Reforming international financial regulation

Reforming international financial regulation

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All information is current as at May 2010

First published May 2010

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Reforming international financial regulation First edition

Reforming international financial regulation ISBN: 978-1-921245-71-8

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This paper is part of a thought leadership series dedicated to ensuring Australia and its next generation of leaders remains fit for the future. Entitled Reforming international financial regulation this paper is the second in a series of papers dedicated to broader economic thinking and engagement with Australia’s business community.

The Fit for the future series is to bring together business, social, political leaders and thinking on key issues impacting Australia now and in the future. As a leader in the Australian accounting profession the Institute of Chartered Accountants in Australia (the Institute) has a role and responsibility to contribute to Australia’s public policy agenda. It is in this regard that we have teamed up with Access Economics to produce this paper.

Reforming international financial regulation details how regulation is being reformed internationally. The global economic downturn uncovered severe weaknesses in the international framework of regulation and it is paramount that Australia moves with best practice to ensure its regulation architecture remains viable. To achieve this there needs to be a subtle calibration between efficiency and stability – a delicate mix but critical to the future evolution of Australia’s financial services industry.

Australia will face many challenges in financial regulation over the coming decades. Reforming international financial regulation represents a building block to a greater level of understanding of the international trends and how Australia is placed internationally.

The Institute is pleased to have worked with Access Economics on this paper and I trust that you will find it both interesting and thought provoking.

Michael Spinks FCA

President Institute of Chartered Accountants in Australia

Foreword


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Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

1 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

1.1 Context for reform and Australia’s response . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

1.2 The proposed reforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

1.3 The reform timeline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

1.4 Australia’s obligations and approach to reform. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

2 International regulatory reforms most likely to affect Australia . . . . . . . . . . . . . . . . . . . . . 11

2.1 Capital and liquidity enhancements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

2.2 Leverage ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

2.3 Procyclicality measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

2.4 Systemic risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

2.5 Products and markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

2.6 Regulatory boundaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

3 How might Australia respond? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

3.1 Incorporate reforms within existing structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

3.2 Re-assign regulatory responsibilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

3.3 Selectively implement reforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

3.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

Appendix A Consultations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

Appendix B International regulation standard-setters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Appendix C Outline of the proposed reforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Appendix D Reform timeline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

Appendix E Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

Charts

Chart 2.1 Ratio of private credit to GDP in selected countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Chart 2.2 US private credit as a share of GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Tables

Table 2.1 Lessons from past crises regarding appropriate levels of capital . . . . . . . . . . . . . . . . . . 13

Table 2.2 ‘Skin in the game’ reforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Table A.1 List of stakeholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

Table B.1 FSB members . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Figures

Figure 2.1 Liquidity ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Figure B.1 FSB organisational structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

Contents


Executive Summary

The Global Financial Crisis (GFC) showed that macroeconomic policy and prudential supervision are not sufficient to ward off systemic crisis in the international financial system. In the wake of the crisis, financial regulators and standard-setters are moving to tighten regulations and raise standards across the globe. This report identifies the main reforms under review and the challenge facing Australian authorities to respond appropriately.

Capital and liquidity enhancements

Proposed enhancements to capital and liquidity standards will oblige banks to hold more capital and more liquid assets on their balance sheets. These changes will instigate widespread deleveraging and lower banks’ return on equity. Consequently, the cost of bank intermediation is expected to rise. The wider spread between banks’ cost of funds and their lending rates (ie. their net interest margins) will be paid by bank customers. Raising the cost of bank intermediation will slow global economic growth.

Australian banks are well capitalised under the current Basel II framework. Moreover, Australian banks have raised extra capital (and notably high quality Tier-1 capital) to further strengthen their balance sheets. While the level and nature of the proposed new capital requirements are not yet final, Australian banks are well down the path to any new standard. Similarly, liquidity requirements are already being tightened in Australia and should easily meet any new standard proclaimed internationally.

Leverage ratio The proposed unweighted leverage ratio may alter international perceptions of the capital adequacy of healthy banks. The leverage ratio is intended to complement existing risk assessment models, targeting the problem of excessive leverage. However, not being weighted to reflect the riskiness of a bank’s assets, the leverage ratio represents a significant departure from current supervisory practice.

An unweighted leverage ratio affects banks with low-risk balance sheets, like Australia’s banks, whose balance sheets generally have large exposure to low-risk mortgages. The leverage ratio will show these banks as under-capitalised relative to their international peers when they easily meet APRA’s risk-weighted capital adequacy standards. Given support for a leverage ratio from key international regulators, Australian authorities are working to influence the calibration of the ratio so that it does not penalise well-managed, low-risk banks. If these efforts are unsuccessful, Australian banks may face a higher cost of borrowing in global capital markets. Some of the resulting impact on Australian borrowers may be mitigated if the RBA targets a lower official cash rate over the business cycle.

Procyclicality measures

Procyclicality measures seek to equip financial systems with regulatory ‘shock absorbers’ by requiring financial institutions to build up capital reserves in good times in order to sustain their activities during the inevitable bad times.

APRA’s discretion over minimum capital requirements effectively replicates aspects of the proposed procyclicality measures, namely, building up capital buffers in good times. However, introducing forward-looking provisioning and credit-linked capital buffers may not have a positive impact: the former may not dampen the credit cycle at all (as exemplified by Spain’s experience); while the latter may compromise the effectiveness of monetary policy – especially when the factors driving credit growth are beyond the RBA’s influence. In addition, investors may shy away from banks whose discretion to distribute earnings is constrained, making it more difficult and/or expensive for them to raise capital. The ability of Australia’s banks to raise equity capital during the GFC contributed to their resilience.

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Systemic risk Mechanisms to address systemic risk remain conjectural at this stage. Many and varied proposals have been brought forward. Regulatory options such as structural reforms, taxes on size or ‘living wills’ are likely to reduce the size and scope of financial intermediaries and stimulate the growth of ‘shadow banks’. The net impact on systemic risk is arguable.

Obliging financial institutions to reduce their size, complexity and links to counterparties reduces systemic risk. However, there is a cost to be borne in reduced economies of scope and potential sharing of risk across markets. Requiring institutions to plan for their own demise or dismembering may force them to re-assess their counterparty risks, and simplify and reduce their exposures. But it may also induce them to move beyond the reach of prudential regulators, which could be counterproductive. Australian regulators are amenable to measures for dealing with institutions that are systemically important. The ‘four pillars’ policy is an example. Yet, even with this policy in place, the moral hazard of institutions judged ‘too big to fail’ has been increased by moves to protect Australia’s banks during the GFC.

Product and market regulation

Modifications of the securitisation process along with the development of rules and exchanges/clearing houses for trade in Over-The-Counter (OTC) derivatives are likely to reduce systemic risk. There will be a cost to the issuer in the form of reduced returns for a given issue, and clearinghouse users will have to pay for their use of clearing/trading systems. There is also a risk of reduced innovation in OTC markets as contracts become standardised, more commonly traded on exchanges and cleared through central clearing houses.

Returns to originators from securitised issues will fall as a bigger share of the risks is retained and internalised through regulatory reforms, including revised requirements for retaining ‘skin in the game’. This will increase the cost of raising funds through securitisation, particularly for smaller banks and non-ADIs. However, other measures are expected to have a lesser impact owing to the relatively small size of local markets for the more problematic OTC products – such as CDS – and the Australian hedge funds sector. In any case, ASIC is moving in advance of the international timetable and initiatives, including those relating to securitisation, due diligence and credit rating agencies. Some initiatives may be in place in Australia before international standards are set.

Regulatory boundaries

Re-defining the coverage and responsibilities of regulators at international and domestic levels will reduce opportunities for regulatory arbitrage and duplication of regulatory effort. The ‘twin peaks’ model will become somewhat blurred as procyclical measures combine elements of monetary policy and prudential regulation. Even product and market regulation will encounter this blurring effect if prudential regulation is extended to cover securitised issues.

Recognising that systemic risk afflicts financial markets as well as intermediaries blurs the neat division of regulatory responsibility assigned in the Wallis Report. Moves to extend the reach of prudential regulation into the ‘shadow banking’ system risks overlap between ASIC and APRA, and potentially leads ASIC into areas it is insufficiently resourced to perform. Independent moves by APRA to adjust capital requirements as part of macroprudential policy potentially confuse and conflict with the RBA’s countercyclical monetary policy. A review of coordinating mechanisms among Australia’s financial regulators will be essential as part of the reform process.


Responding to the proposalsThere are three broad responses which Australia could make to the international reform agenda. Specifically, Australia could respond by:

Fully signing up to the reforms but carefully managing >their implementation within the existing Australian regulatory structure

Re-defining regulatory responsibilities among Australia’s >financial regulators to better reflect the revised approach to systemic risk management emerging from the FSB process

Explicitly repudiating some of the more interventionist >proposals on the grounds that they are redundant in an Australian context or potentially compromise the discretion of Australian regulators.

Australia needs to decide how to respond to the raft of initiatives likely to emerge from this complex process. There is Australia’s international reputation for sound and effective financial regulation to protect, as well as Australia’s obligations to the G-20 to consider. On the other hand, Australia’s national interest must be guarded when signing up to regulations which may, at least in some cases, compromise rather than enhance the integrity of Australia’s system of financial regulation.

In the best case, Australia can accommodate the new requirements within existing structures. There is also the possibility, however, that the global standards oblige us to implement more fundamental changes than might be considered desirable or even necessary. For this reason, the option to reject some or all of the proposed changes should not be foreclosed or dismissed lightly.

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The Group of Twenty (G20) countries are reforming regulation of their financial systems in the wake of the Global Financial Crisis (GFC).1 The GFC revealed significant weaknesses in the global framework of financial regulation. While it is understood that periodic crises are an inherent feature of financial systems, the global reach and impact of the GFC have forced authorities to re-think their approach to the mitigation of systemic risks (Caruana, 2010). As a member of the G20, Australia will come under pressure to align our financial regulations with the emerging standards adopted internationally.

