property loans are growing. I would say that our hope and intent for the tightening of lending standards is that it will be permanent. The policy changes on capital are as permanent as any policy changes are. Putting explicit constraints or guidance on growth rates is something we do not do very often and will probably reconsider at some point.

Mr BUCHHOLZ: With rolling out your reforms, does APRA do any work on looking at the effects of the blunt instruments you have on the housing market in more subdued markets? Once you look through the Sydney, Melbourne and potentially Brisbane markets do you look into the regional sectors—in particular, at the downturn in the real estate section in the resource-heavy states. Do you have an assessment of what the effect will be in markets that are already subdued?

Mr Littrell : At that point there were fewer subdued markets than there are now. The fact that the major banks were levering their portfolio at 65 to one and we were reducing it to 40 makes at least as much sense in subdued markets as it does in hot markets. The fact that we were constraining the industry from lending to the most overextended borrower and pulling that back makes at least as much sense in subdued markets as in hot markets. The guidance to constrain the growth of investment property lending—in subdued markets it is not growing that fast anyway, so it is not really relevant. We looked at it qualitatively and said, 'If you are in a regional market that's had a big run-up due to a mining boom, for example, the run-off of that mining boom is going to have a much larger effect than anything we would do.' Remember, we have not actually clamped the supply of house lending; we have moderated how aggressive the most marginal borrowers can be and we have moderated some of the growth in the sector and we have improved the capitalisation of the sector. None of that stops an individual from getting a loan.

Mr Byres : Charles raises an important point, because there is often a suggestion that the constraints on investment lending are actually reducing the supply of credit. They have had impacts on investors, but the total supply, the total speed of growth of credit to the housing sector, has actually run pretty much unchanged for the last six months. There is this substitution of owner-occupiers for the investors that may not be as prevalent any more. But total housing finance is not actually greatly changed from where it was six months ago or 12 months ago

Mr BUCHHOLZ: I do not know if that completely answers my question, because I did ask in my question if you were to look through the capital cities' markets, which would be falsely inflating—

Mr Littrell : The answer to that is we considered directionally what would happen.

Mr BUCHHOLZ: I understand it is difficult; I just wanted to get your opinion.

Mr Littrell : Of three moves we made, the capital increase and the tightening up of the marginal underwriting standards, essentially making a sounder lending portfolio—those do not particularly make a difference in hot markets versus cold markets. They were just sensible things to do. The issue of constraining investment property lending we looked at as well. It does not actually make any difference in a cold market, because there is not loan demand at that level in a cold market, so it is not like somehow people are being pulled back. If you are a smaller ADI and you are in a market that is growing at, for argument's sake, five per cent, the fact that APRA is suggesting that you should not grow faster than 10—it does not actually affect any one of your borrowers.

Mr BUCHHOLZ: Thank you. I will leave that there. I want to ask another unrelated question. When we were talking about the IRBs, where you have your first and your second tier rates, you said that it was acceptable that someone who was managing their risk better be given a cheaper rate—can you help me understand what are the practices for managing risk that give the first tier operators the discount or the lesser rate?

Mr Littrell : I will start from the other end. If you start with a fairly traditional bank on a standardised approach—and by banking, I am including credit unions and building societies—they have traditionally said: 'Okay, we know the property, and we know something about the borrower.' What they know about the borrower would vary a little bit, based on the circumstances. There are some rules of thumb, which still apply, about loan to value ratio on one income or whatever. So that is the normal state of play, and our standardised capital is based on that normal state of play. Now the people who are doing the internal modelling approaches have to go through an extensive accreditation with APRA that their data and their model improve on that outcome. What happens under the modelling approach is these banks build models that predict, on a broader data set, what is happening with any prospective borrower. For example, they will often have the bank account of that individual, and they can extract useful information from the cash flow stream that they have seen from that person. They also tend—

Mr BUCHHOLZ: Like what?

Mr Littrell : Essentially how disciplined they are as a saver and as a spender. If you see someone who routinely is paying their credit card on time versus not paying their credit card on time, that makes a difference. If you are seeing someone who is spending all of their money on the pokies every Thursday payday versus not, that is a data point you can use.

The broader issue you have is modelling banks are moving from a loan by loan decision to a portfolio decision, so they tend to be broader geographically and in product terms. So what happens is that any individual loan is not more or less risky based on whether it is IRB or standardised; the loan does not know how the lender has capitalised it. So it is not that the loan somehow becomes safer; it is that the portfolio becomes safer. The IRB lender is selecting loans and pricing loans and chasing that one and not chasing that one on a more sophisticated risk basis than the standardised player.

Mr BUCHHOLZ: Is there any work done with APRA to enhance the risk management of the second-tier operators, or is that left to their own commercial instinct?

Mr Littrell : There is quite a lot done. We have talked about the underwriting, in terms of things like traditionally your interest rate and your adversity margin was a certain level, and it has been chipped away from competition—you push that back. But what happens with the standardised players is that you cannot get the same fine definition of detail on a loan by loan and portfolio basis. I do not want to overstate this, right; as I said earlier, the loan itself is going to default or not default without any reference to what—

Mr BUCHHOLZ: It is the quality of the book.

Mr Byres : It is the quality of the book—and also, it turns out, the quality of how quickly you can see problems emerging in the book. One of the nice things about this data is an IRB bank will know earlier if he is seeing emerging trends: 'This sort of borrower is more of a problem than they used to be, and I should avoid them; that sort is less of a problem and I should chase them.'

Mr BUCHHOLZ: I have an appetite for seeing more players competing in the market on more of an equal playing field.

Mr Byres : At the risk of anticipating a question that you have not asked, but I think what is behind your question—

Mr BUCHHOLZ: I was not going to ask that one!

Mr Byres : No, but I think what is behind the question is the issue of the competitive landscape.

Mr BUCHHOLZ: Yes.

Mr Byres : There will always be a difference here. Larger banks—not necessarily the major banks, but as institutions get larger they can invest in better risk management, better databases, better analytics et cetera. I just wanted to highlight the fact that late last year we did write to all of our regulated deposit takers about some changes to the way that we were going to go about the approval process, to get approval to use the internal models. The objective was to make it slightly easier—it is not meant to be easy, but slightly easier—for the next tier of institutions to achieve approval to use their models. I think that is at the heart of your question.

Mr BUCHHOLZ: And if that step starts to bring the differentials closer and create a more level playing field for the market, that is a great thing for consumers. I was a bit clumsy, Mrs Rowell: when you gave your comments before and you are talking about the governance and directors, were you talking about the industry or about the board of APRA? I was a bit remiss in—

Mrs Rowell : The superannuation industry.

Mr BUCHHOLZ: Of course. How is that tracking along, given that—I just had a quick look. Your first piece of correspondence to the sector was back on 7 October 2014—is that right? It is on your webpage, under correspondence. I just thought it was a remarkable time frame; it was a letter to:

… All directors of authorised deposit-taking institutions, general insurers and life companies

Improving APRA’s board engagement

You talked about 'Aid for Directors', you spoke about a 'Review of board requirements'—actually, this might have been the chair. Yes, it was Mr Byres. It is the same intent, or what you are—

Mr Byres : Yes. So there are a couple of things—

Mr BUCHHOLZ: Before you go on, my question goes to the time frame of 2014 and how far have we come since, up to today?

Mr Byres : The trigger for that letter that you refer to was that during the course of 2014 we were introducing a new standard that applied across industries in relation to risk management. Within that standard, there were various obligations put on boards of directors, including the reference to culture that I made in my opening statement.

Mr BUCHHOLZ: Yes, and that was the trigger for me.

