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Australian Prudential Regulation Authority

CHAIR —I call the officials of the Australian Prudential Regulation Authority. Do you have an opening statement?

Dr Laker —In my opening remarks tonight, I would like to update the committee on global financial market developments and their implications for APRA and the financial institutions under our supervision. I would also like to offer some comments from the perspective of a prudential regulator on two market practices that have come under a stronger spotlight over recent months, namely, margin lending and securities lending. In late February when I last spoke to this committee, I noted that global credit and equity markets had been subject to a prolonged period of turbulence which showed every sign of persisting. So it proved. Market sentiment deteriorated even further over ensuing weeks but, more recently, sentiment has begun to improve. The turning point appears to have been the US Federal Reserve’s intervention in support of a major US investment bank, Bear Stearns, in mid-March. Nonetheless, in the face of sharply higher oil prices and uncertainty over the strength of US and global economic growth, market sentiment remains fragile and financial asset prices may not yet have found a firm anchor.

Throughout this recent period, the fundamental strength of the Australian financial system has continued to assert itself. This positive assessment applies to authorised deposit-taking institutions, ADIs, affected most by increases in wholesale funding costs and the drying up of securitisation markets. It applies as well to the other industries that APRA supervises—insurance and superannuation—that have, to varying degrees, been affected by declines in equity and other asset markets. Four main factors have been underpinning the strength of the ADI sector. Firstly, ADIs have continued to enjoy solid, double-digit growth in both business and housing lending, supported by an economy which still has considerable forward momentum. That said, rates of balance sheet growth have been slowing in response to the recent tightening in financial conditions. Secondly, ADIs have generally been able to meet their funding needs in 2008 through more aggressive pursuit of retail deposits and through wholesale market raisings, though often at shorter maturities than preferred. Securitisation markets, however, remain moribund, but some flickering of the eyelids has been observed recently.

Thirdly, the asset quality of ADIs remains generally strong, although, as expected in a higher interest rate environment, arrears rates have begun to edge up again, albeit from an historically low base, and some problem corporate loans have emerged, particularly corporates needing to refinance high debt levels in the current difficult environment. Finally, ADI profitability and capital levels remains sound. Increases in funding costs and higher levels of provisioning against distressed borrowers have brought the run of record profits to an end for some ADIs but not for others. ADIs that have sought to strengthen their capital levels have been able to access capital markets without difficulty. APRA remains in a heightened state of alert and it is far too early to heed any call to stand easy. We have been able to step back from our previous day-to-day monitoring of ADI liquidity positions as market conditions have improved but we continue to work closely with ADIs on their funding plans and we have strengthened reporting arrangements in this area. Our goal is to ensure that ADIs have articulated specific and realistic expectations for the funding of their planned asset growth, looking 12 months ahead.

The change in reporting arrangements forms part of an enhancement to APRA’s prudential framework for liquidity risk management that will be released for industry consultation later in 2008. It will take into account a review of international standards in this area by a working group of the Basel Committee on Banking Supervision in which APRA is participating. Earlier this week the government announced a range of actions that are being undertaken by APRA, including this work on liquidity risk management, and by other Australian financial authorities in response to the recommendations of the Financial Stability Forum, a global body established to promote international financial stability. APRA will continue to work closely with our fellow authorities to ensure a coordinated approach to Australia’s contribution to global reform initiatives and in implementing the Financial Claims Scheme also just announced by the government.

APRA has been active on a number of other fronts as well that are additional to its normal supervisory activities. As part of the so-called pillar 2 process of the new Basel II framework, we have been reviewing the capital management plans of ADIs to ensure that they are holding adequate capital buffers against risks. We have been closely monitoring lenders mortgage insurers, LMIs, in Australia, which have significant exposures to credit risk on housing lending. Recent claims experience has been readily manageable and the LMIs continue to perform well, reporting solid underwriting profits that support the strong capital base of the industry in Australia. While the major rating agencies have downgraded the parent companies of two foreign-owned LMIs due to reported group losses, the agencies have also acknowledged the strength of the Australian subsidiaries and of APRA’s prudential framework for lenders mortgage insurance. We have sought information from both life and general insurance companies on the sensitivity of their capital buffers to adverse movements in equity markets and interest rates. Generally speaking, this information has confirmed that equity markets would need to fall significantly below their 2008 lows before the capital adequacy of insurers would be threatened.