The Institute of Chartered Accountants in Australia (the Institute) has commissioned Access Economics (AE):

To report on the deliberations to date of international >regulatory agencies and to identify high-priority issues on their agendas for reform

To report on the likely responses of international >regulators to these high-priority issues

To identify how these responses potentially align or >conflict with policies already in place, or under active consideration, in Australia

To analyse the likely impact of proposed reforms on >the Australian financial system.

The body of this report considers what international regulators are most likely to do. The findings are based on desktop research complemented by consultations with regulatory experts, industry specialists and academics as well as domestic and international regulators. (A full list of institutions consulted appears as Appendix A.)

The report distils its findings into six key areas considered most relevant to Australia (even if they are less relevant to international players). The facts are presented in each area and then analysed, highlighting how the proposed reforms align or conflict with policies already in place or planned in Australia. Some comments on the likely timing of each reform are included for completeness.

The report concludes with an assessment of the options open to Australia in responding to the reforms most likely to emerge from international deliberations. Ultimately, the impact on the Australian financial system will turn on how the Australian regulatory authorities respond.

In choosing their response, Australian authorities will be wise to recall that there is almost always a trade-off between efficiency and stability in any economic system. To the extent that increased regulation promotes systemic stability, it generally comes at a cost in terms of lower economic efficiency (both static and dynamic). The question for

Australia is how to calibrate this balance so as to optimise the performance of our internationally respected financial system.

1.1 Context for reform and Australia’s responseRapid contagion of stresses originating in the United States’ financial system was met with a co-ordinated response from governments around the world. Political leaders from the G20 nations have since announced their intention to reform global financial regulation in the wake of the GFC. While Australia’s experience was benign by comparison with that elsewhere in the world, our reliance on international capital markets means that Australia has a vested interest in the robustness of the international financial system and its regulation. Australian financial intermediaries and markets rely on the soundness of their counterparties. The GFC was communicated to Australia through stresses experienced by these same counterparties.

The G20 nations have transformed the former Financial Stability Forum into the Financial Stability Board (FSB) with a mandate to coordinate the international response to regulatory reform. There are a number of different agencies that set standards which individual countries then decide whether to adopt or not (see Sections 1.2 – 1.4 overleaf). The FSB comprises senior representatives of national financial authorities (central banks, regulatory and supervisory authorities and ministries of finance), international financial institutions, standard-setting bodies, and committees of central bank experts (see Appendix B).

The FSB hopes its efforts will spark a ‘race to the top’ – as more countries adopt its standards, others will face a stronger incentive to follow suit. A decision to stand aside from these reforms could risk a country being treated as a pariah or, worse, becoming a magnet for operators keen to locate where financial regulations are less stringent than international norms. Australia would be ill-served by either of these outcomes.

Australia’s system of financial regulations is among the more advanced in the world. This is one reason why preconditions for the GFC, including excessive leverage and lax bank lending standards, did not apply in Australia – at least not on a systemic scale. Australia’s benign experience of the GFC has drawn international attention to the robustness of our financial regulations and strengthened Australia’s reputation for financial safety and soundness.

Hence Australia has much to lose from an inappropriate response to the G20 initiatives. On the one hand, we would sacrifice a well-earned reputation for financial probity if we stood aside from international reforms in the belief that

1. Background

1. The term ‘Global Financial Crisis’ encompasses a sequence of events including the sub-prime mortgage crisis beginning in 2006 and gathering pace in 2007, a subsequent banking crisis, and the collapse of Lehman Brothers investment bank in September 2008. Observers generally regard the demise of Lehman Brothers as triggering the most dramatic phase of the GFC.


our system has already achieved ‘world’s best’ regulatory practice. On the other hand, there is no evidence that our system of financial regulation needs a major overhaul to redress failures exposed by the GFC. Australia’s experience in this regard, like that of a minority of countries including Canada, India and Hong Kong, is precisely opposite to that in the United States, UK and parts of Europe, most notably Ireland and Iceland. Nevertheless, Australia will benefit from reforms implemented in those countries whose financial weaknesses were transmitted globally, including to Australia. Failure to play our part in such global reform risks undermining initiatives elsewhere in the world from which Australia stands to benefit.

Calibration of Australia’s response to international financial reform calls for some subtlety. Our circumstances are not those of the major economies whose experience of the GFC has been devastating. Yet, while Australia has developed through experience and good management an approach to financial regulation that is admired by many, we would not be well served by complacency.

This report lays out the main areas where international reforms will challenge Australian authorities to devise an appropriately calibrated response. Rather than speculating on what that response might be, the focus is on calling attention to the issues and how they might play out in practice. The range of possible responses the authorities might take as the reform proposals take shape is also identified.

1.2 The proposed reformsThe international regulatory response coordinated by the FSB canvasses a wide range of proposals. Broadly speaking, the reforms can be considered under four headings:

‘Whole of system’ reforms relating to global cooperation, >enforcement and monitoring (FSB being the lead standard-setter)

Reforms of regulations applying to financial intermediaries >(BCBS being the lead standard-setter)

Reforms relating to the regulation of capital markets and >instruments (IOSCO being the lead standard-setter)

Reforms relating to the regulation of professional services >and ancillary support (IASB and IAIS being lead standard-setters for accounting and insurance, respectively).

Details of the proposed reforms are presented as Appendix C.

1.3 The reform timelineThe sheer number of proposals under review plus the variety of stakeholders seeking input to the deliberations complicate the reform process and will inevitably slow the rate of implementation. There will also be an extended transition period given the weight and complexity of the reforms in view.

Current activities of the international standard-setting agencies fall into three groups:

Completing reviews of the coverage of existing regulations >

Ensuring that, at a minimum, FSB member nations have >adopted 12 key international standards (that existed prior to the crisis)2

Determining new regulations and policies. >

Details of these activities and the timetable for their expected completion dates are presented as Appendix D.

1.4 Australia’s obligations and approach to reform

As a member of the FSB, Australia is obliged to implement reforms agreed by the various standing committees and to undergo peer assessment to check on implementation. A number of proposals have already been implemented in Australia or are well advanced in implementation. Other proposals may require Australia to make significant changes to existing regulatory practice.

The approach of Australia’s regulators to implementing FSB reforms will determine whether regulatory changes achieve desired improvements to the financial system. Our regulators are accustomed to consultation with stakeholders and this will be vital if unintended consequences are to be avoided or at least minimised. The field is fraught with the possibility of misapplied reforms.

2. The FSB has determined 12 Key Standards as critical to ensuring sound financial systems. They include standards relating to macroeconomic policy, data transparency, institutional and market infrastructure, and financial regulation and supervision. These standards have been developed by the IMF, World Bank, OECD, IASB, IFAC, CPSS, FATF, IOSCO, BCBS and IAIS.

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2. International regulatory reforms most likely to affect Australia

The GFC showed that macroeconomic policy together with prudential regulation of individual financial institutions could not prevent the build-up of systemic risk. This gap in the regulatory framework allowed pressures to accumulate that ultimately disrupted the provision of financial services to the global economy. The G20 countries have deemed that macroprudential policy is required to fill this void.

Essentially, macroprudential policy aims to help dampen the credit cycle and increase the resilience of financial systems in times of stress. The intention is to raise and lower capital standards applying to financial intermediaries in a countercyclical (‘leaning into the wind’) fashion. The G20 Working Group 1 (2009) recommended a number of potential macroprudential tools and the BCBS (2009b, 2009c) has released consultative documents detailing the measures most likely to be adopted.

Working out operational aspects of macroprudential policy is a challenge for international regulators. The G20 Working Group 1 (2009) finds a rules-based approach ‘attractive’ but also recognises the value added by informed judgment. The ‘rules versus discretion’ debate has a long history in monetary policy. It would be incongruous if the conventional wisdom that monetary policy should be ‘rules-based’ but not ‘rules-bound’ should be tipped on its head in the realm of macroprudential policy. Moreover, the interaction of the proposed macroprudential tools with monetary policy is not well understood. In Australia’s case, where monetary and prudential policy are administered by separate agencies, the roles of the RBA and APRA may need to be re-cast.

The GFC revealed that systemic risk is pervasive and afflicts financial markets as much as financial intermediaries. Financial markets can suffer the equivalent of a ‘bank run’ since ‘asymmetric information’ is more ubiquitous than most people thought. Consequently, improved product disclosure and market conduct regulation also feature prominently on the reform agenda. The boundaries between prudential and disclosure regulation may also shift in the wake of the reform process with implications for the respective roles of ASIC and APRA.

Against this background of international regulatory reform, six key issues emerge for Australian regulators and those they regulate. This list is informed by consultations with local and international regulators and market professionals. The six key areas of reform are:

> Capital and liquidity enhancements – to raise the level and quality of capital on an institutions’ balance sheets and to shore up liquidity in order to better insulate the financial system from episodes of stress

Leverage ratio > – to cap the build-up of leverage in an institutions’ balance sheets so as to mitigate damaging episodes of deleveraging and guard against model risk and measurement error in risk-based capital adequacy ratios

> Procyclicality measures – to reduce the amplitude of the credit cycle and build buffers in excess of minimum requirements during good times

> Systemic risk – limiting the capacity for failure of large or interconnected institutions to disrupt the provision of financial services to the broader economy

> Product and market regulation – to address information asymmetries and incentives for excessive risk-taking that interfere with the capacity of financial markets to allocate capital efficiently, especially during times of stress

> Regulatory boundaries – (re)defining regulatory boundaries – cross-border, prudential, disclosure and macroeconomic – to enhance the effectiveness of regulation and accommodate the increased reach of financial institutions and markets.

2.1 Capital and liquidity enhancementsDuring the GFC financial institutions were more affected by problems in capital markets than anticipated. The quantity and quality of capital held by financial institutions was insufficient to ensure that banks could continue to provide intermediary services to the economy. What began as a credit crisis quickly morphed into a liquidity crisis and then a solvency crisis as banks financial positions weakened. Central banks and governments were required to provide capital and liquidity to the market by buying toxic assets. In some instances governments became equity holders of private financial institutions or forced healthier banks to acquire unhealthy banks as a means of providing capital.

