Financial Stability Review – March 2004 3. Developments in the Financial System Infrastructure

As outlined below, a number of initiatives are currently underway to improve the operation of the Australian financial system. These initiatives address various prudential requirements, the operation of financial markets, the regulation of clearing and settlement systems, and the transparency of firms' balance sheets. A number of these initiatives will be subject to a more detailed discussion in future issues of the Financial Stability Review.

3.1 Prudential Requirements

The New Basel Capital Accord

Financial institutions in Australia are supervised by the Australian Prudential Regulation Authority (APRA). A cornerstone of APRA's regulatory framework is a set of minimum capital requirements for banks and other authorised deposit-taking institutions (ADIs). The current arrangements date from 1988 when the Reserve Bank – which, at that time, had responsibility for the supervision of banks – implemented the risk-weighted approach to assessing minimum levels of capital established by the G10 Basel Committee on Banking Supervision, known as the Basel Capital Accord. Under this approach, banks are required to hold capital against credit risk for loans to the corporate, household, banking and government sectors. While the adoption of the Accord was an important step forward in the harmonisation of international banking regulation, the failure to distinguish between the quality of individual credits within each of these sectors was recognised as a shortcoming in the Accord from early on. This lack of differentiation means, for example, that a bank must hold the same amount of capital against all corporate exposures regardless of whether they are to a well-established ‘blue-chip’ company or to a firm starting up in a high-risk industry. In addition, the Accord did not explicitly address some important non-credit risks, notably operational risk – which arises from difficulties with internal processes, people and systems, or external events.

Over the past five years the Basel Committee has been working on a New Accord to address the shortcomings of the current Accord. New and considerably more sophisticated capital requirements provide two broad options for measuring credit risk, reflecting differences in the levels of sophistication among financial institutions. The first option, the standardised approach, is similar to the current Accord but allows for external credit risk assessments to be used to determine the riskiness of some credit exposures. The second option, the internal ratings-based approach, differs substantially from the current Accord in that it allows banks to make use of their own internal assessments of credit risk to determine minimum levels of capital.

The New Accord also requires banks to hold capital against operational risk. Again reflecting differences in sophistication, there are three options. Under a ‘basic indicator’ approach, capital is determined by a bank's gross income, while the more advanced approaches allow a bank to use its own assessment of operational risk.

In addition to the revised capital requirements, the New Accord also includes guidelines for supervisory review of risk management and capital adequacy and recommendations regarding the use of disclosure to strengthen market discipline.

The Basel Committee expects the New Accord to be implemented internationally by the end of 2006 and APRA has issued transition guidelines for its introduction in Australia. APRA expects the four largest Australian banks to adopt the internal ratings-based approach to credit risk measurement. While most other ADIs are expected to begin by using the standardised approach, any ADI will be permitted to use the internal ratings-based approach if they are able to demonstrate to APRA that their measurement and management of risk are sufficiently rigorous. Overall, APRA estimates that the effect of the various changes on Australian ADIs will be a small reduction in minimum capital requirements.

Existing capital requirements

In light of ongoing innovation in the financial system, APRA has recently made, or proposed, a number of modifications to existing capital requirements.

• Housing loan risk weights

  Under the current Accord, APRA allows ADIs to hold less capital against housing loans than most other loans. While business loans attract a 100 per cent risk weight for capital adequacy purposes, a weight of 50 per cent is currently applied for housing loans that either have a loan-to-valuation ratio of less than 80 per cent, or are fully insured with a highly rated mortgage insurer. APRA has recently proposed that if an ADI does not independently verify an applicant's income as part of the loan approval process, the loan will only qualify for the 50 per cent risk weight if the loan-to-valuation ratio is less than 60 per cent or the loan is fully insured by a highly rated mortgage insurer. This reflects the potentially higher level of credit risk for loans where such verification does not take place. APRA is currently considering comments on the proposal and intends to implement changes in July 2004.

• Capitalised expenses

  Australian accounting standards allow banks to capitalise expenses such as loan and lease origination fees and commissions paid to mortgage brokers, securitisation establishment costs and costs associated with debt and capital raisings. Over the past few years, capitalised expenses have accounted for a small but increasing proportion of regulatory capital held by ADIs. However, given that capitalised expenses cannot be readily converted to liquid assets in the event of unexpected losses by the ADI, APRA has recently moved to exclude from capital those expenses associated with capital raisings, strategic business development initiatives, loan origination fees paid by institutions, and securitisation establishment costs.

  The effect of this change will vary considerably across institutions. Many of the most affected ADIs have raised additional capital ahead of the new requirements coming into effect in July 2004 and, as a result, the overall impact on the average regulatory capital ratio will be small.

  APRA has deferred, for now, any decisions regarding capitalised expenses associated with software development and other IT initiatives.