Finally, in this period of prolonged market volatility we have been emphasising to superannuation fund trustees the importance of maintaining adequate liquidity in the different investment classes to meet potential demands from members to change their investment mix or to transfer to other funds. After experiencing strongly positive cash flows over the last few years, superannuation funds in coming reporting periods may be delivering negative returns to members for the first time since choice of fund was introduced.

Let me turn now to margin lending and securities lending, in which I know members of this committee have a particular interest. Margin lending and securities lending are long-established market practices. APRA does not have specific policy requirements for these practices nor does it supervise them directly or routinely. Rather, as a prudential regulator, APRA’s role is to ensure that regulated institutions participating in these activities identify the counterparty, legal and other risks involved, manage these risks appropriately and, where relevant, hold capital against these risks. As a general point, APRA also expects regulated institutions participating in these activities to understand the legal framework for their transactions and to comply with all applicable laws.

Margin lending is a specialised business undertaken by the major bank groups, some smaller bank groups and some other institutions not supervised by APRA, such as investment firms and securities brokers. Margin lending is conventionally thought of as lending to a retail investor for the purpose of purchasing a portfolio of shares or other financial products; wholesale lending by banks to brokerage firms or other lending that may be fully or partially secured by shareholdings of the borrower generally falls outside this definition. In aggregate, margin lending currently constitutes only about two per cent of the total loan portfolio of ADIs in Australia. This share was around one per cent for a number of years but it rose during 2006 and the first half of 2007 to a peak of nearly 2½ per cent, coincident with the strong rise in equity markets.

APRA expects banks that provide margin lending to manage their lending exposures within a comprehensive risk management framework that, amongst other elements, focuses on the capacity of the borrower to service the loan and on the value of security. Banks have generally taken a conservative approach to this form of lending, with relatively prudent criteria for shares they will lend against and low loan-to-valuation ratios—around 50 per cent or lower. APRA monitors the banks’ approach to this form of lending but does not set detailed prudential requirements. Decisions, for example, regarding the timing and need for margin calls are made by the bank as part of its normal business practices. APRA expects banks to have clear policies around these aspects of their margin lending activities. For those banks with material margin lending portfolios, APRA assesses the adequacy of lending policies and controls during regular on-site credit risk reviews. However, APRA does require ADIs to hold regulatory capital against their margin loans as a buffer against unexpected losses. In fact, APRA recently exercised its national discretion and departed from the new Basel II framework, which does not include any capital on margin lending because of the historically very low risk in this activity. APRA imposes a 20 per cent risk weight—equivalent to a 1.6 per cent capital requirement—on ADI margin lending.

As I advised the committee in February, banks have reported to us that they have not incurred any material lending losses in their retail margin lending. While recent market volatility has led to significant increases in margin calls, our discussions with banks indicate that borrowers are normally able to meet them. It is worth pointing out that recent highly publicised events involving liquidation of securities positions do not involve banks’ retail margin lending business but more complex lending arrangements secured by individual shares or wholesale funding to brokers for their own margin lending activities.

Let me turn, finally, to securities lending, which is also a well established market practice in Australia and overseas. As the Reserve Bank of Australia noted in a recent report, ‘both short-selling and securities lending are critical to the efficient functioning of the equity market’. For market participants, the practice adds to market liquidity and to the efficiency of pricing, and facilitates on-time settlement of trades. For holders of securities, securities lending is a means of increasing overall investment returns while retaining long-term exposure to the underlying securities. In the case of superannuation funds, share lending reduces the overall cost of asset custody and is often associated with reduced fees from custodians rather than direct income to the fund. Superannuation trustees are responsible for managing their portfolios in the best interests of beneficiaries, as we know, and that includes addressing any custody-related risks that could arise in securities lending arrangements.

