Achieving Effective Supervision

By the middle of 1998, legislation

permitting, a new regulatory agency will come

into existence. It will reflect the Wallis

Committee’s call for a more integrated and

consistent approach to prudential supervision

and regulation, geared towards a rapid pace

of change in the financial system and an

increasing prevalence of financial

conglomerates. APRA, the Australian

Prudential Regulation Authority, will combine

the banking supervision functions of the

Reserve Bank with the activities currently

car ried out by the Insurance and

Superannuation Commission. On present

plans, the new agency will be supplemented

in the middle of 1999 by inclusion of the

supervisory functions of AFIC (the supervisor

of building societies and credit unions). With

the Wallis Committee’s recommendation on

this accepted by the Government, the key

challenge now is to put in place the new

arrangements to achieve a flexible regulatory

system focusing on both the prudential

soundness of the financial system and,

importantly, financial system efficiency.

As a preliminary, I should make the obvious

point that the new arrangements are not

starting from scratch (or worse, starting with

a financial system which is in trouble, or a

regulatory system which is deficient). The new

arrangements build on a well-functioning

system, but seek to adapt it to expected future

developments. The task is to take over the best

features of the current approach, to continue

the kind of adaptive evolution which has

occurred, and to tailor the existing institutions

more precisely to achieve a snug fit with the

demands of a fast-changing financial sector.

It is never possible to achieve perfect

congruence between institutional

arrangements and multi-dimensional needs,

but there is now a new opportunity to re-align

institutions and methods. The various

objectives will not flow automatically or easily,

however, from creating a single prudential

regulator. So there is some point in offering

some thoughts, as the Bank passes on the

baton to the next runner, urging them to run

the good race. In that spirit, let me offer the following comments.

First, I will touch on the issue of flexibility.

There can be a tendency for regulators

covering a wide institutional field to become

more highly bureaucratic than those with a

narrow focus. A legalistic, accounting-based

approach to regulatory matters can emerge

over time. Why is that the case? The answer is

relatively simple. Big institutions by their

nature tend also to be complex institutions.

The simplicity, flexibility and innovation that

is often the hallmark of a smaller entity can

fade with size. This view should not be

especially controversial for it applies to most

organisations and institutions – it is why the

small to medium business sector is often

viewed as the engine for growth and

employment in the economy. It is why mergers

of smaller businesses into large corporates

often fail to deliver the expected benefits.

Sometimes large regulators also have large

rule books which are often written into

legislation. The rationale is usually that this

approach is more consistent with the notion

of the level playing field, with everybody in

the market knowing the rules of the game.

There is often, also, a strong sense that

supervisors should not be permitted to make

arbitrary judgments on policies or supervisory

approaches. Policy is policy and should be

applied to the letter of the law until it is

changed. It is an approach that is

administratively tidy. Yet, there is also a big

cost, for as soon as you proceed down that

legalistic path, flexibility can disappear.

Regulatory rule books can, of course, always

be rewritten and legislation changed where

circumstances warrant but the time scales

involved in achieving change through that

channel can be measured not in days or weeks

but sometimes in terms of years. The history

of the Capital Adequacy Directives in the

European Union is compulsory and sobering

reading for anyone who might question this

view.

In developing APRA, therefore, it will be

important to keep those dynamics firmly in

mind. The financial system of the future will

require an increasingly flexible and

quick-footed approach to prudential

supervision and one of the key challenges will

be to ensure that the regulatory system meets

that need. Financial institutions should be able

to get a quick answer when they come to the

regulator with a proposal. They should also

feel that they do not have to be accompanied

by their lawyer.

There is every reason to believe that this

objective can be achieved if it is kept in mind.

A noteworthy feature over the past five or so

years has, in fact, been the increasing trend

internationally towards ‘market friendly’

approaches to supervision. One example of

this trend in Australia is the development of

the on-site visit programs to banks, covering

first credit risk and, more recently, market risk.

Such developments can be described as

market friendly not because they have led to

any easing of prudential standards, but

because they reflect an approach to

supervision that aligns itself more to the way

that banks themselves think about and address

risk. Rather than requiring banks to provide

reams of standardised statistical data on, say,

the health of their credit portfolios, the

approach has been to reach in to the

information and data that the individual banks

have developed for their own credit risk

management purposes, and to examine the

systems and controls in place to measure and

manage the risk. The same approach applies

in relation to the supervision of traded market

risk in banks and, in theory, could apply to all

other forms of risk facing financial institutions.

By taking that path, the supervisory burden

on institutions is reduced, supervisors get

better information than could otherwise be

obtained and, through closer interaction

between the bank and the supervisor, the

result is a much improved understanding

between the two par ties. It should be

recognised, however, that it is also a more

difficult approach to adopt and can make

consistency of treatment across institutions

harder to achieve. It is not as tidy as the

traditional approach. It requires supervisors

to know more about the businesses they

supervise. It is also an approach that, possibly,

may be at odds with the natural inclination of

some supervisors or regulators to stay quite

removed from the activities and institutions

they monitor. The outcome of the preferred

approach, however, is a much better balance

between prudential objectives and market

efficiency.