Mr Byres : In the course of the consultation on that new standard, the director community in Australia expressed concern that the draft of the standard was mixing up the roles of directors versus the roles of management and that we were asking directors to do things which it was unreasonable for them to do and which were actually the domain of management. So part of our effort to provide clarity and demonstrate that was not our intent was that letter that you referred to, which was part of an exercise that we had to try to explain how we saw the role of directors of an APRA-regulated institution. That particular aid to directors was designed to be a document that you could give to a new director of an APRA-regulated institution and say, 'You may be a director of a toy company or a coalmine'—or whatever it might be—'but, when you come into the APRA-regulated space, there are some additional obligations on you when you are a director of a financial institution.' That aid was part of setting out and explaining what they are.

Mrs Rowell : That particular correspondence was directed at banks and insurers, where our cross-industry prudential standard around governance applies. The superannuation framework is a little different because there is more prescription in the superannuation legislation and a little less in our prudential standards around governance and, in particular, board composition and other requirements. Our general policy intent, if you like, is to achieve similar levels of governance practice across all of our regulated industries, but where they are on that journey and the particular requirements that are in place are a little different for superannuation because it was starting from a different place.

Ms O'NEIL: Mr Byres, you talked in your opening statement about the importance of culture and governance in good prudential management. There have been a number of incidents in the last 18 months in particular that suggest that the Commonwealth Bank in particular has some issues around its governance. Do you agree, based on what we have seen, that the Commonwealth Bank has a cultural problem?

Mr Byres : I am reluctant to talk about an individual institution and particularly to make such a sweeping assertion. We have seen across the industry issues where individuals within financial institutions have not behaved in a particularly exemplary way.

Ms O'NEIL: There has been a bit of a preponderance of it, though, hasn't there, in one particular bank?

Mr Byres : We see things across the sector in a number of areas that we think could have been done better or could have been handled better. That is why we have tried to focus much more attention on it. As I said in my opening statement, we put this explicit requirement on boards to specifically and explicitly face up to this issue and to demonstrate that they are actively monitoring, observing and, if necessary, remediating issues that they have. As I said—

Ms O'NEIL: Sorry, just to get back to this, do you think they have a cultural problem or not?

Mr Byres : I did not want to comment on the Commonwealth Bank because we do not generally comment on individual institutions.

Ms O'NEIL: Are you looking at their culture at the moment as an organisation?

Mr Byres : We are looking at all of the institutions we regulate in terms of culture. It is one of the things that we have called out as a particular priority area at present. So, yes, we are looking at the Commonwealth Bank in the same way we are looking at other similar institutions.

Ms O'NEIL: Could you tell us a bit more about the work that you are doing with the Commonwealth Bank on its culture?

Mr Byres : It starts primarily with this prudential standard that I talked about. Its technical term is CPS 220. Our engagement has been with—

Ms O'NEIL: Sorry, can I interrupt for one second. I understand the new requirement for boards to consider their risk management and whether that is in line with their risk appetite, but are you doing anything specific with the Commonwealth Bank regarding the series of significant issues that have come into the public light over the past 18 months?

Mr Byres : Yes, we have been following up on those issues. That involves engagement with the board of directors, engagement with the senior executives, understanding what their explanation of those issues are, understanding what their remediation programs are-if necessary-and trying to test whether those remediation programs have effect. At the end of the day, wherever we see a problem, Commonwealth Bank or anywhere else, part of our job is to try and work out, 'Well, what caused that to happen?' As I said in the opening statement, we are not the agency that deals face-to-face with customer complaints, but we do look at these issues seriously and with a great deal of interest for what they tell us about an organisation and the way it operates, and the incentives that people have within organisations that might drive them to do things which are not appropriate.

Ms O'NEIL: Just going to those incentives: what role do you think the remuneration program at CommInsure has had in this recent incident?

Mr Byres : Remuneration is one of the things we look at. It is very early days. Even if I wanted to comment on the Commonwealth Bank I do not think I could, because we are still at the early days, in terms of our inquiries into what happened and why did it happen. It may be that remuneration is part of the issue, but it is simply too early to tell. As a general observation though, we have called out that we think remuneration and culture are highly related, so it will certainly be something that we look at.

Ms O'NEIL: Can you tell us anything about specific concerns that you have about the structure of remuneration at CommInsure, in particular?

Mr Byres : No.

Ms O'NEIL: One of your standards, CPS 510, has a very specific requirement for APRA institutions to have sound governance and to conduct their affairs 'with a high degree of integrity'. Do you think CommInsure is living up to that standard at the moment?

Mr Byres : That is, obviously, one of the things that we have to look into. Geoff is leading our lines of inquiry, here. It is, naturally, one of the things we are going to have to look at, when we see some of these issues that have emerged. It is, simply, too early to offer a definitive view-

Ms O'NEIL: Yes. Perhaps it would help if you could be a bit more specific about how it is that you are going to work with the CommInsure board, to give some comfort that APRA is taking this seriously and addressing the issues that have been raised.

Mr Summerhayes : Obviously, we are aware and involved in some detail, as you would expect in any institution that attracts issues as have been publicised for the Commonwealth Bank and, in particular, CommInsure. This is a general statement but, with institutions, we meet with boards on a regular basis, we meet with management, we do prudential reviews of the processes within those organisations through the lens of governance and risk management and, when we are uncomfortable with where an institution is at, that oversight is heightened and is far more intense than it would be otherwise. We work closely with ASIC. We have a different mandate. As you would expect, that is occurring in this instance.

Ms O'NEIL: Could you be a bit more specific about exactly what you are doing about this problem? Other than heightened oversight, what exactly are you doing?

Mr Summerhayes : I am happy to say that, as you would expect, we have met with the board of the institution. We have met-

Ms O'NEIL: Of CommInsure or Commonwealth Bank?

Mr Summerhayes : Of CommInsure. We have met with management and continue to do so. We have powers to request various documents, which we are reviewing.

Ms O'NEIL: Great.

Mr Summerhayes : We are working in consultation with ASIC, as I said. It is early days, and that work will inform our next steps.

Ms O'NEIL: Thank you. One of the things that your policy is very crystal clear on is the importance of the whistleblower protection. Have you spoken with Dr Ben Koh, who was the chief whistleblower in the CommInsure case?

Mr Summerhayes : No.

Ms O'NEIL: Are you planning to talk to him?

Mr Summerhayes : The issues around how a whistleblower is handled are very prescribed within the Life Insurance Act, but that is likely to be one of the conversations we will have, yes.

Ms O'NEIL: So you will, at some stage, probably talk to him.

Mr Summerhayes : That is expected.

Ms O'NEIL: I assume we can work on the basis that the whistleblower issues that have been raised here are going to be a chief focus for you in working with CommInsure. Is that correct?

Mr Summerhayes : There were a number of issues raised and they are of concern to us to make sure that they are appropriately dealt with, and those inquiries are not yet complete.

Ms O'NEIL: Are you going to be looking at the whistleblower protections and how they might be improved in the organisation?

Mr Summerhayes : That would form part of our work, absolutely.

Ms O'NEIL: Thank you so much. One of the things that CommInsure does is provide insurance for members of a number of industry super funds. Are you concerned, in addition to the matters that we have discussed, about whether CommInsure is complying with APRA's LPG 270 practice guideline? This is about insurers paying in a timely manner and in a manner that is fair for their customers.

Mr Summerhayes : I do not think it appropriate for us to go into the details of that particular inquiry and that particular institution at this early stage of our investigation, but you would expect that we would look at both the insurer's obligations and the trustee's obligation.

Ms O'NEIL: Sure. There is an enormous amount of public interest in this case, as you are aware. Can you give us a sense of how this is going to progress over the coming months and—Mr Byres, this is probably a better question for you—when you are not able to make a lot of specific comments and give us much information now, when is that going to change? The public have a right to know what is going on in this organisation and how its regulator is handling it.