APRA has examined this practice in the past and did not consider it to pose a significant prudential risk to superannuation funds or their investments. Normally, share lending is conducted by the custodian as part of its routine operations and under standard terms and conditions, so trustees are aware of and agree to the lending of their fund’s shares. The arrangements are also well collateralised. Superannuation trustees have not advised us of any recent losses arising out of this practice. APRA expects superannuation trustees to have policies governing exercise of share voting rights that ensure votes are exercised in the best interests of fund members and that take into account the implications of securities lending. Our understanding is that entities that wish to vote their shares on a particular matter generally have a right to recall any shares that have been lent. Like any other investor, a superannuation trustee could instruct its broker to short-sell shares within the ASX’s rules for short-selling.

Superannuation legislation does not impose quantitative controls over investments, including short-selling. However, our understanding is that superannuation trustees generally do not engage directly in this form of activity, although some funds may have investments in hedge funds that include short-selling in their trading strategies. Such investments need to be consistent with the investment strategy that all superannuation trustees are required to have for the fund that takes into account the risk and likely return from investments, the diversification of those investments, liquidity requirements and the ability of the fund to discharge its liabilities. Trustees must also have a formal risk management plan for the funds which identifies the risks to its investment strategy and which must be reviewed at least annually. My colleagues and I are now happy to take the committee’s questions.

Senator MURRAY —In terms of opening statements in the estimates process, that is amongst the best statements we could ever have. So I am glad it was both long and full. Thank you very much.

Senator EGGLESTON —I would like to ask some questions about the four-pillars policy and the proposed Westpac takeover of St George, which has been getting a lot of press lately, with people like Terry McCrann supporting the four-pillars policy; theAustralian Financial Review saying that it is on its swan song; Allan Fels saying competition is the real issue we have to be concerned about; and Gordon Renouf saying decreased competition and increased fees may be the outcome. Since time is short, I will make my questions very brief. What is the track record of the four-pillars policy and how effective has this policy been in achieving its objectives? Has it failed in any way?

Dr Laker —As Chairman of APRA, I really cannot engage in the policy question of whether four pillars is the appropriate policy. That is a matter for government. What I can say and what I said in the opening statement is that we have a very strong banking system. We have strongly capitalised banks, large and small. It has been a major focus of APRA over the last five or six years that their approach to lending is conservative and that is reflected, I think, in the summary I gave you tonight as well. We, as a prudential regulator, look at each institution to make sure that it can hold its own in the tough competitive marketplace in which it operates and, on that score, I think we in APRA are proud of the Australian financial system at this point. It has weathered a tough storm well.

Senator Sherry —The only comment I would make about four pillars—I would confirm what Dr Laker has said—it is a government policy. It has just been reiterated, reannounced, earlier in the week and it was obviously the policy of the previous government. The Treasurer has made a statement as part of the announcement relating to the Financial Claims Scheme that he also detailed earlier in the week.

Senator EGGLESTON —One can read much into both of those sets of comments. What presentations, if any, have been made to APRA about the proposed merger between St George and Westpac?

Dr Laker —I think you will find my answers frustrating, but I cannot talk publicly about our dealings with regulated institutions because the parliament has quite wisely charged me to respect confidentialities. What I can say in general about mergers of this type, and we have dealt over the last few years with a number of large mergers, is that we work very closely with both parties to a merger. We normally require a project team on our part to assess the implications of any merger. Our focus is to ensure that the resulting entity, the merged entity, is robust, well-capitalised and well-governed and has a strong board, strong fit and proper standards within the institution. We also place considerable emphasis on the actual integration process itself because that can expose the entities to considerable operational risk and distraction of management time and resources while a merger, or takeover, is being implemented. We will work closely with merging parties through a merger of any scale. This possible merger on the scale of St George and Westpac is clearly quite resource intensive for us. But we need to ensure that, when we allow institutions to run onto the field, they are fit and they are strong, and they know the rules of the game and they are capable of playing it as hard as they need to in the marketplace.

Senator EGGLESTON —I have one other question which you may or may not feel able to answer: could you outline the implications of not having any Australian-owned banks and, if this scenario were to occur, would sufficient mechanisms exist to protect our domestic interests?