• Financial conglomerates

  Previously, ADIs had to fully deduct their exposures to their non-banking subsidiaries when calculating capital requirements. In June 2003, APRA revised the capital adequacy standards to allow capital adequacy to be assessed at the ‘full conglomerate group’ level. This assessment will be in addition to the existing ‘banking group’ and ‘stand-alone ADI’ level requirements and will apply to six ADIs (Commonwealth Bank of Australia, National Australia Bank, Westpac, St George Bank, Macquarie Bank, and Suncorp-Metway). While the first phase of these arrangements came into effect in July 2003, further changes will be made when the New Basel Accord is introduced by the end of 2006.

  In a related change, APRA released new standards regarding large exposures to related entities. The standards place more stringent limits on intra-group exposures, which aim to better insulate ADIs from risks posed by non-banking companies in the same conglomerate group.

General insurance

APRA has also proposed further reforms to general insurance regulation, a number of which flow from recommendations by the Royal Commission into the collapse of HIH Insurance. These reforms deal with capital management planning, the deduction of capitalised expenses from regulatory capital, the deduction of reinsurance when calculating minimum capital requirements, intra-group reinsurance concessions, enhanced disclosure and governance. APRA has now received comments on these proposals, and intends to release revised prudential standards for general insurers later in the year.

APRA is also reconsidering the current requirement that lenders' mortgage insurers need to be separately authorised and can only provide this one type of insurance business. Relaxation of the single business line requirement is intended to increase competition in the mortgage insurance market, which is dominated by two institutions, by allowing other insurers to offer lenders' mortgage insurance.

Superannuation licensing

The Government has recently introduced legislation designed to strengthen the prudential framework that applies to the superannuation industry. The Superannuation Safety Amendment Bill 2003, expected to come into effect in July this year, requires all trustees of APRA-regulated superannuation funds to be licensed by APRA. To obtain a licence, trustees must meet minimum standards relating to their fitness and propriety and their ability to manage risk; existing trustees will have until July 2006 to obtain a licence. Actuaries and auditors will also be required to report certain information to APRA about superannuation funds, and APRA will have improved enforcement powers. APRA is currently seeking comments on the draft guidance material it has issued relating to these reforms.

Fit and proper requirements for responsible persons

APRA intends to introduce ‘fit and proper’ requirements for individuals in positions of responsibility within APRA-regulated institutions. New prudential standards will require institutions to assess whether ‘responsible persons’ have the technical competence and integrity to perform their duties; responsible persons include directors, senior managers, auditors and, for insurers, actuaries. APRA would have the ability to remove and possibly disqualify individuals deemed not to be fit and proper. APRA expects to implement the standards from 1 January 2005, following a period of consultation.

3.2 Financial Markets

The smooth functioning of financial markets is important to the health of the overall financial system. Recent initiatives in this area address the operation of clearing and settlement systems, insider trading and the licensing of financial services providers.

Clearing and settlement systems

An important prerequisite for financial stability is the safe operation of clearing and settlement facilities – systems that provide mechanisms for parties involved in financial transactions to meet their obligations to each other. To help achieve this, the Reserve Bank has now determined financial stability standards (under the Financial Services Reform Act 2001) to which the licensees of clearing and settlement facilities must adhere. The standards apply to the central counterparties and securities settlement systems operated by the Australian Stock Exchange and the Sydney Futures Exchange, and came into force at the end of May 2003, with some transitional arrangements in place. There are separate standards for central counterparties and for securities settlement systems, reflecting differences in the nature of their businesses.

Central counterparties interpose themselves between the buyer and seller of a particular trade. They do this when a broker enters into a contract to buy shares from another broker, and the contract is replaced (or ‘novated’) with two separate contracts – one between the buyer and the central counterparty, and the other between the central counterparty and the seller. To complete the transaction, the seller delivers shares to the central counterparty in return for cash. The central counterparty in turn delivers the shares to the buyer who pays cash to the central counterparty. A default by participants due to deliver shares or pay cash can therefore expose the central counterparty to liquidity pressures and eventual losses. This could have implications for the financial system more generally if the solvency of the central counterparty were threatened.

The main purpose of securities settlement systems is to record changes in the ownership of securities; the system does not become a counterparty to the trades that it is recording. The SFE Corporation's Austraclear is an example of such a system for debt securities while the Australian Stock Exchange's Clearing House Electronic Subregister System provides a similar facility for shares. The main risk in such a system is that one counterparty transfers title to securities (or cash) but does not receive cash (or securities) in return. This risk can be avoided by ensuring that the system operates on a delivery-versus-payment basis, so that both legs of the transaction occur simultaneously.