Mr Byres : Here, I would distinguish between our focus of inquiry and the ASIC focus of inquiry, because ASIC is particularly focused on the issues with individual customers and making sure that customers are treated fairly and to the extent customers have not been treated fairly that that matter is put right, in some shape or form. I would expect, as a result of that, that there will be—I cannot, obviously, commit ASIC's timetable—some public response. ASIC has made it clear that they are doing an investigation and, usually, when they do those investigations there is some public response at the end. We tend to work in a different way by virtue of the confidentiality constraints on us, so we would not, in the normal course of events—unless we launched a formal investigation, which we have not yet done—produce a particular report at a conclusion.

Ms O'NEIL: What are the triggers for you performing a formal investigation?

Mr Byres : They are set out in the life act but, essentially, they relate to issues of a prudential type—which are whether there are question marks over the viability, the solvency, the soundness or the appropriate management of a regulated, in this case, life insurer.

Ms O'NEIL: Surely, that is met, in this instance.

Mr Byres : I do not think there is any suggestion that the solvency or viability of CommInsure is under question. In fact, I would suggest—

Ms O'NEIL: Maybe not solvency and viability.

Mr Byres : it is not under question.

Ms O'NEIL: So this is not meeting the standard for you to launch a formal investigation. You are just going to do some inquiries behind closed doors and we will not know what your conclusions are, from this matter. Is that right?

Mr Byres : Based on the best available information we have today, we will be looking into this issue. It has implications for the way the organisation is operated. In fact, it might have broader implications for the way we view the broader Commonwealth Bank group, but it is just too early to tell, at this point.

Mr HUSIC: It is the typical way that APRA manages these things. It is all behind closed doors.

CHAIR: Thank you, Mr Husic. Ms O'Neil, you have the call.

Ms O'NEIL: I think it is a little bit of a disappointing outcome for us. We are trying to get information that is very much in the interests of the financial system. It is not just about consumers and how they are affected; you put culture and governance at the heart of good prudential management. Here we have one of the most terrible incidents of culture and governance within CommInsure we have seen in recent years, and you are saying that we are not going to be able to get any determination of what APRA thinks about this. I am putting that on the record as an issue of concern and, perhaps, something that you can discuss amongst themselves after the meeting.

I want to ask a couple of quick questions about self-managed super funds. I know that you do not regulate self-managed super funds, but I want to understand whether you have concerns about the significant growth that we are seeing within this type of investment vehicle in the Australian economy. Are you worried about this, generally?

Mr Byres : I think 'no' is the answer, unless Helen wants to add anything.

Mrs Rowell : No. I would observe, as you quite rightly pointed out, that APRA's role is focused on two-thirds of the superannuation sector, not the self-managed superannuation sector. From our perspective, the self-managed super sector has increased quite considerably over the last 10 years and now forms, as I said, about a third of the total superannuation assets. That rate of growth has slowed somewhat in more recent years, relative to what it was three, four or five years ago. We do monitor movements between the APRA-regulated sector and the self-managed super fund sector, more in terms of the implications of those cashflows for the APRA-regulated superannuation funds' ongoing viability, what they are doing to manage the liquidity and other investment issues that might arise from that. As to whether the self-managed super fund sector in and of itself is a concern, that is not part of APRA's purview.

Ms O'NEIL: You are monitoring it in part, though, to assess whether there is systemic risk to the financial system at some point—is that correct? Tell us why you are monitoring it, if you are not worried about it.

Mrs Rowell : The point is that the APRA-regulated superannuation sector has cashflows coming in and out from all sorts of sources. Part of that is outflow to self-managed super funds. We are not oversighting the self-managed super funds per se; we are looking at what is changing, in terms of the flows within the APRA-regulated sector, and the implications of that for how they are managed.

Ms O'NEIL: Do you have a comment on the use of limited recourse borrowing arrangements by self-managed super funds? Do you have any concerns about how this is affecting systemic risk or the economy more broadly?

Mrs Rowell : That is not a matter for APRA. It is not under our responsibility.

Ms O'NEIL: I would guess, in that case, that you do not have a view about the government's decision to reject the Financial System Inquiry's recommendation to ban limited recourse borrowing arrangements.

Mrs Rowell : I do not think it is appropriate for us to comment on that.

Ms O'NEIL: Do you maintain, according to your submission to the inquiry:

that the risks associated with direct leverage are incompatible with the objectives of superannuation and cannot adequately be managed within the superannuation prudential framework .

Mr Byres : That is the position we put in the submission. I think that holds. It is not something that fits with the prudential framework that we have, but self-managed super sits outside the prudential framework.

Ms O'NEIL: I understand that, but you as an organisation still have this view that you do not believe that these risks are appropriate—is that still your view?

Mr Byres : That is still our view.

CHAIR: We will take a quick morning tea break.

Proceedings suspended from 10:53 to 11:07

CHAIR: We might take our seats so we can reconvene. Thank you, everyone. I will now give the call to Mr Kelly for some questions.

Mr CRAIG KELLY: Mr Byres, in your opening statement you said:

… there is a compositional shift occurring as investors are less prominent and owner-occupiers account for a greater share of new lending.

That is in the housing market. Do you have any quantitative measures on that?

Mr Byres : We do not have particular limits, if that is your question, or if you are just after the statistics—

Mr CRAIG KELLY: No, what I am asking is: do you have any statistics to support that statement? When you say it is less prominent, is it five per cent less prominent or 10 per cent less prominent? What has the shift been when compared to other years?

Mr Byres : I would have to take that on notice and then we can give you the statistics. I have not got them at my fingertips. But the proportion of new lending for investors, off the top of my head, was 40-something per cent. It has probably come off five percentage points or something of that order. But I will take it on notice and send you the statistics.

Mr CRAIG KELLY: Of all the areas that APRA looks at, where do you place the risks to housing loans, as a risk to the banking sector, in your priorities?

Mr Byres : This has been one of our top couple of priority areas for our supervision of the banking system over the last couple of years. I would say that it is a very high priority, and that reflects the fact that housing loans are two-thirds of the loan book of the banking system, in aggregate. It is not an area where you want to get things terribly wrong.

Mr CRAIG KELLY: Do you see the actual risk as being a substantial fall in housing prices?

Mr Byres : The risk for us is that, for some reason, there are losses in the loan book. That will only happen if people are unable to pay their loans. That is not necessarily going to be the case if house prices decline. The key issue for most people's ability to continue to pay their loan is whether they are still employed or not. When we stress test the banking system against adversity, it is usually a scenario that involves a significant increase in unemployment, and that has all sorts of adverse effects, including a decline in house prices. But the key for most people's ability to maintain paying their loan is whether they have employment and whether they have income.

Mr CRAIG KELLY: But the house price, also, going forward, makes up an important component.

Mr Byres : Yes.

Mr CRAIG KELLY: If APRA thought there was a bubble in house prices, would that be of concern to you?

Mr Byres : When a bank makes a loan to a person that is secured against a house, two things need to go wrong for the bank to lose money. The first is the customer cannot pay, which might be triggered by unemployment or some other adversity. The second thing will be whether the house, when the house is sold, covers the value of the loan. If house prices were falling, then it would increase the probability that the sale of the property would not cover the debt that the customer had.

Mr CRAIG KELLY: Is that where you have concerns about loan-to-valuation ratios?

Mr Byres : Yes. We are always watching for a very high proportion of high LVR lending, because they are invariably going to be the loans where, even if prices only fall a small amount, the customers' equity is quickly eroded to zero. If you have a 95 per cent LVR loan, there is not a lot of margin for error there if house prices decline. If you have a 60 per cent or an 80 per cent LVR loan then, obviously, there is a much bigger buffer there to absorb any variation in house prices.

Mr CRAIG KELLY: Does APRA constantly monitor housing prices in different markets across the country?