Dr Laker —I think you can appreciate that is a speculative question because government policy, as stated, has been the preference for Australian banking to remain predominantly in Australian hands. I think that was how the previous government had expressed the view. We have comprehensive mechanisms to supervise any institution, whether it is foreign-owned or Australian-owned, and we work closely with overseas regulators where there is a sharing of responsibility between a host and a home supervisor. An example of that at work is the role of the Australian banks in New Zealand.

Senator BUSHBY —I have a question about Members Equity Bank. I understand that a few months back, Standard and Poor’s placed the bank on credit watch but they have since made some arrangements which have alleviated some of the matters that led to that. Would you like to comment on that, please?

Dr Laker —I cannot comment on individual cases.

Senator BUSHBY —Has APRA read the Parliamentary Joint Committee on Corporations and Financial Services Report into the structure of the superannuation industry?

Dr Laker —Very closely.

Senator BUSHBY —What is APRA’s view on the committee’s recommendation for mandatory unit pricing?

Dr Laker —Can I ask my colleague who handles superannuation matters.

Mr Jones —APRA does not have a view itself on whether unit pricing is better than crediting rates. APRA’s principal objective here is to ensure that there is the appropriate application. We put out a unit pricing guide jointly with ASIC and we have seen a significant improvement in the quality of the responses to unit pricing over the past 12 months in terms—

Senator BUSHBY —When were those guidelines put out?

Mr Jones —They would have been out 12, 18 months ago. They have actually been quite well received by the industry—

Senator BUSHBY —Do they apply to all funds?

Mr Jones —Yes, all the—

Senator BUSHBY —As to unit price?

Mr Jones —They are guidelines. They are not requirements. It is simply best-practice guidelines.

Senator BUSHBY —What percentage of super funds have implemented daily unit pricing?

Mr Jones —We do not collect information on the percentage because it is not a prudential matter. Probably, though, the easiest way to think about this is that we do collect information on retail and public offer funds. Most retail funds and most public offer funds engage in unit pricing. In terms of the number of funds that APRA regulate, it is probably about a third of them but in terms of—probably a more interesting number would be the number of members, rather than the actual number of funds. Given that there are more people in public offer funds, this is top-of-the-head stuff because we do not actually collect accurate information, but I would suggest it is probably between two-thirds and three-quarters of the APRA regulated membership would be in retail public offer type funds that unit price.

Senator BUSHBY —Would that translate roughly as well to the percentage of super funds under management?

Mr Jones —Not necessarily.

Senator BUSHBY —Would you have any idea of the percentage of super funds under management—

Mr Jones —In dollar terms?

Senator BUSHBY —No, you mentioned that a better way of looking at it would be the number of members, as opposed to the number of funds—

Mr Jones —Yes.

Senator BUSHBY —Would that same percentage that you hazarded a guess at, or an estimate, transfer across roughly also to the percentage of the total super funds under management?

Mr Jones —No because we only supervise the prudentially regulated sector. Self-managed super funds are not regulated by APRA and they represent about a quarter of the total funds, the $1.1 trillion worth of funds, in the industry.

Senator BUSHBY —That is a good and useful point. What are the trends showing in terms of funds moving to daily unit pricing? Is it increasing as a trend or is it—

Mr Jones —Again, we do not collect that information. I could only give you information in terms of the trends, say, in terms of public offer and retail. So, for example, if the percentage of the market controlled by retail funds was rising, in all probability we would assume that the numbers that were in unit pricing were also following that trend. But, in fact, given that we do not collect the information, I could not be any more accurate than that.

Senator BUSHBY —For the record, what process do funds that do not daily unit price follow?

Mr Jones —They use crediting rates and those crediting rates could be done on an annual basis, quarterly basis, six monthly basis, according to—

Senator BUSHBY —The amount of information going to members as to what has happened with their funds is not as great, effectively?

Mr Jones —I am not sure because, in the cases of many of the assets, many of the assets may not need to be valued daily in terms of members who are in funds for long periods of time.