ProposalsThe BCBS is seeking to improve the consistency, quality and transparency of capital held by financial institutions and to shore up their liquidity. To do this, it has proposed a multi-pronged approach including:

> Redefinition of capital – In order to ensure greater consistency and transparency in the determination of capital requirements internationally, the BCBS is re-defining Tier 1 and Tier 2 capital requirements and abolishing Tier 3 capital. Of note is the new requirement that Tier 1 capital comprise common equity and retained earnings only, while structured capital (or ‘innovative hybrids’) are to be phased out (currently at 15%)

Implementation of stronger risk-adjusted capital >requirements – Financial institutions will be required to determine their capital requirements with respect to counterparty risk using stressed inputs. This is so that capital held is sufficient not only to meet counterparty default risk but also to address credit valuation adjustment risk. Further, stronger margining requirements are proposed and longer time periods are to be used for determining whether regulatory standards are met


> Employing a Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) – These ratios will be used to provide an additional backstop for internationally active financial institutions. The LCR requires institutions to hold sufficient high quality, liquid assets to sustain a 30-day market event while the NSFR, by contrast, seeks to promote the longer-term resilience of financial institutions by promoting more stable funding sources.

Figure 2.1: Liquidity ratios

Liquidity Coverage Ratio

Stock of High Quality Liquid Assets≥ 100%

Net Cash Outflows over 30-day Period

Banks are expected to meet this requirement continuously and hold a stock of unencumbered, high quality assets as a defence against the potential onset of severe liquidity stress.

Net Stable Funding Ratio

Available Amount of Stable Funding> 100%

Required Amount of Stable Funding

The NSF standard is defined as a ratio of the available amount of stable funding to a required amount of stable funding. This ratio must be greater than 100%. ‘Stable funding’ is defined as those types and amounts of equity and liability financing expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress. The amount of funding required of a specific institution is a function of the liquidity characteristics of various types of assets held, off-balance sheet contingent exposures, and/or the activities pursued by the institution.

Source: BCBS (2009b)

ImplicationsThe key implication for financial institutions is that more capital, more stress-testing and less opportunity for regulatory arbitrage will exist under the new international standards. This is expected to result in moves to strengthen capital bases, including through deleveraging and buying risk-free sovereign bonds. If financial institutions need to retain significantly more capital on their books, they will not be able to lend as much. This may, in turn, induce a decline in global economic growth.

Greater consistency and transparency globally will reduce opportunities for regulatory arbitrage. The BCBS has been careful not only to define what types of capital are suited for each tier but also to specify the characteristics, so that institutions and more lenient regulators cannot implement

the standard ‘in name only’. This will reduce differences between jurisdictions, for example, between the US and the EU where capital requirements are significantly different, and will assist the efforts of regulators to monitor global banks.

Implementing the new capital rules is likely to raise the cost of capital globally. Banks balance sheets may not have adequate capital currently (for example, many European banks only hold 2% risk-adjusted capital in total compared with Australian banks holdings of around 8%). To meet this higher capital standard, many institutions will have to deleverage or acquire more capital from traditional sources, such as equity and sovereign bonds. Given that this will occur on a system-wide basis, it is reasonable to expect the global cost of capital to rise.

If the global cost of capital increases, the rate of economic growth will slow. Businesses will access bank funding at a higher interest rate, reducing the amount of debt they can take on, and ultimately reducing the rate of economic expansion. The extent to which this affects a given jurisdiction will depend on the current capital held by banks, the capital required and the rate of transition required by the BCBS. The BCBS has indicated that it intends to begin implementation in 2011 and will finish by 2012; however, this timing is subject to the Quantitative Impact Statements (QIS) currently being completed by regulators in various jurisdictions, including Australia.

In addition to capital adequacy requirements, liquidity requirements being considered by the BCBS will likely change the composition of financial institutions’ assets. The BCBS is still determining what the appropriate definition of high quality, liquid assets should be:

‘... the Committee is assessing the impact of both a narrow definition of liquid assets comprised of cash, central bank reserves and high quality sovereign paper, as well as a somewhat broader definition which could include a proportion of high quality corporate bonds and/or covered bonds(BCBS, 2009b:7).’

If a narrower definition is accepted, Australia may have difficulty meeting this requirement from its domestic sources. It has been widely noted that the Australian government debt market is not deep enough to meet existing criteria for liquid assets, as acknowledged by APRA last year:

‘We are currently working with industry and the Reserve Bank to find a pragmatic solution that reconciles the concern with the realities of Australia’s relatively small Government bond market (APRA, 2009a:8).’

Conceptually, a wider definition of acceptable debt securities would solve the problem and Australian regulators are mindful of this in considering how international standards might be implemented in Australia.

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ExamplesThe Bank of England (BoE) undertook its own retrospective stress-testing exercise to understand what levels of capital might be appropriate under a revised regulatory regime (see Table 2.1). The BoE’s work broadly suggests that capital requirements for Tier 1 may sit around 8%.

Table 2.1: Lessons from past crises regarding appropriate levels of capital

Source Description Capital requirement

Past international financial crises (BoE calculations) Based on experiences of Sweden, Finland, Norway and Japan

8.5% Tier 1

Macroeconomic downturn scenario (BoE calculations) Stress-test variables include GDP growth, CPI inflation and unemployment

9% – 10% Core Tier 1

Turner Review (Financial Services Authority) Through-the-cycle fixed minimum

At the top of the cycle3

4%

6% – 7%

Core Tier 1

Core Tier 1

US stress tests (Federal Reserve) For 19 largest US banks to survive a deeper and more protracted downturn than Consensus forecasts

8.1% Tier 1

Source: Bank of England (2009)

The impact in Australia would not be as severe since Australian banks already maintain stronger capital balances and meet APRA’s stricter requirements on capital definition. Nevertheless, some additional capital may need to be raised. While Australian banks held around 8% Tier 1 capital during the GFC, the move to allow only equity holdings or retained earnings as Tier 1 capital may reduce Tier 1 capital levels to 4.5 – 5.7% for the major Australian banks (Takáts and Tumbarello 2009: 11).

APRA has already commenced a round of consultations on a range of proposals consistent with the BCBS. These include proposals to broaden the coverage of its ‘going concern’ requirement to all ADIs, increasing its ‘name crisis’ time period from five days to one month (consistent with the LCR) as well as incorporating a three-month market disruption scenario for its stress-testing regime (APRA 2009, 3).

Australian banks are well capitalised under the current Basel II framework. Moreover, Australian banks have raised extra capital (and notably high quality Tier-1 capital) to further strengthen their balance sheets. While the level and nature of the proposed new capital requirements are not yet final, Australian banks are well down the path to any new standard. Similarly, liquidity requirements are already being tightened in Australia and should easily meet any new standard proclaimed internationally.

3. The Turner review explains that the dynamic capital mechanism ‘is expected to generate an additional buffer equivalent to 2%-3% of core Tier 1 capital at the top of the cycle’. However, ‘it should remain open to supervisors to require a further discretionary buffer above this’.


2.2 Leverage ratioExcessive leverage is the underlying source of asset price bubbles and was a major cause of the GFC. The build-up in leverage in the banking system during the lead-up to the GFC occurred both on-balance sheet and off-balance sheet. The extent of the leverage and its implications for the stability of the banking system were not well understood – rapid financial innovation and the growth of the ‘shadow banking’ sector obscured the extent of the exposure.

As the GFC progressed, a clearer picture emerged of the true nature of the exposure and the interconnectedness of financial institutions. This revelation raised concerns about the level of leverage to the point where banks came under pressure from the market to deleverage, adversely affecting credit availability to the broader economy. The resulting sudden contraction in credit transformed what might have been a mild economic downturn into a global recession.

ProposalsThe BCBS recommends introducing a leverage ratio. It is intended to:

‘Put a floor under the build-up of leverage in the banking sector, thus helping to mitigate the risk of the destabilising deleveraging processes which can damage the financial system and the economy.

Introduce additional safeguards against model risk and measurement error by supplementing the risk based measure with a simple, transparent, independent measure of risk that is based on gross exposures (BCBS 2009b:7).’

Notably, the leverage ratio will not be adjusted for risk; it will be calculated based on gross exposure, not net exposure; and derivatives and off-balance sheet items will attract a 100% credit conversion factor.

Most OECD countries use risk-based Basel II capital measures. The US has been slow to adopt Basel II and is one of the few countries to use a (non-risk based) leverage ratio.

Advocates of a leverage ratio say it clearly shows the maximum loss a bank can take on assets before running out of capital. Also, the risk-weighted approach of Basel I and II has been blamed for contributing to the GFC, by promoting capital arbitrage and the inappropriate use of derivatives (Blundell-Wignall et al 2010:18). However, Basel II was not in place at the outset of the GFC and has been improved as a result of the testing times experienced in 2008-09.

Critics of the leverage ratio say it does not take account of the risks of different business models and funding sources, creating a perverse incentive for banks to take on more risk.

At this time, consultations are under way to refine the design of the leverage ratio, including how it would work as a supplement to risk-weighted measures and how to adjust for different accounting treatments. In time the BCBS envisages moving towards a Pillar 1 treatment of the leverage ratio, ‘based on appropriate review and calibration’ (FSB, 2009c, BCBS, 2009b).

ImplicationsThe leverage ratio is intended to supplement risk-based capital measures, not to supersede them. Opposition is strong in Europe but the European Union is considering the introduction of leverage ratios. Moving to a Pillar 1 treatment would facilitate the impact of the leverage ratio being incorporated into the calculation of the overall capital requirement. This helps to ensure the leverage ratio does not make overall capital requirements unreasonably high. It also assists in controlling – via a capital buffer – for any effects of a leverage ratio on the procyclicality of capital levels.

If a leverage ratio is enforced, it will limit the build-up of leverage in the banking system by constraining individual institutions capacity to build leverage. It will not prevent the market forcing complying banks to reduce their level of leverage below the standard. Nor will it address excessive leverage building up outside regulated entities.