Mr Byres : Yes, we do keep an eye on house prices in different parts of the country, even to the extent that when we did our stress test we did not just apply a blanket fall in house prices. We did have some variability according to states and capital cities to recognise that we do not have a single housing market in this country; we have various markets.

Mr CRAIG KELLY: So you do it generically Australia-wide, then state-wide and then regionally?

Mr Byres : Yes. So, in a sense, we take a common scenario and then amplify it or moderate it a little bit, depending on a particular geography.

Mr CRAIG KELLY: Just go through the tools in your kitbag that you would utilise if you thought there had been an undue rise in house prices.

Mr Byres : Here, I will probably have to step back a bit and say that we do not have any mandate to target a particular level of house prices in the Australian economy. Our job is to make sure that, whether house prices go up, down or sideways, banks are lending in a sensible fashion. Obviously, a concern in any market, housing or otherwise, is that if things have gone up rapidly in a short period of time there is always—

Mr CRAIG KELLY: If you saw excessive house price inflation, that would raise concerns?

Mr Byres : It would raise concern, because anything that has gone up rapidly could come down rapidly, so you have to be quite conscious of that. It does not mean that you hope it happens or you think it necessarily will happen, but it could happen. Over the last few years where we have seen, particularly in the two largest cities, very rapid price growth, there is a need to think about what would happen if that growth reversed somewhat.

Mr CRAIG KELLY: Are loan-to-valuation ratios the types of things that you would talk to the banks about?

Mr Byres : We collect statistics, so we are keeping a track on what proportion of high-LVR lending there is. We have deliberately not put limits on that because we recognise that there are legitimate reasons to have high-LVR lending. If you want to get first-home buyers, for example, into the market, you cannot require extremely large deposits because you would make it too hard for those people. But, equally, if a bank had an extremely high proportion of very high LVR lending in its portfolio, then that would be a trigger for further investigation.

Mr CRAIG KELLY: So they are the things you look at on the demand side. Is APRA doing anything on the supply side of housing—for example, looking at what housing construction is in the pipeline in different areas and potential demand going forward?

Mr Byres : Obviously we look at that, because it is a factor in determining how markets might develop. But we have no role in housing supply policies, land release policies et cetera. But it is certainly information that we keep an eye on because it helps inform the general picture that we have about how the market is developing and where it might go.

Mr CRAIG KELLY: Over the last five years has there been a mismatch between the supply coming onto the market, which is fairly regulated by local governments and state governments, compared to demand.

Mr Byres : With the caveat that there are probably different experiences in different jurisdictions. If you focus on the major cities, I think it is reasonably well acknowledged that there has been a long-running shortage of supply relative to demand. There has been a supply response, so housing starts are at record levels now, and hopefully that will help meet some of the unmet demand. But obviously that is not necessarily the case if you go elsewhere in the country beyond the big cities.

Mr CRAIG KELLY: So is that something that APRA comments on? Do you think you could comment on it more, or are you happy with where your commentary is on that issue at the moment?

Mr Byres : For us it is taken as a given because it is not for us to determine what state government land supply policies might be. We just acknowledge it is what it is, and it feeds into our analysis.

Mr CRAIG KELLY: But even though it may not be specifically in your charter, surely, if you are looking at the risk factors to the banks, major imbalances in the supply of housing could increase the risks that banks face?

Mr Byres : To the extent that there is the supply-demand imbalance and that has led to some significant increases in house prices, we have commented on what we are observing in terms of house prices. I would try and characterise it by saying we keep an eye on it; we are very interested in it. But we have not gone so far, because it is probably beyond our mandate, to comment on what housing supply policy should be.

Mr CRAIG KELLY: But housing supply policy can have a significant effect on movements in the price of housing, which then could come back and put pressure on the risk factors to the banks.

Mr Byres : Yes.

Mr CRAIG KELLY: That is a fairly highly regulated area of the economy, but there seems to be no coordination of its regulation. There does not seem to be anyone at state government, federal government or even local council level looking at whether we are getting enough supply through. Do you have a general comment to make about that?

Mr Byres : I do not think there is any lack of attention to the issue amongst the various arms of government, but I cannot really comment on the extent to which that is coordinated.

Mr ALEXANDER: Just following on from Craig's questions in regard to the possibility of oversupply: I understand that APRA does not include obligations on the part of off-the-plan apartment purchasers in its reporting on residential mortgage exposure. Is that correct?

Mr Byres : Sorry, could you say that again.

Mr ALEXANDER: APRA does not consider exposure of off-the-plan purchases in the exposure to banks.

Mr Byres : In terms of the—

Mr ALEXANDER: There are a lot of people who are entering into the market, buying off the plan—

Mr Byres : Yes.

Mr ALEXANDER: and there is an enormous amount of exposure there.

Mr Byres : Yes.

Mr ALEXANDER: If we are entering into a period where these things seem to rubber band, where we go from undersupply to oversupply, this could represent oversupply. If they are owner occupiers and they have to go through and complete the purchase, they may end up with negative equity from day one. If they are investors and there is an oversupply, they may not be able to rent, so there could be problems. So there is, as I understand it, billions of dollars of exposure in this area. Do you have any way of calculating that?

Mr Littrell : We are going to have to take that on notice. If a lender has a committed facility, we collect that; but if they have an uncommitted arrangement we do not. It is better for us to take it on notice and give you the precise answer.

Mr ALEXANDER: There are probably some who would have a commitment from their bank, when the project is finished, to—

Mr Littrell : There are a range of levels of commitment, and the answer varies, as I understand it, a bit. We should really go back and check our statistical instructions and give you the exact answer.

Mr ALEXANDER: That would be appreciated. In regard to the gathering of statistics, I understand that residential property exposures have only, to this point, been available on a national level. Is there any way of breaking that down to state and city levels?

Mr Littrell : Not in APRA's statistics. Ours are broken down by institution, and we can aggregate that nationally.

Mr Chapman : We do not collect data from individual institutions at a postcode or regional level, which would enable us to produce that data.

Mr Byres : The ABS does collect some information on housing approvals by state, but I am not sure at what level of granularity it collects that.

Mr Littrell : If you want to put that on notice, we could also tell you what we have. But it is not hugely—

Mr ALEXANDER: As has been raised with us, there is not one national market; there are many markets. There are some that are overheated and possibly seen as bubbles, and others that are not.

Mr Littrell : True. But remember that we are monitoring individual institutions, and, broadly speaking, for each of those ADIs, we know where their lending is. So, from the point of view of stewardship of an institution as opposed to stewardship of the market, our focus is much more on what the institutions are reporting to us, not how it aggregates at a particular state level.

Mr ALEXANDER: Given the action that was referred to earlier today and concerns from late 2014 regarding lending on real estate and the rapid increase in housing prices in various markets and the continuation through 2015 of a very rapid rise in borrowing, particularly by investors, and investor-led inflation in housing in certain areas, private homebuyers were highly leveraged, buying at a peak in the market, which seemed to, in turn, lead to restrictions on investors and a greater margin for homebuyers. Whether there will be a bust, an overcorrection or a long cool period as this plays out, at a time when interest rates have been historically low—and we have gathered all sorts of evidence—we are seeing the impact that this is having. Some unusual incidents have happened. The gathering of this knowledge should lead to a greater level of experience. Experience is a very valuable thing. In time, if interest rates went back up to eight per cent or 10 per cent and then this whole strange scenario came around again, armed with that experience, would APRA and the RBA be likely to seek to act in a pre-emptive way rather than a reactionary way?

Our Prime Minister often talks about agility. The questions might be, 'Have we been agile enough? Have we had tools available that have been able to be finely calibrated and targeted? With all of this would we seek to have things available in the future having had this experience to address these situations?'