Senator BUSHBY —You mentioned that you have issued guidelines on appropriate procedures for unit pricing. Are there guidelines on appropriate procedures for funds that do not unit price?

Mr Jones —No, there are not.

Senator BUSHBY —How does APRA ensure that member equity prevails in funds where daily unit pricing is not applied?

Mr Jones —The equity issue with all these things is the valuation of the assets, so when we do our supervision we look at the way in which these things have been evaluated but, of course, there is always the issue of the notional idea of equity between members when members come and go, as members enter the fund and members leave the fund, and that occurs across all funds.

Senator BUSHBY —Are there any prudential risks that arise when funds do not use daily unit pricing? We have touched on that, I think, but I am asking the question specifically.

Mr Jones —I do not think there are necessarily any more prudential risks associated with crediting rates than there are with unit pricing. Unit pricing can be fairly complicated, and one of the things that we found, for example, with unit pricing guidelines is that we are finding some unit pricing errors which had significant dollar values, not significant necessarily for every individual member but in total the unit pricing error has been some actual numbers in aggregate, and what we have found in the past 12 months is that they seem to have decreased. It is a very positive sign.

Senator BUSHBY —Is it not possible that an individual who leaves a fund that does not daily unit price at a time when asset values are falling could disadvantage the members who remain?

Mr Jones —It is possible in all circumstances with members who leave at any particular time because of changes in any evaluations, share markets or anything else. That is always a possibility.

Senator MURRAY —I took the precaution of asking you some questions in advance, which you very kindly covered at length in your remarks, and thank you for that. Thank you for the thoroughness. It was very helpful. The other day I asked questions of the Future Fund concerning the issues of their policy with respect to margin lending and various types of short-selling, securities lending with respect to profit taking and for voting. In some categories they were very clear as to their policy and in others they had not developed policy and undertook to go back and ask their board what the policy should be, my prime position being that anyone engaged in this very large-scale activity should have a policy which guides them. As I understand it, that is what you have indicated is APRA’s approach. What I want to check with you is how do you check that the policy exists with respect to each of those areas? Is there a tick-a-box kind of questionnaire, or do you go and look, or what happens?

Mr Littrell —We have something called the APRA supervision framework which outlines the areas of interest in a supervisory visit. We also have extensive off-site work but that is not so relevant here. The general answer to the question you raised is that, when our supervisors go into a super fund, that is one of the things they look at. It is not necessarily a tick-a-box literally in the sense of—it is not like there is a series of fine detail of regulation of how these things work but there is a general approach of how you would go about, for example, ensuring that if someone had an agreement with a custodian to lend scrip that it was properly collateralised and managed.

Senator MURRAY —You would establish that the policy was not that of an operational procedure which simply managers adopted but it was that which had been properly developed by the trustees or the board, whichever applies in the particular case?

Mr Littrell —In this particular case, most custodians have developed a reasonably standardised approach and agreement. Most trustees would sign up to something that looks like that agreement. It is one of many areas we would look in satisfying ourselves that a trustee was covering its risk. It is not one that is a particularly great focus for us.

Senator MURRAY —Apart from its topicality, my interest in this is the sheer scale. It really did take me by surprise. I am not as close to the market as some but I am close enough. I was startled by the scale of it and that is why I think it matters.

Dr Laker —I was just going to add to Mr Littrell’s response that, when we went through the process of superannuation licensing, what trustees needed to have developed is an investment strategy and a risk management plan for their fund. We went through those in very careful detail before a licence was granted and, in the couple of years since, we have gone back and satisfied ourselves that these are living documents, that they are applied and that they are fully understood throughout the organisation. We have been following up to see whether the elegance of the plans and the thoroughness as written are actually implemented in practice. As you say, this issue has become topical and we have been talking to some of the larger superannuation funds about their approach and whether they have been revising and rethinking that approach. We have been talking to them about this particular issue.

Senator MURRAY —I would indicate to you that, in conversations and questioning I have had of associations in some funds, it seemed to me that some, in their responses at least to me, were much more up to the mark and more current and more focused than others. But I just make that comment for what it is worth. The last question I have is relative to banks and the superannuation funds. I have the impression with respect to these three categories I have outlined that banks have pretty well protected their interests and have not been exposed to excessive risk. That is my impression. But I have the impression that superannuation funds, by virtue of the way in which they are engaged in the market, have been more exposed to risk.