The leverage ratio in its proposed form is likely to penalise institutions in jurisdictions that have adopted Basel II risk-weighted conventions, even though it is meant as a supplement to the latter measures not as a replacement. Regulators in countries that have already adopted Basel II, including Europe and Australia, question the need for such a measure. The proposal has support in the US but is opposed by the Germans and France.

A non-risk weighted leverage ratio is significant for Australian banks since they typically hold relatively high levels of home mortgages among their assets. The high quality of most of these mortgages would not be recognised by an unweighted leverage ratio as proposed. In any case, the ratio will be difficult to ‘parameterise’ and the BCBS is seeking comments on how to reconcile the conflicting approaches of the risk-weighted and unweighted leverage ratios.

The BCBS proposal for a leverage ratio does provide some additional insurance against model risk and measurement error. The GFC left many banks exposed to their off-balance sheet vehicles, through, for example, guaranteeing lines of liquidity (eg. Bear Stearns). Some institutions that sold protection using credit derivatives were left with crippling exposures (eg. AIG). Gross exposure is more transparent than net exposure, eg. for counterparty and operational risks (eg. Lehman Brothers).

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ExamplesBlundell-Wignall, Wehinger and Slovikl (2009:21) provide an example of the impact of imposing a lower group leverage ratio upon a financial conglomerate comprising a commercial bank and an investment bank. They show that the riskiness of the conglomerate falls, but this does not eliminate contagion risk from the investment bank to the commercial bank. They also note that European banks have relatively low levels of capital and US banks have higher levels. The introduction of a leverage ratio would force significant capital raising or deleveraging upon European Banks – with attendant risks for credit availability and economic growth.

Gros (2010) illustrates some of the limitations of the leverage ratio using the example of Deutsche Bank, which reports its balance sheet under both US-GAAP and IFRS. At the end of 2008, the IFRS version showed about €2 trillion of assets and the US-GAAP version showed €1 trillion. Equity was roughly similar, so the leverage ratio was halved by applying the US-GAAP treatment. Goldman Sachs’ leverage ratio at the time was around 15 under US-GAAP and 72 under IFRS.4

An unweighted leverage ratio affects banks with low-risk balance sheets, like Australia’s banks, whose balance sheets generally have large exposure to low-risk mortgages. The leverage ratio will show these banks as under-capitalised relative to their international peers when they easily meet APRA’s risk-weighted capital adequacy standards. Given support for a leverage ratio from key international regulators, Australian authorities are working to influence the calibration of the ratio so that it does not penalise well-managed, low-risk banks. If these efforts are unsuccessful, Australian banks may face a higher cost of borrowing in global capital markets. Some of the resulting impact on Australian borrowers may be mitigated if the RBA targets a lower official cash rate over the business cycle.

4. The SEC has announced a work plan that would delay transition for US companies to IFRS until 2014, although some companies may change before then (Reuters 2009).


2.3 Procyclicality measuresMarket participants tend to behave in a procyclical manner, expanding their balance sheets when liquidity is relatively cheap and plentiful, and contracting their balance sheets when restrictive monetary policy starts to bite. This exacerbates volatility in the credit cycle. The financial system can amplify these tendencies rather than acting as a shock absorber (eg. through practices such as leveraging and deleveraging, and potentially also through mark-to-market accounting). Despite the ‘Great Moderation’ of economic growth and inflation in recent decades, credit growth has become even more volatile.

ProposalsThe BCBS proposes to introduce a number of measures intended to help the banking system counteract destabilising, procyclical elements in the financial system. The key objectives are to:

‘Dampen any excess cyclicality of the minimum capital requirement

Promote more forward looking provisions

Conserve capital to build buffers at individual banks and the banking sector that can be used in stress

Achieve the broader macroprudential goal of protecting the banking sector from periods of excess credit growth. (BIS 2010b:7).’

To achieve these objectives, the BCBS advocates adopting a range of complementary measures to alter liquidity, capital and loan-loss provisioning requirements when asset prices, loan growth or leverage depart from their long-run trends.

Cyclicality of the minimum capital requirement > – the probability of default (PD) estimates used in calculating banks capital requirements decrease during favourable credit conditions, and increase when conditions sour. The BCBS is exploring the use of highest average PD estimates over the cycle and historical averages of PD estimates over time to replace procyclical PD estimates

> Forward-looking provisioning – current accounting standards require provisioning based on ‘incurred losses’ (IL). Prudential regulators and other stakeholders also require information on an institutions capacity to withstand losses in the future. Consequently, the BCBS advocates moving towards an ‘expected loss’ (EL) approach

Capital conservation > – banks continued to distribute capital to shareholders and employees during the GFC even though it may have materially damaged their financial condition and, collectively, their actions may have weakened the resilience of the financial system. A framework will be introduced to ensure banks build

up capital buffers above the minimum requirement in good times, to be drawn upon in times of stress. A range of possible methods to achieve this is intended to be provided to supervisors and banks

> Excess credit growth – excessive credit growth leading up to the GFC exposed the banking sector to large losses and amplified the downturn. The BCBS is in the early stages of developing measures to ensure banks build up countercyclical capital buffers when there are signs that credit growth is excessive.

ImplicationsThe measures proposed by the BCBS to counter procyclicality are intended to be complementary. The first two measures address information asymmetry by providing stakeholders with better estimates of banks’ exposures. The other two measures aim to prevent banks’ financial positions from being compromised.

Removing the cyclicality from the estimation of the PD should help to mitigate procyclicality of the credit cycle. Under the Basel II framework, supervisors and banks are already able to apply higher PDs. When APRA asks a financial institution to increase its capital – for whatever reason – the prudential regulator is effectively substituting a higher PD to model the capital requirement. However, retaining discretion to choose between a downturn PD or a through-the-cycle PD may dilute the effectiveness of the measure.

Forward-looking provisioning, based on an EL approach, increases the stock of provisions when actual losses are low and helps banks weather episodes of above-average losses. This approach clearly is less procyclical than the IL approach. Loan loss provisions should reflect all expected losses from existing loan portfolios. The rapid deterioration in the credit quality of US sub-prime mortgages, and the resulting losses to investors in products securitised against portfolios of these assets, were features of the GFC. EL reduces the volatility of bank income statements when actual losses significantly differ from long-run norms.

An EL approach makes sense from an economic perspective and a risk-management perspective but not necessarily from an accounting viewpoint. Accounting bodies produce statements that allow investors to value a company at a specific point in time. The BCBS has sought to secure support from the IASB for the shift to an EL approach.

Capital buffers can be built up either from internal sources (profits) or external sources (capital markets). The BCBS proposal constrains a bank’s discretion to distribute profits to shareholders and employees when the bank’s capital level falls within a buffer range above its minimum capital requirement. This helps prevent irresponsible distributions that compromise the financial health of a bank. It places depositors’ interests ahead of those of shareholders,

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creditors and employees. It would apply at a consolidated level, although supervisors could also apply it to specific parts of the group.

The restrictions on distributions are intended to be graduated in such a way that the buffer range does not become a new (higher) minimum capital requirement. However, it is not clear how this would be achieved. The restriction will make banks less attractive to investors than companies in sectors without such restrictions.

Introducing a countercyclical element to calculating the capital buffer will help to reduce the amplitude of the peaks and troughs in the credit cycle. The BCBS proposes using macroeconomic variables as indicators of excessive credit growth. The further the indicator variable deviates from its long-run trend, the greater the impact on the size of the capital buffer above the minimum requirement. Trend breaks in official credit data complicate the issue. Innovation or

deregulation also may raise the average rate of credit growth over the long run.

Most monetary policy frameworks target a macroeconomic variable, usually a measure of inflation, but allow central banks discretion to consider other information in setting policy (interest rates). It is envisaged decision makers would enjoy similar discretion with capital buffers.

Targeting credit growth may create tensions with inflation-targeting monetary policy. Official interest rates are the primary tool monetary policymakers use to target inflation, but they also affect credit growth. In times of moderate economic growth and inflation, but excessive credit growth, the capital rationing implied by raising capital buffers is likely to constrain economic activity and place downward pressure on inflation. The typical monetary policy response would be to reduce interest rates but this will increase demand for credit and confound the objectives of the capital buffer.

2.5

2.0

1.5

1

0.5

0.0

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Ratio

United States

Spain

United Kingdom Switzerland

Germany

Examples

Chart 2.1: Ratio of private credit to GDP in selected countries

Source: BoE (2009)

The Spanish ‘dynamic provisioning’ model – provisioning for expected losses – for capital adequacy has been employed since 2000 and has received considerable attention (BOE, 2009). Chart 2.1 above shows that, despite employing procyclical buffers, the growth of private credit relative to GDP has not become obviously smoother in Spain. Nonetheless, dynamic provisioning may have contributed to the resiliency of Spanish banks during the GFC.


Chart 2.2: US private credit as a share of GDP

Source: BCBS 2009a

250

200

150

100

50

0

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Share of GDP

US Household and corporate sector US Financial sector

Then Federal Reserve Governor Ben Bernanke (2004) famously remarked on the decline in macroeconomic volatility over the preceding twenty years and the prosperity that it brought, noting that ‘writers on the topic have dubbed this remarkable decline in the variability of both output and inflation the Great Moderation’. For a central banker this reduced variability in output and inflation indicated policy success. The extreme growth of credit being created – as a share of GDP, credit doubled during the later stages of the Great Moderation – was not seen as a sign that something was amiss. Post-GFC, this dichotomy indicates additional measures need to be considered if policymakers wish to return to the Great Moderation. (BCBS 2004).

APRA’s discretion over minimum capital requirements effectively replicates aspects of the proposed procyclicality measures, namely, building up capital buffers in good times. However, introducing forward-looking provisioning and credit-linked capital buffers may not have a positive impact: the former may not dampen the credit cycle at all (as exemplified by Spain’s experience); while the latter may compromise the effectiveness of monetary policy – especially when the factors driving credit growth are beyond the RBA’s influence. In addition, investors may shy away from banks whose discretion to distribute earnings is constrained, making it more difficult and/or expensive for them to raise capital. The ability of Australia’s banks to raise equity capital during the GFC contributed to their resilience.