Mr Byres : That is a kind of hypothetical. I think that one of the challenges that we have as regulators—and this is not just an APRA issue but also a regulatory issue that applies to the central bank and to others—is that it is always easy to spot the problem with hindsight, but, as things happen, there is always a fair degree of uncertainty and you can never predict how things will travel into the future. Regulators always face a problem when they try to get ahead of the game. They are accused of being party poopers, unnecessarily interventionist and worried about things that will not happen because it is all under control.

While we are always going to try to be as nimble, as responsive and as proactive as we can be, often it is hard to pick the point at which you want to intervene. When regulators are intervening, they do things that cut across community interests and commercial interests, and different people have different perspectives. It is hard to respond to that question and say, 'Yes, next time we would do it differently and we would do something earlier,' simply because it is not always clear when is the right time to do something.

Mr Littrell : I would add that APRA is always responding proactively. We have talked today about 2002 to 2005, 2014 and 2015. We have consciously restrained home lending at a point when all the metrics on home lending suggest it was a wonderful, low-risk business. The constraints that we applied up to 2005-06 started to look wise in 2007, 2008, 2009 and 2010. We do not know what is happening here. We do not predict the future; we only predict what could plausibly go wrong in the future. What we have done in 2014 and 2015 on home loan markets and what we do fairly routinely in various insurance and other banking markets is that, if something has gone wrong, we look at that closely, but if something seems to have gone too right we look at that too. Very often, that generates some sort of response like what we have talked about today with home lending.

The actual metrics today on Australian home lending show that the loss rates are vanishingly small and it is a very, very profitable business. But we are consciously restraining it, because we are proactively thinking that we are in a position where industry could be vulnerable if it goes very badly wrong. We are not predicting it, but we are ensuring that industry is ready for it if that is where we end up. That is not unique to home loans. We try to do that across all substantial exposures of the banking and insurance business.

Mr Chapman : I think the other point that is worth noting here is that all of this discussion has been about proactiveness at an industry level, whereas, at an individual institution level, we are doing this all the time. The answer to your general point, Mr Alexander, about whether experience helps is yes, because you learn from every experience that helps you work out whether that can apply somewhere else or whether there is a different technique you can take somewhere else.

At an institutional level, there have been individual institutions where we have said, 'You have to cut your high LVR lending' or, 'You need to raise more capital' or, 'You need to stop doing this sort of business' or, 'You need to stop expanding in that place.' Within APRA there is always that institutional proactive experience. What we have been talking about largely today so far has been how we aggregate it up to an industry-wide perspective.

Mrs Rowell : The other point that I would make is that on a reasonably continuous basis we review both the data that we are collecting on both a regular and ad hoc basis, and also the types of analysis and the metrics that we are using to identify risks and enhance the information that we have to support making judgements about where we need to intervene versus not. So there is this ongoing process of refining both the information that we look at and how we use it internally, which builds on the experience to date. Inevitably, the future issue is likely to be different to the ones we have seen to date. We need to be thinking ahead, not just about what we collect to better pick up the sorts of issues we have just seen, but also about where we think the issues are going to be going forward and what information we need to be looking at to be able to deal with those.

Mr ALEXANDER: It is difficult to know when the right time is, particularly when you are using possibly large or macro tools. If there were more finely calibrated tools, it could be eased in and eased back in a timely way, if that were available.

Mr Byres : Hypothetically, yes. If we had the tool and you could ease it in and out as needed, the concept makes sense. I do not think anyone has yet worked out what that tool is and how to make it operational,

Mr ALEXANDER: The Reserve Bank controls inflation by the setting of interest rates. Interestingly, the CPI has not included housing inflation since 1998—is that correct?

Mr Byres : It does have some element of housing-related costs in it, but I will confess that I doubt that anyone at this table is an expert on CPI composition. We could take that on notice and find that out for you.

Mr ALEXANDER: I understand it has not been included since 1998. You have housing inflation sitting out as a bit of an orphan, yet it is the biggest asset class in Australia. Maybe there should be some tool or some focused effort to harness housing inflation in much the same way as the interest rate controls our CPI inflation. Would that seem reasonable?

Mr Byres : I think it is a political decision to determine what the right answer is for house price inflation. If you think about the target that the Reserve Bank has for inflation generally, there is an agreement with the government of the day about what their target is, then they pursue it with the instruments they have. If the government or the parliament wanted to determine an objective in that regard, obviously people could think about how to pursue it. It is not for APRA to set that target.

Ms SCOTT: Mr Alexander went to exactly where I was wanting to go in regard to housing prices and you saying that they have cooled and things like that. There is possibly not a lot more that I would want to add to what you have said there. You see housing prices growing, but housing prices across the country are more of a mosaic—the effect is different in regional areas. An experience from one of my colleagues in Darwin is that they already have quite substantial cooling up there, whereas there are members of the committee here who occupy seats in Western Sydney that are seeing quite substantial growth. In my electorate alone I have seven property developments going on, so there is substantial growth there.

In your opening remarks you also said, and you have reiterated a few times today, that there is a compositional shift as investors are less prominent and owner occupiers account for a greater share of new lending. When it is first home buyers, in my electorate in particular in Western Sydney, where it is still quite hot, you are talking about young families that have large commute times to get to and from work. If their assets do decline in value I guess the exposure of those families is greater. What sort of security or confidence can you give the home owners and first home buyers in places like Western Sydney and other growth regions around the country that there will not be substantial decline in the value of their greatest asset, and how can you help with that sort of support?

Mr Byres : The answer to your first question is that I cannot give any guarantee. As I said, we do not control house prices and we have not set out to control house prices. There is a whole raft of other issues that will determine whether house prices go up, down or sideways in the next little while. That will vary according to geography, as you rightly pointed out. In some parts of the country prices are already softening, while in other parts of the country they are still increasing.

The best thing we can do to protect against the sorts of concerns that you have raised is to make sure that people get loans they can afford in the first place—that banks are not doing reckless lending and are meeting their responsible lending obligations. That is an ASIC responsibility. If we make sure that the lending policies more generally are sound, itmaximises the probability that a borrower can continue to service the loan.

If you are looking at house prices over the last five or six years, there is a chart that the Reserve Bank puts out which shows house prices by capital city and in regional areas. Through late 2010, 2011 and early 2012 house prices were falling across the country in just about every capital city. Those falls were somewhere between five and 10 per cent, depending on what jurisdiction you were in. They have subsequently recovered all of that loss and are higher than they were before 2010. If you had a loan that you could afford and continued to service your loan through that period, the fact that your house may have gone up and down in value briefly for a period has not impacted you. You could sail through that period as long as you could continue to service your loan. That is the protection that we can offer—sensible loans are made to people, which they can afford.

Ms SCOTT: There are various greenfield property developments across different growth regions. Western Sydney is not unique in that. One of these brand new suburbs, in particular, has seen increases in property values of up to $100,000 in less than 12 months. You are talking big business operators in that space as well. As you would appreciate, if you are buying the type of package deal of house and land, the loan comes in two parts: you pay for the land first and the house second. The land has then appreciated, and some people are then refinancing the construction against the appreciation in the value of the land to be able to get around things like mortgage insurance.

Should their land be inflated as part of a bubble, obviously that exposes that home buyer, whether they are an investor or an owner occupier, to the volatility of the market, and potentially leaves some of these greenfield developments vulnerable. What are we doing there? How are we regulating some of those changes because, as you said, markets come up and markets go down. If investors are leaving—and a lot of these properties have been driven by investors—and the market value of this land that is leveraged against the construction of a house changes, how are we then protecting against building houses that are eventually going to be vacant or not completed?