Dr Laker —This is in the process of securities lending?

Senator MURRAY —Securities lending in particular. I just want to hear from you whether that is an accurate impression and, even if the superannuation funds are more exposed to risk, in your view they are still well managed and manageable.

Dr Laker —I can only confirm what I have said, that, firstly, the practice predates APRA. In Australia, my understanding is that it was really in the 1970s and 1980s that it was first established officially, but the practice of securities lending goes back into the 19th century in other countries. Secondly, our superannuation funds are natural participants in that market because they are holders of the securities that can be lent. Thirdly, I think the point you need to remember is that the superannuation funds are long-term holders of these securities in general, so their main focus is to take a long-term view about the price of shares. They use the securities lending facility, as Mr Littrell said, under established Australian Master Securities Lending Agreements. There is a very well-established template for lending. It has not come on our radar as a source of risks that are not well managed.

Senator MURRAY —Do they get the general approval of the ultimate beneficial owners, which are the superannuants themselves, for their policy?

Mr Jones —No.

Dr Laker —Not in this specific case but the trustees act in the best interest of their members. In general, I think the relationship would be between the trustee and the custodian.

Mr Jones —It is also a similar example say when some of the lending has gone on and there are issues, say, regarding the voting. The trustee still has an obligation to ensure that any voting of shares is in the interests of members and so, of course, the circumstances are always that the trustee can call back those notionally linked shares under those circumstances.

Senator BUSHBY —Given that we are very short on time, I will change off unit pricing. There has been some discussion in the public, in the media and otherwise regarding the performance gap between retail and industry funds and I understand—and I think it was fairly recently—that Mr Jones made the statement that ‘the profit motive may diminish the alignment of interest between a fund and its beneficiaries’. Would you care to expand on that statement, and what you mean by that?

Mr Jones —Could you repeat the question?

Senator BUSHBY —I am reading from a media report from 25 May this year. It says:

Last week APRA released research backing the claims of not-for-profits. ‘APRA data collection since 1996 suggests systemic differences in investment returns,’ APRA deputy chair, Ross Jones, told an industry forum in Melbourne. Most controversially Mr Jones suggested that ‘the profit motive may diminish the alignment of interests between the fund and its beneficiaries’.

Mr Jones —The context was two things. We have been doing two sets of research. One, which does go back over 10 years, shows the performance. Our statistics show that the performance of the retail funds over the decade—we put out something last year called ‘Celebtrating Ten Years of Superannuation Data Collection 1996-2006’. In that publication, it showed that the retail funds significantly under-performed compared with the other types of funds. The second part of the research that I think that quote probably refers to is that we then did some follow-up work which we published a few weeks ago, and I would imagine that is where that came from, which was looking at some more subjective factors such as governance and trying to look at whether there are any sorts of links. At various times we have speculated—and I certainly have in speeches—as to the reasons for the significant under-performance. One of the things that has been made clear is that, in fact, retail funds do need to make a profit. It is simply a statement of fact. Retail funds are for-profit funds. They are a business. On the other side of it, they will argue, quite justifiably, that they have a capital backing that some other funds do not have, and they have a reputation. And some of these things will have an impact.

Senator BUSHBY —You are saying that there are a number of things or factors—and this may be one of them—that lead to the performance gap?

Mr Jones —There are all sorts of things. One thing that we do not have, for example, through our statistics is strong information on costs. We have very good information on net returns and that is what we publish, but we do not have a great deal of information on costs, for instance.

Senator BUSHBY —You will look to add to your information store—

Mr Jones —It is certainly something that we have been trying to do. In fact, interestingly enough, we are holding a major seminar or conference in the first week of July looking at our statistics collection, and that is one of the issues that I hope will be raised by all participants.

CHAIR —I thank APRA officers for attending this evening and I adjourn this committee until 9 am tomorrow.

Committee adjourned at 10.59 pm