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2.4 Systemic riskThe GFC highlighted the risks posed by systemically important institutions and the high costs of dealing with those risks. Systemic risks stem from the size and complexity of institutions and their relationships with other parts of the financial system. These characteristics of ‘too big to fail’ institutions made them hard to handle during the GFC and are presenting reformers with stiff challenges after the GFC, delaying agreement on reforms.

The FSB has proposed a variety of options to mitigate the risks posed by institutions deemed too big to fail. These are essentially aimed at:

Reducing the size and complexity of firms, by direct >regulation or providing incentives to institutions to change their structure

Enabling authorities to rapidly break-up or wind-down >systemically important institutions, including across national borders.

ProposalsIn the US, calls to limit commercial banks activities reflect a view that government has a role in protecting depositors’ funds, but should not bail out risk-taking investment banks and their ilk. The ‘Volcker plan’ would prevent commercial banks from taking stakes in hedge funds and private equity firms and limit the trading they do on their own books to meeting the needs of their clients (eg. for hedging).

Other proposals for tighter regulation of large firms and supervision of non-financial firms, and giving the government power to shut down failing institutions, are also being pushed by President Obama’s team. In addition, imposing taxes on the largest US financial firms has been mooted.

In Europe, a different approach focusing more on supervision and increased capital requirements is being advocated. In the long-run Europe is trying to encourage consolidation – including universal banking – across its 27 member states.

In the UK, the FSA has pushed for banks to draw up ‘living wills’ and the most systemically important institutions to set aside extra capital. The FSB (2009c) also favours systemically important cross-border operations being required to prepare ‘living wills’. Australian regulators too are amenable to the idea of introducing resolution plans agreed in advance.

ImplicationsMeasures that reduce the size or interconnectedness of a financial institution will, by definition, reduce the systemic risk attaching to it. It is to be hoped that losses from shrinking banks (eg. economies of scale in back-office functions and in costs of raising capital), will not greatly outweigh potential gains from reduced systemic risks.

The implications are pronounced for US investment banks forced to change their structures to holding companies during the GFC in order to qualify for government funds.

US investment banks may prefer to revert to their original form to avoid the tougher regulatory regime and commercial banks may court riskier clients to replace their revenue-generating proprietary trading desks. However, non-operating holding company (NOHC) structures have been in use in Australia for many years and have wide acceptance, with major institutions operating banking, insurance and funds management arms.

Taxes on size are problematic as they require authorities to provide a transparent definition of systemic importance – and an implicit guarantee of institutions so defined. Moreover, some institutions that may not pose a significant systemic risk in normal conditions may suddenly become potentially toxic during periods of market turmoil (eg. Northern Rock). And cross-border banks may be systemically significant in some countries and not in others.

Living wills offer an alternative, one that can be applied to all financial institutions if need be, to avoid singling out those that may be too big to fail. Undertaking such an exercise can also help institutions to gain a better understanding of their exposures to their counterparties.

ExamplesThe consequences of not having the right tools to deal with the failure of a systemically important institution were illustrated during the GFC by the Lehman Brothers bankruptcy. Attempts to find a buyer for Lehman Brothers failed and the US Treasury did not have the power to close it down. In an unprecedented move, the International Swaps and Derivatives Association held a ‘netting trading session’ on a Sunday afternoon, ‘to reduce risk associated with a potential Lehman Brothers Holdings Inc. bankruptcy filing’ when US markets reopened on Monday. The existence of a living will, for example, could potentially have expedited the netting process, helped authorities to identify and ring-fence other weak points in the system and reduced the panic selling of financial institutions’ shares that followed Lehman Brothers bankruptcy.

Obliging financial institutions to reduce their size, complexity and links to counterparties reduces systemic risk. However, there is a cost to be borne in reduced economies of scope and potential sharing of risk across markets. Requiring institutions to plan for their own demise or dismembering may force them to re-assess their counterparty risks, and simplify and reduce their exposures. But it may also induce them to move beyond the reach of prudential regulators, which could be counterproductive. Australian regulators are amenable to measures for dealing with institutions that are systemically important. The ‘four pillars’ policy is an example. Yet, even with this policy in place, the moral hazard of institutions judged ‘too big to fail’ has been increased by moves to protect Australia’s banks during the GFC.


2.5 Products and marketsThe GFC revealed that information asymmetry in capital markets was far greater than generally assumed. As the GFC progressed, some sectors of the market struggled to allocate capital at all, let alone efficiently or rationally. While information issues affect all transactions in financial markets to varying degrees, markets where the complexity of products or lack of transparency is prevalent – such as securitisation and OTC derivatives – have received most attention in international deliberations.

Securitisation is an important innovation that reduces the amount of capital lenders are required to hold to support their lending. It increases competition among lenders and allows a wider range of borrowers to access capital. However, the GFC revealed that a lack of transparency and incentive problems need to be addressed before securitisation can thrive again.

OTC markets are where professional market participants execute individually negotiated transactions, rather than the standardised contracts traded on exchanges. Thus financial product innovation flourishes in OTC markets and most of the derivatives used for hedging and insuring individual financial exposures are traded there. Despite these benefits, the high losses associated with failed credit default swaps (CDS) during the GFC revealed deficiencies in the transparency, counterparty risk and processing of transactions in some OTC derivatives markets.

ProposalsA number of reports published overseas, including the International Organisation of Securities Commissions (IOSCO) report (2009d) and the European Commission’s De Larosière Report (2009), make recommendations regarding the reform of securitisation. Some of the principle recommendations include:

Refining incentive structures at all points along the >securitisation value chain by mandating ‘skin in the game’ for originators and improving transparency of all verification and risk assurance practices undertaken by the various parties

Requiring independence in the provision of professional >services and advice

Improving risk management throughout the process >by encouraging the development of analytical tools for investors

Revising investor suitability requirements and defining >what a ‘sophisticated investor’ is for each market

Mandating continuous disclosure. >

These reports have advanced further regulatory proposals which are now being assessed and coordinated by IOSCO, along with the Bank for International Settlements’ Committee on Payment and Settlement Systems (CPSS) and the OTC Derivatives Forum. These recommendations include:

Facilitating the standardisation of CDS contracts to assist >the development of central counterparty (CCP) clearing houses and to encourage industry initiatives to enhance operational efficiencies

Developing an appropriate regulatory framework for CCPs >as well as implementing it

Monitoring of CDS to be made more transparent through >the collection of data including post-trade price, volume and open-interest data which should be fully disclosed

Encouraging the co-operation of national market regulators >to facilitate information sharing and co-ordination.

IOSCO also plans measures to manage systemic risk arising in financial markets. These measures are yet to be disclosed.

ImplicationsBoth sets of reforms focus on reducing volatility in the market and internalising risks in financial instruments. This will reduce returns to originators of structured products and investors willing to hold the riskier tranches. However, it will also deliver benefits to the financial system by lowering systemic risk through improvements in transparency and accountability.

Realigning incentives along the securitisation supply chain and increasing transparency throughout the process will help mitigate problems posed by asset-backed securities. By requiring issuers and sellers to retain the riskiest portion of the issues, a strong incentive is provided to undertake better risk assessment before the product is issued. It should provide confidence to the market and build trust in the product.

Improved disclosure enables investors to make better decisions. It may come from within (greater investment in in-house credit analysis) or without (improved ratings methodology and better incentives for CRAs). It should result in products that are easier to understand, and hence more popular with investors and regulators alike. Such ‘plain vanilla’ products are likely to become favoured assets for financial institutions required to hold more, higher quality capital.

OTC derivatives will become more standardised as the proposals are implemented and risk will be reduced as system infrastructure improvements allow greater

21

transparency and ease of monitoring. Introduction of CCPs will encourage a shift to electronic trading (which offers greater price transparency, faster, simpler trading, confirmation of trades and supervision), quicken the settlement process and netting of positions to reduce operational and credit risk, and reduce counterparty risk.

The imposition of new regulatory requirements and platforms will involve costs, however. As with any exchange traded platform, OTC market participants will have to pay to trade on CCPs. Further, many current OTC products cannot be standardised or will be less efficient for their users in a standardised form. While regulators do not intend to

force counterparties to standardise all instruments, capital requirements will reflect whether counterparty positions are ‘on exchange’ or not, resulting in more innovative or tailored deals requiring a greater amount of capital.

Examples

Preliminary indications of what might be involved with ‘skin in the game’ requirements are shown in Table 2.2. In Australia ASIC is yet to issue new guidelines to the securitisation industry. The Australian securitisation industry is expecting IOSCO’s taskforce on unregulated markets to announce its standard for ‘skin in the game’ in the near future.

Table 2.2: ‘Skin in the game’ reforms

Jurisdiction Restriction

European Union Restriction on regulated credit institutions (the ‘buy’ side), retention of 5% of issue and four options as to how to achieve this.

United States Restriction on regulated creditors/securitisers (‘sell’ side), 5 – 10% retention depending on credit underwriting standards.

Australia (Australian Securitisation Forum)

Proposed that the originator/sponsor retain all tranches with credit rating of B or lower.

An expected loss approach would ensure the capture of unrated deals/tranches.

Returns to originators of securitised issues will fall as a bigger share of the risks is retained and internalised through regulatory reforms, including revised requirements for retaining ‘skin in the game’. This will increase the cost of raising funds through securitisation, particularly for smaller banks and non-ADIs. However, other measures are expected to have a lesser impact owing to the relatively small size of local markets for the more problematic OTC products – such as CDS – and the Australian hedge funds sector. In any case, ASIC is moving in advance of the international timetable and initiatives, including those relating to securitisation, due diligence and credit rating agencies. Some initiatives may be in place in Australia before international standards are set.


2.6 Regulatory boundariesA key challenge for reform is to extend the boundaries of regulation and supervision so as to cover all systemically important financial activity. There are a number of dimensions to the problem including:

Filling in gaps in the system >

Resolving overlapping jurisdictions that may >compromise regulators ability to perform

Changing or thickening boundaries between >prudential regulation and disclosure

Co-ordinating the global response to minimise >opportunities for regulatory arbitrage.

Consequently, where the appropriate tools are available, effective regulation may come down to deciding who is best placed to do it. Note that this is another area where work is not as far advanced as the BCBS projects.