Mr Byres : That risk does exist, and that is part of the system we work in. Developers are actually developing properties with the expectations, but with no guarantees, that there will be the demand there for them. The thing that we can do is to try to ensure that when banks are lending to people, whoever they might be, that there is a sufficient margin for error in everyone's calculations. We do not want loans that assume that house prices will go up, we do not want loans that assume that interest rates will always stay this low and we do not want loans that assume that borrowed income is going to grow at a very rapid rate. Rather, when banks are looking at lending propositions, and ideally when customers are thinking about it—but we can only control the lending side of the equation—that there is enough margin for error in there that it is not necessarily fatal to anybody if there is a downturn in the market. As I said, we cannot put a floor under prices. We just cannot solve that particular issue.

Ms SCOTT: In this environment—where I think it would be negligent to say that there are not many Australian families that are currently in those sorts of circumstances or investors who are possibly too heavily leveraged—if a shock hit the market, of broad-ranging macropolicy, potentially what would that do to the market and potentially what would you do to soften a fall in real estate values if that actually hit?

Mr Byres : If we had some kind of shock, as I said, the key here is not that prices have gone down because, in and of themselves, if people can continue to service their loans, history tells us that Australians will do that. They will, in a sense, ride it out and, hopefully, come out the other side. The key shock would be if there was something that led to a significant increase in unemployment that would jeopardise people's abilities to service their loans. In that instance, a whole lot of hardship mechanisms would effectively kick into place. There are a range of things that have been set up to try to have banks deal with customers, in a sensible way, who are in hardship that does not involve everyone being kicked out on the street immediately they miss a payment. That is probably the most important thing. If you look at what happened in the US experience in the subprime crisis, the markets are very different. Customers who find themselves in difficulty there can hand back the keys and walk away from the debt. That is not something that an Australian borrower can do. The resulting fire sale of properties was probably the most damaging thing to household values because you had a flood of properties for sale in a very short period of time, and that is necessarily going to push prices down even further. We have a different market structure and provisions to deal with that which, hopefully, would avoid that problem of fire sales exacerbating a situation that is already stressed.

Ms SCOTT: So you would say that the real estate market now is already stressed.?

Mr Byres : No, I did not mean to imply that. I was saying that, if we were in that scenario where you had an economic shock, such that unemployment was significantly increased and you had borrowers under stress, that would place a strain on the housing market. Undoubtedly, it would place a strain on all sorts of sections of the economy. But I think there are differences in the way our market operates that mean that the damaging impact of a fire sale of lots of properties from distressed borrowers would not happen here in the same way that it happened in other jurisdictions.

Ms SCOTT: Do you have a view or an opinion on what the ideal ratio between wages and house prices should be?

Mr Byres : No.

Ms SCOTT: If we looked at a broad-ranging policy area that is highly political and contentious at the moment—like negative gearing—a broad-ranging macro policy that sat right across the country, not necessarily taking into account the mosaic of property values and not looking at growth centres and investment that sit in there, is that an area that we need to be quite delicate about with property values and how these would affect the market?

Mr Byres : I would say be delicate about it, not necessarily because of concern about a particular market but delicate about it because any single cap across Australia is likely to have a significant impact in some areas and probably be irrelevant in others.

Ms SCOTT: How do you think it would affect growth regions and places where we are seeing huge amounts of development and growth, particularly when you have owner-occupiers, first home buyers and investors in the market that are potentially leveraging the value of the land to build the house? How would you potentially see something like that affecting growth regions?

Mr Byres : Just to be clear: it is a limit on the ratio of loan to income; is that what you are suggesting?

Ms SCOTT: It will probably be best if I rephrase the question for you. What if we did have a broad-ranging policy—like negative gearing changes—that would remove or reduce the amount of investment in the market in the growth regions where that investment has in many ways probably inflated the value of land while at the same time we have got first home buyers and owner-occupiers moving into their first home, young investors, who have bought the land and are leveraging the land to construct their house? They will have a timeframe from the property developer—say, Lendlease—and may have six months or 12 months to lay the first brick. If they are leveraged because they are trying to avoid mortgage insurance or the initial deposit of the house has been put up against, say, a first homebuyers grant or something like that, how would a change to something like negative gearing affect those first homebuyers and what sorts of protections will we need from the banks to ensure that they can continue to pay so that those developments do not fail?

Mr Byres : I find it really hard to answer that because any change to policy will have an impact—that is why you change the policy; you intend to have an impact—otherwise, why would you bother in the first place? Without being precise about what the change is and without being clear about what else might change at the same time, it is very difficult to work out what the impact will be.

Ms SCOTT: Okay. Just changing tack quite dramatically to an area we have not touched on yet today—and this was also in your opening remarks—in regard to private health insurance you say:

We also plan by mid this year to release a road map to private health insurers for the alignment, where appropriate, of the private health insurance prudential framework with those that apply to other sectors that APRA supervises.

Can you highlight to me a few of the elements in that road map that you are looking to achieve?

Mr Summerhayes : Thank you for the question. We start with the overarching statement that we do not have any prudential concerns with how the private health insurance market is regulated. PHIAC, who integrated with APRA last July, has done a very good job on overseeing the sector. We also gave an undertaking to the institutions that there would not be any significant change in this first year of our oversight of the sector. We have flagged to the institutions to give them some certainty about what the next two to three years would look like and we want to progressively align areas around risk management, governance, and at some stage in the future capital models, to ensure that those standards are at best practice. We would typically align those around what we have done within other sectors that APRA regulates and, most notably, across the other insurance sectors. We will put out a discussion paper before the middle of the year. We will seek feedback from the institutions on that discussion paper and then, following that feedback, we will put out a new set of standards. I would want to flag to the committee that these are issues around alignment as opposed to, at this stage, any substantive change.

Ms SCOTT: Your recent analysis shows that the gap between premium revenue health funds receive and the benefits that members are paid is growing wider. Can you give a quick glimpse as to what parts of your road map might address those challenges specifically?

Mr Summerhayes : Mr Chapman might like to comment. Our mandate is the prudential oversight of the health insurers and to make sure that they are sound and operating with adequate capital, adequate risk and governance frameworks to ensure that they can meet the obligations made to policyholders. We do not have direct involvement in the setting of premiums for the insurers.

CHAIR: I want to pick up on the issue of house prices and so on that has been discussed at some length. You mentioned before about how you as an institution are concerned by high loan to value ratios—or that that is something you look at very closely. Could you explain why that is an issue?

Mr Byres : Put simply—and this applies to any sort of loan that a bank makes—it has less margin for error, if it has relatively little contribution to the purchase of a house from a borrower. The high LVR loan means that, if something goes wrong, the value of the loan is very close to the value of the property, and any fall in the value of the property would mean that, if the customer defaulted, there was less likelihood that it would get repaid on the loan.

CHAIR: So it is a significant issue. You talked about how you do analysis about what the consequences of potential downward movement in prices are as it pertains to LVRs and the impact of that. Could you explain a little more about that? What exactly is that analysis, what does it show and how many loans are potentially affected by this issue of high LVRs and therefore are exposed in the event of declining asset values?

Mr Byres : The analysis I referred to before was the stress testing that we regularly do. In 2014 we did a stress test for the largest institutions, which involved a scenario of a significant economic deterioration: unemployment reaching double-digit levels, house prices falling about 40 per cent, commercial property prices falling and a range of other factors that you might expect to play out in that sort of scenario. The result of that stress test was, pleasingly, that the level of losses across the banking system were able to be accommodated within the capital that the system has. So, in really simple terms, we did not break anybody, but clearly it did involve a substantial level of loss across the banking system. These results are published, by the way, but I do not have them in front of me.

CHAIR: Sorry to interrupt, but specifically in relation to high LVRs: how many loans are there out there that are what you describe as a high LVR, approximately, and who are therefore particularly exposed in the event of declining asset values?