The Reserve Bank's financial stability standards aim to ensure for both types of systems that: the legal framework underpinning the facility is well-founded and enforceable; participants have sufficient resources to meet their obligations and that they understand the risks to which they are exposed; clearing and settlement processes are efficient; and sources of operational risk are identified and minimised. Central counterparties must also have arrangements in place that can deal with instances of default, as well as comprehensive risk control arrangements. Similarly, securities settlement systems must have procedures in place for situations in which a participant is placed into external administration.

Insider trading

To the extent that improper practices, such as market manipulation or insider trading, discourage activity in markets and distort market prices, such practices impair financial markets' contribution to the health of the financial system. Under the Corporations Act 2001, anyone who possesses insider information is prohibited from trading or procuring trading, or communicating that information where the Act applies to markets in financial products. In March 2002 the range of financial products covered by insider trading prohibitions was considerably extended. In the light of these changes, the Corporations and Markets Advisory Committee prepared a review of insider trading provisions.^[13] The review made a number of recommendations dealing with reporting requirements for corporate officers, disclosure requirements for various financial markets, regulation of share issues and buy-backs and the limited use of non-discretionary trading plans. It noted that not all of these were supported by the Australian Securities and Investments Commission, reflecting concerns based on its experience with the enforcement of insider trading provisions. The Government is currently considering the Committee's report.

Licensing of financial service providers

The Financial Services Reform Act 2001 streamlines the regulatory regime for financial products and services, financial markets and clearing and settlement facilities. It provides a single licensing framework for financial service providers as well as licences for market operators and clearing and settlement facilities providers. The Financial Services Reform Act came into effect in March 2002. Most financial services providers have met the requirement to obtain a licence under the new arrangements by the deadline of March this year.

3.3 Accounting and Governance

Recent initiatives designed to revamp accounting standards and strengthen corporate governance will not only affect financial institutions directly, but indirectly through their effect on the transparency and governance of firms.

Accounting standards

Considerable work is being done by the International Accounting Standards Board to develop a comprehensive set of International Financial Reporting Standards. The adoption of common international standards will reduce costs for international companies and make cross-country comparisons by investors easier. The Standards are being adopted as Australian accounting standards, with Australian institutions required to apply them for reporting periods beginning 1 January 2005.

The new standards seek to increase the proportion of the balance sheet measured at market prices net of transaction costs, otherwise referred to as ‘fair value’. In the Australian context, users of financial statements are already accustomed to valuations based on market values, particularly for insurance firms and superannuation and managed funds. Many other companies regularly revalue assets, although gains on non-current assets are generally taken directly to a reserve. By and large, the Australian experience has been that markets have quickly become accustomed to financial reports that include fair-value accounting.

Opponents of the move to a more market-based approach are concerned that it will increase the volatility of earnings, with potentially undesirable consequences for firms and possibly the wider economy. In contrast, those in favour of the approach see it as bringing company accounts more closely into line with underlying economic values and reducing the degree of subjectivity in preparing accounts. As such, it should contribute to good corporate governance and the efficiency of resource allocation.

While market-based accounting is already used throughout much of the financial services industry, there have been some concerns about the impact of the proposed new standards on banks' provisioning practices. In particular, under the proposed standards, provisions for loan impairment are only allowed once there is ‘objective evidence’ of impairment. Some have argued that this will restrict banks' ability to undertake forward-looking provisioning and may be at odds with the requirements of bank supervisors.

The proposed treatment of ‘macro hedging’ – the practice of offsetting interest-rate risk across a portfolio of assets and liabilities, rather than on an instrument-by-instrument basis – has also attracted mention. Critics argue that these portfolio hedges may be difficult to recognise as fair-value hedges under the proposed standards, and could lead to unnecessary volatility in an institution's accounts. The International Accounting Standards Board has since proposed amendments allowing institutions to recognise such hedges in limited circumstances.

Australian insurers will be affected by the implementation of international accounting standards for insurance contracts (also being developed by the International Accounting Standards Board). The new standards will be introduced in two phases. The first phase is limited to harmonising disclosure arrangements for insurance internationally. The second phase, not expected to be implemented until 2007, will address broader issues related to insurance accounting and will require insurance assets and liabilities to be measured at fair value. The Basel Committee has expressed some concern about the implications of phasing-in the new standards for banks' insurance subsidiaries, as insurance liabilities would be valued using current national practices while the financial assets backing those liabilities would be measured at fair value. This is not anticipated to be an issue in Australia, given that Australian standards have reflected such an approach for some years.

Corporate governance initiatives

The Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Bill 2003 aims to improve transparency and accountability and to promote shareholder activism. It focuses on issues such as auditor independence, financial reporting, the role of shareholders, continuous disclosure and managing conflicts of interest for analysts. It is expected to come into effect from July 2004. Further, listed companies are expected to disclose their compliance with the principles released last year by the Corporate Governance Council of the Australian Stock Exchange.

Footnote

The Committee is made up of legal and financial market experts appointed by the Treasurer to provide advice on corporations law and financial markets regulation. [13]