ProposalsWorking groups are exploring bringing hedge funds into the regulatory net. The FSB has initiated a work program involving IOSCO to examine the issue of systemic risk posed by hedge funds. Hedge funds are typically viewed as stabilising elements in normal times, supplying liquidity to the market. However, the collapse of several hedge funds during the GFC and the subsequent withdrawal of the liquidity they had provided may have contributed to the freezing of some markets.

The joint forum has also identified areas where the perimeter of regulation needs to be extended:

‘Reducing key regulatory differences across the banking, securities, and insurance sectors – reducing opportunities for regulatory arbitrage

Strengthening supervision and regulation of financial groups – particularly those that providing cross-border services … captures the full spectrum of their activities and risks

Promoting consistent and effective underwriting standards for mortgage origination – accurate assessment of each borrower’s capacity to repay; [and] ensure that different types of mortgage providers, whether or not currently regulated, are subject to consistent mortgage underwriting standards

Broadening the scope of regulation to hedge fund activities

Strengthening regulatory oversight of credit risk transfer products – focuses on two prominent products … credit default swaps (CDS) and financial guarantee (FG) insurance (BCBS 2010)’

In addition, stronger licensing and compliance obligations for credit rating agencies (CRAs) are being developed internationally. There is broad agreement within the G20 that there is a need to address conflicts of interest in CRAs’ business models and differentiate ratings on structured products from other ratings. However, while the EU has suggested that the buyer of credit exposure will pay for the rating rather than the originator, to eliminate conflicts of interest, US proposals suggest disclosure of any conflicts of interest is sufficient.

Increasing cross-border cooperation and supervision is to be based on better information sharing, including the establishment of early warning systems and setting up of supervisory colleges.

Cross-border issues for Australian regulators mainly involve subsidiaries of Australian banks based in New Zealand. Regulators have given consideration to what would happen if the New Zealand arm of an Australian bank got into trouble, but there are no specific contingency plans in place. Foreign banks operating in Australia and Australian banks operating in other jurisdictions may also be affected. Development of protocols for cross-border crisis management is under way and being overseen by the FSB.

ImplicationsAustralia’s regulatory boundaries are relatively well defined, with ASIC looking after everything that does not come under APRA’s mandate. Australia’s commitment to the G20 outcomes means that domestic regulators may be forced into areas where they have little experience or limited tools for the job.

Financial intermediaries are more closely intertwined and reliant upon financial markets than anticipated in the Wallis Report, suggesting the neat division of responsibility between APRA and ASIC may no longer be tenable. At issue is how and to what extent prudential supervision should extend to the ‘shadow banking’ system, including mortgage trusts, managed investment schemes (MIS) and hedge funds, currently subject only to disclosure regulation administered by ASIC.

It is important to keep in mind that Australian regulators look at the world through different lenses. APRA and the RBA view the financial system from an economic perspective, with an emphasis of getting the balance of risks right – a matter of being prudent. ASIC takes a legalistic approach, with a greater focus on detection and prevention of white-collar crime – making sure the market is transparent, or discloses enough for the regulator to see what is going on.

APRA and the RBA are most likely to bump up against each other in the space where macroprudential and macroeconomic policy merge. For example, APRA’s guidance to financial institutions is (micro) countercyclical.

23

It is feasible that APRA may decide that a group of institutions, with combined influence large enough to be considered ‘macro’ or systemic, need to increase their capital reserves. This potentially would have ‘macro’ consequences for credit supply and, hence, economic growth and inflation. It is not clear how this would be communicated to the RBA, the organisation charged with managing inflation – after all, the RBA does not tell the Council of Financial Regulators when it is about to increase interest rates.

While APRA’s mandate is relatively well defined, by the list of institutions it is mandated to oversee, ASIC effectively has responsibility for ‘all the rest’. If prudential requirements are imposed on parts of the realm of disclosure regulation, eg. to capture hedge funds, there is a concern that ASIC may not have the necessary tools or expertise. For example, if called upon to determine whether a mortgage trust has adequate capital backing or the appropriate capital requirements for a securitisation vehicle.

The issue of where prudential regulation ends and disclosure begins is a live political issue, given the failure of disclosure alone to protect investors (eg. Storm Financial). It is more than a case of credit rating agencies methods not being up to the task. As eminent economist Richard Thaler (2009) has observed,

‘If you give people 456 mutual funds to choose from, they’re not going to make great choices.’

Disclosure only works if it gives investors the ability to make good decisions.

Recognising that systemic risk afflicts financial markets as well as intermediaries blurs the neat division of regulatory responsibility assigned in the Wallis Report. Moves to extend the reach of prudential regulation into the ‘shadow banking’ system risks overlap between ASIC and APRA, and potentially leads ASIC into areas it is insufficiently resourced to perform. Independent moves by APRA to adjust capital requirements as part of macroprudential policy potentially confuse and conflict with the RBA’s countercyclical monetary policy. A review of coordinating mechanisms among Australia’s financial regulators will be essential as part of the reform process.


3. How might Australia respond?

There are three broad responses which Australia could make to the international reform agenda as it unfolds. They differ according to the degree to which Australia accommodates internationally agreed reforms by making changes to our current system. Specifically, Australia could respond by:

Fully signing up to the reforms but carefully managing >their implementation within the existing Australian regulatory structure

Re-defining regulatory responsibilities among Australia’s >financial regulators to better reflect the revised approach to systemic risk management emerging from the FSB process

Explicitly repudiating some of the more interventionist >proposals on the grounds that they are redundant in an Australian context or potentially compromise the discretion of Australian regulators.

3.1 Incorporate reforms within existing structuresThe first approach assumes that there will be enough ‘wriggle room’ at the end of the day for national regulators to abide by the spirit of the reforms while adapting the letter to local conditions. It further assumes that our regulators, having brought us this far, will successfully negotiate arrangements through the G20 process which leave them with ample discretion to do what they would have done anyway. In other words, the authorities can easily manage any increase in the regulatory burden within local Australian tolerances and requirements.

If these assumptions are correct, then the international reforms may have little discernible impact on Australian institutions over and above what the authorities would have done anyway in response to the GFC. It is important to note that this does not mean no change from the status quo. Rather it means that APRA, ASIC and the RBA will make whatever change they deem necessary more or less independently of international moves – but sufficiently consonant with those moves to avoid any suggestion that Australia had reneged on its responsibilities as a member of the G20.

Such a benign outcome assumes that our regulatory authorities can be trusted to manage the implementation of proposed reforms in a manner and at a pace which they control. It is plausible to the extent that the proposed reforms bring international regulatory practice closer to where Australian practice has been for some years. This together with the fact that Australian regulators are more ‘hands on’ than many of their overseas counterparts, ie., they actively supervise adherence to regulatory standards rather than merely promulgate them, supports the view that APRA, ASIC and the RBA are sufficiently ahead of the game that they can easily integrate whatever the FSB comes up with.

This response is also more plausible the more one expects the G20 process to eventually fracture along political lines. Some of the reforms will require major revisions to the way banks are regulated in, eg. Europe while requiring fewer changes in other jurisdictions, including even the US. Some of these changes will therefore be resisted by G20 countries and it is a reasonable guess that the negotiated outcome will allow greater discretion at the national level than is currently envisaged. The more discretion is built into the final framework, the more the assumption that Australia will be free to craft an approach independently of international pressures rings true.

Again, the response does not predict that nothing will change in the approach of Australian regulators. Australia is part of the G20 and must be seen to be contributing to a global effort to secure the financial system from an early repeat of the GFC. This will involve a tightening of regulatory standards in various areas, including capital and liquidity controls and disclosure standards at the very least. The point is that the extent of the response will be determined locally – in the first instance by the regulatory authorities themselves but potentially also involving local political engagement if there is a backlash among regulated stakeholders in the Australian financial system. It will be a local debate with a local outcome, not one imposed from afar.

3.2 Re-assign regulatory responsibilitiesThe second response assumes that pressure to re-assign responsibility for systemic risk management and to extend the reach of prudential regulation forces a re-assessment of the current responsibilities assigned to Australia’s existing regulators. The respective roles of APRA, ASIC and the RBA date from the Wallis Report of 1996-97, which foresaw a much stricter division among prudential regulation, conduct and disclosure regulation and systemic risk management than now appears tenable post the GFC.

Given the emphasis on systemic risk mitigation coming through the FSB proposals, pressure will be placed on Australia’s regulators to share responsibility for mitigating systemic risk rather than leaving the task solely to the RBA, as at present. It is possible that this sharing could be accommodated through discussions at the Council of Financial Regulators, the existing coordinating framework on which all three regulators and the Treasury are represented. However, this scenario envisages an outcome where the FSB declines to accept Australia’s assurances that the CFR is sufficient and obliges us to re-assign responsibility for systemic risk mitigation more explicitly among the three regulators.

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A similar outcome could arise in the case of prudential supervision. Again, the FSB proposals envisage widening the scope of prudential regulation to encompass all systemically important financial intermediaries. This potentially extends the reach of prudential regulation beyond ADIs to include, eg. mortgage trusts, securitisation Special Purpose Vehicles and even hedge funds. At present only ADIs are prudentially regulated and this is the sole responsibility of APRA. If non-ADIs are to be subject to some measure of prudential regulation, this responsibility will fall to ASIC unless APRA is required to extend its remit beyond ADIs.

In either case, structural change to Australia’s regulatory framework will be required, either to empower and resource ASIC to develop prudential expertise which it currently lacks, or to push the boundaries of APRA’s mandate beyond deposit-taking intermediaries and insurance companies. APRA’s remit could no longer be neatly summarised as protecting depositors and policyholders – in such a new configuration, some of APRA’s charges would fall into neither category.

Indeed, there is a danger if APRA is left to operate within its existing boundaries that ASIC ends up carrying a significantly expanded set of responsibilities under the new arrangements. This could produce a seriously lop-sided regulatory framework. Not only would ASIC carry its traditional conduct and disclosure and consumer protection responsibilities but it would also pick up prudential responsibilities and potentially also its share of systemic risk mitigation in financial markets.