Mr Byres : I do not have the number of loans. We will take that on notice and tell you. Loans that are greater than 90 per cent LVR are just a touch under 10 per cent of new lending and loans that are greater than 95 per cent LVR are around three per cent of new lending.

CHAIR: In the event of a reduction in housing prices, I think your previous answer was that the likelihood of those loans being repaid, particularly those high-LVR ones, would be lower. Is that right?

Mr Byres : It is conditional on whether the borrower is unable to service the loan. As I alluded to in one of the earlier answers, house prices across Australia fell in 2011—by different amounts in different cities but they certainly were all on a downward trajectory. Banks did not incur any material level of loss from that fall in house prices simply because unemployment was still relatively low—or employment was healthy, to put it the other way—and borrowers continued to service the loans. The concern about the fall in house prices leading to losses is conditional on borrowers not being able to service their loans, and then banks have to look to the property as a source of repayment for the loan.

CHAIR: Yes.

Mr Byres : If borrowers are in a position of stress and banks have to resort to selling the properties to have the loan repaid, then it is the ones with a high loan to value ratio which will inevitably be the source of the greatest losses.

CHAIR: Yes. I think you said something to Ms Scott along the lines of any change in policy will have an impact, and she was asking questions about potential shocks in the system. Could you elaborate on what you meant by that?

Mr Byres : It was just a general comment that, whether APRA changes prudential policy or the government changes its policy on something, you do it with the intention of changing incentives and behaviour within system. That is the whole purpose of doing something—otherwise, why would you bother? But, in response to the question, I was simply saying that, depending on how that change is made and whatever else changes at the same time, will determine what that impact is. It is very hard to say up-front.

CHAIR: Sure. I am conscious of your not wading into policy areas but I would, in that general theme, put to you a scenario. In a scenario where a tax or something affects the property market is changed by, say, tens of billions over a 10-year period, is it in any way conceivable that such a policy could have zero impact on the behaviour of participants in that market?

Mr Byres : That is a fairly vague specification. Changes in policy have impact. That is their intent. Some people will find there are negative impacts; it may have positive impacts for others. How that will all play out is very difficult to say.

CHAIR: Sure. Are you aware from your professional experience in looking at the housing market and markets in general of increases in tax leading to the parties affected by that increase in tax investing more? Are you aware of any scenario in history where that has occurred?

Mr Littrell : The introduction of the GST created an investment boom between when it was announced and when it was imposed.

CHAIR: But specific to the particular category of investment?

Mr Littrell : At that point, if you were trying to get a contractor six months before the GST came in, you were out of luck. I am answering a specific question here. Yes, there are cases where introducing taxes created increases in housing investment.

CHAIR: Have you seen an example of attacks on the profits on investment in housing leading to an increasing investment in housing?

Mr Littrell : I am not in a position to respond to that. I do not have enough of an information background to give you an answer.

CHAIR: Okay. I would also like to ask Mr Byres a little about the OTC derivatives issue where further capital was going to be required to be held against those over-the-counter derivatives. Could you just explain a little what you see as the likely impact of that. Obviously, it is being done for prudential concerns. Do you see an impact on investor behaviour as a consequence of that?

Mr Byres : On housing investors or just—

CHAIR: No, the over-the-counter derivatives issue.

Mr Byres : Coming out of the GFC there is what I call a three-strand effort to improve the resilience of the derivative markets. One strand is to encourage a lot of standardised derivatives onto exchanges—standard interest rate swaps et cetera to be moved onto an exchange-traded environment rather than over the counter. There is a limit to what you can do there. The second strand is to encourage counterparties to derivative transactions to exchange margins or collateral with one another. So to the extent that there are exposures between you and I, for example, as derivative counterparties, if I owe you money you will take some collateral to protect against the risk that I might default. If you choose not do that then the third strand is to say 'If you are not going to not trade on an exchange, and you are not going to take collateral to reduce the risk of derivative transactions, then you should have higher capital requirements.' It is part of this broader suite of reforms that flow from the G20.

The end result of it is to create a set of incentives that mean where possible people will transact derivatives or organised exchanges where there is a central counterparty and all sorts of rules in the market that are designed to make sure there is integrity and relatively low levels of risk. If you are not trading on an exchange, ideally you will do so with at least collateral backing the exposures so that the risk of one counterparty defaulting does not have cascading consequences through the financial system. If you still insist on trading over the counter and without any collateral, you will have to have higher capital requirements. So the end result is that ideally there will be more derivatives trading in those first two categories—on exchanges or with collateral—and less uncollateralised over-the-counter trading.

CHAIR: And what is being done here is consistent with what is happening globally?

Mr Byres : Yes.

CHAIR: My final question is back on the issue of prices and so on. Is it fair that in markets where there is reduced demand for a product that the general impact is a negative impact on the pricing of that product, in your experience?

Mr Byres : The basic rule of economics tends to be that reduced demand leads to lower prices. There are various specialist examples where that does not necessarily apply in certain circumstances. Economics 101 is the starting point, but the world is far more complicated than economics 101 teaches.

CHAIR: But from your regulatory position looking at institutions and so on, is it reasonable to assume that if there was less investment in the housing market—and we can debate what may or may not cause that to occur—prices would fall?

Mr Byres : I know what you are trying to get to here, but I genuinely do not think it is. One of the interesting aspects of the whole experience we have had in the housing market is that, as investors became more and more prominent and the housing market heated up, you would have thought that as the demand for credit increases it would have increased the price of credit. In fact, banks competed hard for it and reduced the price of credit. I think it is just too complicated to try to make any kind of sweeping assumption about what would happen.

Mr HUSIC: Continuing with the fan dance, I want to put a quote to you by Treasury official Greg Cox to this committee on 26 June last year. He said:

I do not see investor behaviour as being solely driven by tax treatment, in the sense that investors make decisions based on a whole range of factors: what they expect house prices to do, their own personal circumstances, their ability to take on debt—all those sorts of things. So the tax system is there, absolutely. They would consider the tax system inside their range of investment factors, but it is just one factor inside all of the decision-making processes.

Do you agree?

Mr Byres : I think that is a reasonable statement, yes.

Mr HUSIC: Let's put that aside. I have been very consistent about what I am going to put to you, Chairman, and that is that I have this maybe cute belief that a corporate watchdog should do their biting publicly. I have this view about macroprudential tools and their application. I express to you a concern. If there were people who were operating on the fringe, conducting or extending loans in a way that was high risk and not following the types of expectations that APRA would have, I would hope you would single out those people publicly and it would not be done behind closed doors and it would also be a reportable incident to the share market. You have expressed on behalf of APRA that you take a different view. In response to my colleague Clare O'Neil you said that you would do the work in relation to CommInsure behind closed doors. Again, is it APRA's view that the watchdog does the biting within the kennel at night when no-one can see, or can the public have confidence that the types of things you do to stamp out bad behaviour will be seen publicly to send a signal to others not to behave in that way and as a result of their actions not hurt regular Australians?

Mr Byres : That is a long question.

Mr HUSIC: You are welcome!

Mr Byres : Yes, you can be assured that we act on these issues. We act on them all the time. As we have explained before—and I know we have a different perspective on things—there is a confidentiality requirement on us in the act. That is there for very good reasons. The secret of whatever success we have had has been our capacity to operate behind the scenes to get information when we ask for it and to have access to individuals, information, reports, data or whatever it might be. Our ability to do that is founded on the fact that institutions have faith that they are talking to us on a confidential basis and issues will remain confidential. As I said, it is critical to our ability to do our job. If we had to operate in a way where everything we did was public, I actually do not know how we would operate.

The way we operate is not unusual or in any way unique. It is the way prudential regulators around the world do operate. I know there is always a public desire to know more, but many of the things we deal with are best dealt with behind the scenes. They get fixed, and the community has continued confidence in the system.