As we look to the future of the financial

system, and to the development of prudential

standards over time, there is no doubt that

this approach of utilising institutions’ own risk

measurement and management systems, and

of requiring the management and Boards of

institutions to vouch for the adequacy of those

systems, must be the way forward.

As mentioned earlier, the Wallis proposals

for a single prudential supervisor also turned

very much on the idea that the process of

financial intermediation, and financial services

more generally, was blurring and becoming

less distinct. The implication is that the

supervision of different types of financial

entities should be more consistent and

integrated within a single agency. There are a

couple of dimensions to this. At the simplest

level, while the broad policies applying to what

we currently define as banks and building

societies can be reasonably aligned, the

supervisory approach adopted and the

techniques applied to an intermediary with a

balance sheet of $150 billion will be quite

different from the situation where a balance

sheet of $50 or $100 million or less is involved.

I think that point is well understood.

Integrating supervisory approaches applied

variously to deposit-takers or intermediaries,

traditional forms of insurance and

superannuation will be very complex. There

is a real opportunity, however, for APRA to

smooth out some of the regulatory

inconsistencies which currently exist between

banks and insurance companies especially.

Not all of these inconsistencies will be capable

of being ironed out, simply because of the

nature of the different sorts of businesses

conducted by banks and insurance companies.

The practical task will be to look for the areas

of commonality between deposit-takers and

insurance businesses especially, and develop

consistent policy where it is possible. That

should be an early priority for the new

regulatory agency.

The new framework should handle

conglomerates more neatly than at present,

but bringing different institutions under one

regulatory roof should not be allowed to

disguise differences in underlying

characteristics of the various institutions or

the products they offer. APRA should work

hard to spell out the boundaries between

financial instruments offer ing capital

guarantees and the market-linked returns

found more frequently in the superannuation

area. Those distinctions are likely to remain

over the long term. It will be important to

ensure that any confusion in the mind of the

investing public between these product

boundaries is not accentuated by the presence

of a single prudential authority covering

banking and superannuation.

I want to say something about supervisory

philosophy because, ultimately, I think it is

the key to achieving effective supervision.

Whether it is in relation to the style of

supervision, or the policies applied, or the

approach to integrating supervisory

arrangements across different types of

institution, the model has to be forward

looking and innovative. I would summarise

all this by saying that APRA should be very

much a policy-driven, not process-oriented,

agency. Analytical effort is central to the task,

which will require it to invest in a significant

financial research capability. That last point

will come as a surprise to some who would

not normally associate supervision and

regulation with a strong research focus.

Research, policy and good supervision are

inextricably linked. I would go as far as to say

that in a dynamic financial system, supervision

is likely to be ineffective and generate

significant financial inefficiencies unless it is

backed up by high-level research and

analytical effor t focusing on broad

developments in the structure of the financial

system, trends within financial institutions,

financial markets and the interconnections

between them. The characteristics of emerging

financial products and instruments need to

be understood and leading edge work must

be done in the area of risk measurement and

management and in the modern finance

theor ies which increasingly underlie

developments in this field.

Only by carrying out work of this nature

can supervisors be attuned to emerging

developments in the system and be capable

of responding accordingly. Only through an

emphasis on research, and the spreading of

the resulting work into the closely related

policy area, and then into the operational sides

of the institution as a whole, that you can

guarantee that supervisors will be credible in

the eyes of the people they deal with day-today

– the supervised institutions. There is a

good deal of evidence to back this view. Come

the end of this year, the Reserve Bank will be

one of the few banking supervisor s

internationally to implement the internal

models approach to traded market risk. The

reason I believe we will be in a position to do

so links back to the research work carried out

on market risk, financial instruments, evolving

risk methodologies, and so forth, over the past

four or five years. Some overseas supervisory

agencies that have not devoted resources to

market related analytical and research

activities are lagging the field. The problem,

of course, is that the institutions they supervise

are not lagging, the effect being that regulatory

arrangements are holding back the market and

creating inefficiencies.

As I mentioned a little earlier, these

approaches we have applied to traded market

risk, involving the use of sophisticated models

and reliance on more r igorous r isk

management frameworks, will come to be

applied to other forms of risk (credit risk,

operational risk, etc.) and to institutions other

than the banks. APRA should have the

capability to deal with those eventualities.

I will conclude with the thought that there

is now a very strong commitment within the

Australian regulatory community to APRA

and to ensuring that it becomes a first-rate

prudential supervisor capable of handling the

issues likely to be confronted within the

financial system over the next decade. Success

as a prudential supervisory agency will not

flow solely, however, from the re-organisation

of functions between the current set of

prudential regulators. Rather, it will be a

product of the development of an

appropriately flexible market-oriented

philosophy within the new authority. A

dynamic, policy-driven institution, feeding off

strong research capabilities which, in turn,

feed into equally robust operational areas, will

achieve the objectives set for it by the Wallis

Committee and the Government.