ASIC is currently not resourced adequately to cope with such an expanded remit. Moreover, its predominant culture and expertise is legal rather than economic, which does not suit it well to an extension of responsibilities into these more economically based areas of regulation. The ‘twin peaks’ system which has served Australia well to date would look more like ‘one and a half peaks’ as ASIC came to dominate APRA in the range of its responsibilities if not effectiveness on the ground.

A similar re-working of the current assignment of regulatory responsibilities would be required if the Australian authorities were obliged to introduce macroprudential regulation in a more than perfunctory fashion. If the FSB’s current proposals for macroprudential regulation emerge intact, there will be a pressing need for the RBA and APRA to coordinate their countercyclical policy instruments: the cash interest rate on the one hand, and mandatory levels of capital adequacy on the other. Again this might be something that is simply added to the agenda of the CFR. However, the FSB may consider such a response inadequate and require more formal machinery for joint decision-making by the two regulators to avoid conflicting settings of the two instruments.

It is possible that the separation of prudential supervision from the central bank might even be reconsidered, (ie. APRA re-merged into the RBA). However, this would be a major structural re-adjustment and politically unpalatable given that neither APRA nor the RBA performed badly during the GFC – indeed, quite the contrary. Possibly the notion of separating prudential supervision from central banking might not have succeeded had the experience of the GFC been behind us at the time of the Wallis Committee’s deliberations. With hindsight, perhaps the justification for separate institutions is now less strong than it was once thought to be. How strongly the FSB emphasises macroprudential controls as part of a complying regime under the new arrangements will determine the extent to which Australia needs to re-structure the current framework to accommodate greater coordination between the activities of APRA and the RBA in a post-GFC world.

3.3 Selectively implement reformsThe third response is for Australia to explicitly reject various specific proposals on the grounds that they are redundant or potentially counterproductive when applied in an Australian context. To forestall Australia being cast as recalcitrant or unwilling to pull our weight in the international effort to coordinate a new global regulatory framework, we would have to argue strongly that our system does not need certain policy interventions because our arrangements already deliver the required effect using different mechanisms, or that to abide by the FSB’s requirements would produce unintended negative consequences for the soundness of Australia’s financial system.

This approach will be a tough row to hoe, not the least reason being that many other countries will seek to argue precisely the same way. Australia will not be alone in seeking to establish that extenuating circumstances apply in our backyard. The difficulty for the FSB is that granting too many exemptions on these grounds will soon see the entire attempt to knit together a new international framework come apart at the seams. By responding in this third way, Australia runs the risk of being seen as abetting just such an outcome and implicitly if not explicitly reneging on its G20 commitment.

Nevertheless, it may well be true that Australia does not need some of the regulations being proposed. Opting for the third response presumes that acquiescence and quietly tailoring our response to local conditions is for whatever reason not available to us. Perhaps the FSB is too insistent, or our efforts to accommodate their wishes while adapting them to local conditions fail the FSB’s audit. In either case, this would leave us with little alternative but to rule out certain interventions on the grounds that they are contrary to Australia’s national interest. This may well make life difficult for us with the FSB and the G20 more broadly.


Candidates for repudiation might include the proposed leverage ratio. Australia could argue that our banks are well capitalised according even to a beefed up risk-weighted capital adequacy standard, primarily because of their overweight exposure to low-risk domestic mortgages. Assessing our banks according to an unweighted leverage ratio would declare them to be undercapitalised.

As much as the regulator might insist that the unweighted ratio is irrelevant to a proper assessment of their underlying soundness, it is not clear that the capital markets would take the same view. After all, these are the same capital markets whose bizarre assessments of liquidity risk in part fomented the GFC when, for example, CDOs and other complex, tailored financial products were incorrectly promoted – and accepted – as if they were ‘liquid’ assets.

It is arguably ironic for a regulator sworn to regulate against the shortcomings of the market to rely on them to distinguish between risk-weighted and unweighted assessments of individual banks. Perhaps the leverage ratio can be tailored to local conditions after all; but, if not, this is an intervention that should simply be repudiated for fear of exposing Australia’s banks to unjustifiably harsh judgment at the hands of imperfect global capital markets.

A similar argument might be mounted against various proposals to deal with the too big to fail problem. Australia’s regulatory arrangements already oblige APRA to assume control of a bank that looks likely to fail to meet its obligations to depositors. It is then entirely within APRA’s discretion how the bank will be managed, dismembered, sold or liquidated beyond that point. It is also entirely possible now for APRA to require systemically important institutions to prepare a ‘living will’ in advance of such an event. Indeed, APRA should have prepared such plans itself given that the law already requires APRA to assume control in the event of imminent failure.

Moreover, in a system the size of Australia’s, there is no great mystery in deciding which institutions are potentially of systemic importance. Again, given APRA’s current remit to protect depositors and policyholders, by rights it should already be imposing more onerous capital requirements on those institutions whose demise would threaten not just their own depositors/policyholders but those of other institutions elsewhere in the system. In other words, it could easily be argued that Australia’s regulatory framework already encompasses sufficient machinery and authority to deal with the too big to fail issue without the introduction of new rules designed for systems elsewhere in the world that lack the flexibility of our own.

Finally, explicit macroprudential regulation could be another candidate for repudiation. To begin, APRA currently has the

power to raise or lower capital standards across the board or institution-by-institution at its own discretion. Protection of depositors interests has a dynamic dimension and APRA may well set capital controls with a view to the longer term outlook for bank solvency across the credit cycle – at least there is nothing to stop it doing so. Similarly, APRA has the power to confer with the RBA about the potential interaction of monetary and prudential policy even though they are separately administered. How would locking APRA into a more mechanical macroprudential instrument represent an advance over its current discretion?

Furthermore, given the subtlety surrounding the use of monetary policy in isolation, let alone in concert with another credit instrument, how are we advanced by compromising the RBA’s discretion to set monetary policy without the need to consider how it might be undone by APRA’s macroprudential policy? Australia’s experience of the interaction of monetary and prudential policy has been without blemish since the separation of APRA from the RBA. If we cannot accommodate the FSB’s requirement for macroprudential policy within our existing arrangements, we may be better advised to repudiate than acquiesce in changes that might undermine the subtle balance we already have in place and which served us well during the GFC.

3.4 ConclusionThe process of deliberation over a potential new global regulatory framework has some way to run. Quantitative impact assessments are still to be conducted in order to assess the costs and benefits and calibrate the recommendations that eventually emerge from the FSB. Still, it is anticipated that the new rules for banks, at least, will be announced by end-2010 for implementation by the beginning of 2012.

Australia needs to decide how to respond to the raft of initiatives likely to emerge from this complex process. We have our international reputation for sound and effective financial regulation to protect, not to mention our obligations to the G20 to consider. On the other hand, we have our national interest to guard in signing up to regulations which may, at least in some cases, compromise rather than shore up the integrity of our system.

In the best case, we can manage to accommodate the new requirements within existing structures. There is also the possibility that the global requirements will oblige us to implement more fundamental changes to existing arrangements than might be considered desirable or even necessary. For this reason, the option to repudiate some or all of the proposed changes should not be foreclosed or dismissed lightly.

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References

Australian Prudential Regulatory Authority (APRA) (2010), Policy Home, APRA, January 2010, http://www.apra.gov.au/policy/ accessed 5 March 2010.

(2009) Discussion Paper – APRA’s prudential approach to ADI liquidity risk, APRA, 11 September 2009, http://www.apra.gov.au/Policy/upload/ADI_DP_PALR_092009_v5.pdf accessed 4 March 2010.

Bank of England (2009), The Role of Macroprudential Policy – Discussion Paper, Bank of England, November 2009, http://www.bankofengland.co.uk/publications/other/financialstability/roleofmacroprudentialpolicy091121.pdf, accessed 4 March 2010.

Basel Committee for Banking and Supervision (BCBS) (2010) The Joint Forum, Review of the Differentiated Nature and Scope of Financial Regulation, BIS Janaury 2010

(2009a) Charles Bean: The Great Moderation, the Great Panic and the Great Contraction, Charles Bean, 25 August 2009, http://www.bis.org/review/r090902d.pdf accessed 10 March 2010.

2009b, International framework for liquidity risk measurement, standards and monitoring, Basel Committee for Banking Supervision, December, http://www.bis.org/publ/bcbs165.htm, accessed 4 March 2010.

(2009c), Strengthening the resilience of the banking sector, Basel Committee for Banking Supervision, December, http://www.bis.org/publ/bcbs164.htm, accessed 4 March 2010.

(2004), Ben S Bernanke: The great moderation, Ben Bernanke, 20 February, http://www.bis.org/review/r040301f.pdf accessed 10 March 2010.

Blundell-Wignall, A, Wehinger, G, and Slovik, P (2009), The Elephant in the Room: The Need to Deal with What banks Do, OECD Financial Market Trends, Vol. 2009/2.

European Commission (EU) (2009) Report by the High-level Group on Financial Supervision in the EU, EU, http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf accessed 10 September 2009

Financial Services Authority (FSA), Addressing the procyclicality of IRB requirements – Pillar 1 or Pillar 2?, FSA http://www.fsa.gov.uk/pubs/international/crsg_procyclicality_pillar.pdf accessed 9 March 2010

Financial Stability Board (FSB) 2010, Member Institutions, FSB, http://www.financialstabilityboard.org/members/links.htm accessed 4 March 2010.

(2009a), Press release: Financial Stability Board holds inaugural meeting in Basel, FSB, 27 June 2009, http://www.financialstabilityboard.org/press/pr_090627.pdf accessed 4 March 2010.

(2009b), Progress since the Pittsburgh Summit in Implementing the G-20 Recommendations for Strengthening Financial Stability, FSB, 7 November 2009, http://www.financialstabilityboard.org/publications/r_091107a.pdf, accessed 4 March 2010.

(2009c), Report of the FSB to G-20 Leader on Improving Financial Regulation, FSB, 25 September 2009, http://www.financialstabilityboard.org/publications/r_090925b.pdf accessed 10 March 2010.