Mr HUSIC: But the public gets burned publicly. You claim, Chairman, if I can paraphrase your words—I do not want to put words into your mouth—that, 'We do all this behind closed doors, and the public is confident with what we're doing.' How do you know that?

Mr Byres : The public has confidence in the financial system, and it is really important to preserve that. That was the point I was making. So, yes, I accept that you would like more information on what we do about individual institutions. As I said, our concern is not to jeopardise the way we operate, because we see it as absolutely critical to doing our job.

Mr HUSIC: There is no measure, though, about whether or not that approach is successful, is there?

Mr Byres : Other than looking at the health and soundness of the financial system? Other than looking at the relative safety and stability of the Australian system relative to other jurisdictions that have experienced much more significant problems than we have had? No, I agree. As I said, you would like more. We are working on ways in which we might be able to demonstrate a little bit more the effectiveness of our supervision, but it will always fall short of naming and shaming because that is not the way we operate.

Mr HUSIC: You have conceded in what you have said so far that it is hard to be able to demonstrate success against objective. If I heard you correctly—and please correct me if I am wrong—you said there is overall confidence in the system. That is such a broad measure that it is, if I can put this respectfully, irrelevant to the point I made to you, which is that your approach is to work behind closed doors. You have had a series of things put forward to you by one of the committee members in relation to CommInsure, yet we will have no idea and we will be none the wiser, other than interpreting recommendations you make to government about legislative change. We have to interpret the move, rather than you putting a clear statement out saying, 'This institution burnt this lot of Australians and, as a result of that, we're taking this action, and we'll recommend these changes.' Would you not agree that that is a much more transparent way than the way that APRA is operating or do you value your ability to have closed door discussions above publicly preventing and being transparent on the type of things that people get burnt on in the financial system?

Mr Byres : I start with our mandate. As I said in my opening statement—and this is not to express any disinterest or lack of concern about the issues that have come out in relation to CommInsure or in other areas—our mandate is not about the individual customer transactions. It is about the health, the stability and the viability of financial institutions. As I said, we take an active interest in those issues, and we will be working with ASIC to share information and make sure they are aware of what we are doing so they can take into account information and assessments that we make in their work. Their work will be the public work, and our work will not be.

Mrs Rowell : Can I just add something. I think it is important to distinguish between the different types of situations and the different types of actions and whether what we are doing is looking at issues that are general across the industry versus issues that are institution specific, and also what the remedies and outcomes of those might be. What is primarily important, from our perspective, is to make sure we have the facts and the information that we need to understand exactly what the issues are in the context of our prudential framework, and behaviour in the context of that prudential framework, before we form a view about the appropriate action and whether there is a matter or an issue that is appropriately dealt with more in the public domain or not. I would point you to some of the enforceable undertakings that we have agreed where there have been clear breaches of prudential requirements and the outcomes of those are made public. What we would say at this point is that, in the specific case of CommInsure and the CBA, we are very much at the information gathering stage. Until we do that, it is hard for us to comment on what the actions and the outcomes will be.

Mr HUSIC: I want to come back to that intervention in a moment and contrast it, Mrs Rowell, with something you said earlier. I totally acknowledge, Mr Byres, it is easy for me as an individual MP on this committee to second-guess the moves of yourself and your colleagues here. The decisions you make have a lot more consequences than me firing off questions on this committee—I am the first to acknowledge it—but the philosophical differences you and I have on this, vis-a-vis targeting individual bad behaviour versus the overall behaviour, I see playing out this way—here is a measure for you. You said, in terms of macroprudential, that you would put the higher cap requirements on and effectively try and slow the growth of investor loans and get it to the benchmark. You saw what happened with clearance rates. Auctions clearance rates in Sydney went from 90 to 60 per cent. That is a massive churn of economic value. Why is it that going through that churn of economic value is better than targeting the individuals? Because you can see what that did in terms of wealth within the economy. Why is your systematic whole-of-sector approach better than targeting the ones that are behaving in a way that they are lending, as your own borrower surveys did—your hypotheticals that you released in May last year? Why isn't a more pinpoint approach better than the broader one you have employed that saw that change in economic value that we witnessed last year or through this year?

Mr Byres : We are doing both, in the sense that—to take the mortgage example—the letter that went out set some benchmarks. For some institutions that required significant change to practice and a lift in lending standards. For others it did not require much change at all. To that extent it was a targeted measure, but there was transparency about what those targets were. The specific dealings we have had with individual institutions depended on where they were at, and on the extent to which some institutions were growing above 10 per cent and had to scale back, and some institutions were under 10 per cent and did not have to do anything. Although at first glance it might look like a one-size-fits-all approach, it did pick at individual institutions in the way it was applied. We also tailored it, to some extent, because when it came to talking with individual institutions that had to make changes we were more focused, and put more pressure, on the larger institutions that had the systemic impact to make changes faster. We gave smaller institutions a bit more time in which to make adjustments. So there has been a more targeted approach to that than perhaps your question suggested.

Mr HUSIC: Okay, but I will never know it. How will I know it? If you do not tell us publicly, how do I know it?

Mr Byres : Partly by answering your question. What you asked me previously was to go through and name: bank X had to do this, and bank Y had to do that. That is where we stop short, because I do not think getting cooperation—which is actually what we are relying on here—is going to be helped by the name-and-shame type approach.

Mr HUSIC: I have said this to you elsewhere: the reason I am so motivated about this is the way the big banks get the smaller players along the way to issue out loans. If I have someone doing something that is at the edge and it catches out someone in that person's electorate—your person in your electorate or my electorate in Western Sydney—and I have got a mortgage holder that is burnt as a result of it, those people suffer in silence. However, so do the people that perpetrated the action in the first place, and you do not stamp it our publicly. It is too late for the people we represent. They go through the grief and have to suffer. The people who set up the processes, set up the approvals, set up the way in which they make the loans and ignore the ability of the applicants as to whether or not they could meet their loans and could serve the loans in the future get off scot-free.

I do not know: I purely have to operate on trust, as an individual MP, that you are doing the right thing as opposed to shining a light on poor performers. That is the biggest issue that I have. It is not some political game or whatever; it is a genuine concern I have for residents in Western Sydney who are being extended loans by people who are doing things that even you know in your borrower's survey work is right on the edge.

Mr Byres : I accept your point. If it is a small consolation in the way I answer that question, I will say: amongst the larger end of the spectrum—and I do not just mean the big four—there was not a single bank that did not have to make a change in some shape or form in response to our work. If you asked me to list who had to make changes, I would list everybody.

Mr HUSIC: The only other question I had, very quickly, was to contrast what Deputy Chairman Rowell was saying about the superannuation sector, where you would walk through smaller decisions being made step by step—I think you said earlier in a response to a question about changes in superannuation governance. Do you recall that?

Mrs Rowell : The context of that comment was to make the point that board governance is not just about big decisions; it is about small decisions and making sure that the a cumulative effect of all the decisions is heading towards meeting member-best interest obligations.

Mr HUSIC: That is done proactively in the super sense, but what about the types of things that led to the question on CommInsure like: is there a similar sort of action being done in that space?

Mrs Rowell : We were looking at a microlevel at individual decisions being made in the superannuation space. I was saying that our expectations of good governance are that the boards are focusing on all of their decisions from a microlevel through to a macrolevel. We do review activity and look into some of those on a case-by-case basis if there is something that causes concern, but I do not think our approach in the superannuation system is any different to our approach in the other industries.

CHAIR: Thank you very much. In concluding the hearing, I will provide some further information: if you have been asked to provide additional material today—and we did have a number of those questions—would you please forward it to the committee secretariat. You will be sent a copy of the transcript of your evidence to which you can make corrections of grammar and fact. I declare this public hearing closed.

Resolved that these proceedings be published.

Committee adjourned at 12:23