Gros, D (2010) Too interconnected to fail = too big to fail: What’s in a leverage ratio?, CEPS Commentary, 28 January 2010, http://www.ceps.be/ceps/download/2881, accessed 5 March 2010


Group of Twenty (G-20) 2009, Communique – Meeting of Finance Ministers and Central Bank Governors, United Kingdom, 7 November 2009, http://www.G-20.org/Documents/2009_communique_standrews.pdf, accessed 4 March 2010.

International Association of Insurance Supervisors (IAIS) (2010a), Press release – international supervisory cooperation strengthens, IAIS, 1 March 2010, http://www.iaisweb.org/__temp/1_March_2010__International_insurance_supervisory_cooperation_strengthens.pdf accessed 10 March 2010.

(2010b) Press release – IAIS approves development of a Common Framework for the Supervision of International Active Insurance Groups, IAIS, 19 January 2010, http://www.iaisweb.org/__temp/19_January_2010__IAIS_approves_development_of_a_Common_Framework_for_the_Supervision_of_Internationally_Active_Insurance_Groups.pdf accessed 10 March 2010.

(2009) Note on systemic risk and the insurance sector, IAIS, 25 October 2009, http://iaisweb.org/__temp/Note_on_systemic_risk_and_the_insurance_sector.pdf accessed 10 March 2010.

International Organisation of Securities Commissions (IOSCO) Technical Committee (2009a), Consultation Report – Transparency of Structured Finance Products, IOSCO, September 2009, http://www.iosco.org/library/pubdocs/pdf/IOSCOPD306.pdf, accessed 4 March 2010.

(2009b), Final Report – Elements of International Regulatory Standards on Funds of Hedge Funds Related Issues Based on Best Market Practices, IOSCO, September 2009, http://www.iosco.org/library/pubdocs/pdf/IOSCOPD305.pdf, accessed 4 March 2010

(2009c), Final Report – Hedge Funds Oversight, IOSCO, June 2009, http://www.iosco.org/library/pubdocs/pdf/IOSCOPD293.pdf, accessed 4 March 2010.

(2009d), Final Report - Unregulated Financial Markets and Products (Consultation Report), IOSCO September 2009, http://www.iosco.org/library/pubdocs/pdf/IOSCOPD301.pdf accessed 16 September 2009

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Takáts, E and Tumbarello, P (2009), Australian Bank and Corporate Sector Vulnerabilities – an international perspective, International Monetary Fund, Working Paper No 09/223.

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Appendix A: Consultations

Table A.1: List of stakeholders

Australian and New Zealand Banking Group Financial Services Authority (UK)

Australian Bankers Association International Association of Insurance Supervisors

Australian Financial Centre Forum Institute of International Finance

Australian Prudential Regulation Authority London School of Economics

Australian Securities and Investments Commission National Australia Bank

Bank of Italy Organisation for Economic Cooperation and Development

Bank of Portugal Reserve Bank of Australia

Bank of International Settlements Reserve Bank of New Zealand

Central Bank and Financial Services Authority of Ireland Westpac Bank

Commonwealth Bank of Australia


Appendix B: International regulation standard-setters

Prior to the crisis, most standards relating to the financial system were developed relatively independently by the four key international standard-setting bodies:

> The Basel Committee on Banking Supervision (BCBS) – representing financial intermediaries

The International Organisation of Securities Commissions (IOSCO > ) – representing securities markets and participants

The International Association of Insurance Supervisors (IAIS) > – representing the insurance industry

The International Accounting Standards Board (IASB) > – representing the accounting industry.

In addition, since 1996 the BCBS, IOSCO and IAIS have collaborated through the Joint Forum to discuss matters of common interest across their sectors.

The FSB seeks to overcome the independence of standard setters, governments and other international financial fora and develop coherent and conceptually consistent regulatory regimes. Its membership comprises representatives from national financial agencies, international organisations and international standard setters as shown in Table B.1.

Table B.1: FSB members

National representatives International organisations International standard setters

G20 nations Bank of International Settlements (BIS) Basel Committee on Banking Supervision (BCBS)

Hong Kong European Central Bank (ECB) Committee on the Global Financial System (CGFS)

Netherlands European Commission (EC) Committee on the Payment and Settlement Systems (CPSS)

Singapore International Monetary Fund (IMF) International Association of Insurance Supervisors (IAIS)

Spain Organisation for Economic Coordination and Development (OECD)

International Accounting Standards Board (IASB)

Switzerland The World Bank International Organisation of Securities Commissions (IOSCO)

Source: FSB 2010

Additional input is provided by non-member international fora although these bodies do not have any decision making capabilities.

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The FSB is structured into a series of working groups and committees, overseen by a Chairman and Steering committee as shown in Figure B.1.

Figure B.1: FSB organisational structure

Source: FSB 2009a

As the names suggest the Standing Committee for Vulnerabilities Assessment (SCVA) assesses and monitors vulnerabilities in the financial systems and develops policy responses to address those; the Standing Committee for Supervisory and Regulatory Cooperation (SCSRC) is responsible for policy coordination amongst members; and the Standing Committee for Standards Implementation (SSCI) develops a framework to ensure standards are implemented and monitored across jurisdictions. All three committees are made up of representatives of FSB members who will make decisions on future standards, principles and policies.

FSB Chair

Cross-border Crisis Management

Working Group

Sound Compensation Practices Working Group

Standing Committee for Vulnerabilities Assessment

(SCVA)

Standing Committee for Supervisory and Regulatory

Cooperation (SCSRC)

Standing Committee for Standards Implemention

(SCSI)

Steering Committee


Appendix C: Outline of the proposed reforms

Inter-regulator reforms coordinated through the FSB

Governance and compensation standards in conjunction with BCBS

Reducing contagion and developing infrastructure to manage systemic risk

Development of supervisory colleges across all regulated components

Institutional regulation Product and market regulation Ancillary support

Capital enhancements including the redefinition of Tier 1 capital and harmonisation of capital definition across jurisdictions.

Regulation of securitisation products including due diligence and disclosure, mandated skin in the game and tight issuer requirements including matters relating to each issue (on an ongoing basis).

Accounting standards enhancement include review of fair value measurement and lending activities and use of expected loss provisioning (in conjunction with institutional capital requirements) and development of convergent approaches to netting rules and treatment of repos.

Procyclicality measures including the use of minimum capital buffers, forward looking provisioning and capital conservation

Regulatory oversight of hedge funds and/or fund managers including mandatory registration, ongoing regulation, provision of data and disclosure requirements

Insurance Standards include better coordination and information sharing between prudential regulators and developing a whole of group approach to insurance.

Liquidity tools including the liquidity coverage ratio and net stable funding ratio

Development of international standards for exchanges and central clearing parties

Macroprudential/systemic risk strategies, which may include additional prudential regulation for institutions of systemic importance, limits on size of institutions, taxing institutions according to size, revision of internal structures or prohibited activities

Special purpose entities regulation including prudential regulation, disclosure requirements, monitoring and identification of systemic weaknesses

Cross border resolution Point of sale regulation for retail investors

Monitoring and data provisioning

Source: BCBS, FSB, IAIS and IOSCO

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Appendix D: Reform timeline

The BCBS is the most advanced with its regulatory agenda and intends to begin implementation at the end of 2010 with a view to completing transition arrangements by 2012.

Transition will be an important issue, not only because of the current uncertainty as to what the reforms will be, but also because of different starting points of different jurisdictions and potential changes in economic conditions. For example, European financial intermediaries hold less capital under the mooted reforms compared with the United States and will require time to rectify this. In addition, economic cycles in the major economies may influence the rate of implementation.

TaskResponsible organisation Time

Review of existing standards and implementation

Evaluation of adherence to international standards FSB Commenced Feb 2010

Peer review of implementation of ‘Principles and Standards for Sound Compensation Practice’

FSB Completed Mar 2010

Cooperative Mutual Assessment Phase I G-20, IMF and World Bank

April 2010

Review of financial instrument accounting standards IASB End 2010

Policy development

Policy frameworks for nations and regions G-20 January 2010

Preliminary assessment and policy options to address ‘too big to fail’ issue for G-20

FSB June 2010

Refinement of mutual assessment and policy considerations G-20 November 2010

International prudential standards – banking BCBS Comments on consultative documents 16 April 2010

Impact assessments to be completed in first half 2010

Final standards at the end 2010

Internationally consistent, firm specific recovery and resolution plans and tools

FSB, IMF and World Bank

End 2010

Concept paper for new insurance standards IAIS First half of 2011

Full framework for new insurance standards finalised IAIS By 2013

Impact assessment of insurance standards IAIS 2013 onwards

Implementation timeline for new policies

International prudential standards – banking BCBS End 2012 subject to economic conditions

Source: BCBS, FSB, G-20 and IAIS


Appendix E: Glossary

ADI Authorised deposit-taking institution

AE Access Economics

AIG American Insurance Group

APRA Australian Prudential Regulation Authority

ASIC Australian Securities and Investments Commission

BCBS Basel Committee for Banking Supervision

BIS Bank for International Settlements

BOE Bank of England

CDS Credit default swap

CGFS Committee on the Global Financial Crisis

CPSS Committee on the Payment and Settlement System

CRA Credit rating agency

EC European Commission

ECB European Central Bank

EL Expected losses

G-20 Group of Twenty economies

GFC Global Financial Crisis

FATF Financial Action Task Force (on money laundering)

FSA Financial Services Authority

FSB Financial Stability Board

IAIS International Association of Insurance Supervisors

IASB International Accounting Standards Board

ICAA Institute of Chartered Accountants in Australia

IFAC International Federation of Accountants

IMF International Monetary Fund

IL Incurred losses

IOSCO International Organisation of Securities Commissions

LCR Liquidity coverage ratio

NSFR Net stable funding ratio

OECD Organisation for Economic Cooperation and Development

OTC Over-the-counter

PD Probability of default

RBA Reserve Bank of Australia

SCSI Standing Committee for Standards Implementation

SCSRC Standing Committee for Supervisory and Regulatory Cooperation

SCVA Standing Committee for Vulnerabilities Assessment

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