APRA's Framework for Prudential Supervision

Having examined the Australian risk-based model at a micro level, it is appropriate to analyse the wider Australian prudential supervisory framework at a macro level. APRA's mission is to 'establish and enforce prudential standards and practices designed to ensure that, under all reasonable circumstances, financial promises made by the institutions APRA supervises are met within a stable, efficient and competitive financial system' (Australian Prudential Regulatory Authority 2013b). This mission statement underpins the principle that the boards of directors of the regulated organisations are ultimately responsible for their financial failures. APRA uses a risk-based, principles-based and outcomes-focussed style of regulation. Such a combination means that APRA can allocate resources effectively to high risks organisations and concentrate on the end results and tailored outcomes rather than the processes used. The unique regulatory style is an affirmation of APRA’s values. APRA's Framework for Prudential Supervision contains five important values: foresight, accountability, collaboration, integrity and professionalism (Australian Prudential Regulatory Authority 2013b). In pursuing these values, APRA is committed to provide consistent, high- quality supervision in a fair and balanced manner.

There are three principal stages of prudential supervision in Australia. They are: licensing, ongoing supervision and enforcement (Australian Prudential Regulatory Authority 2013b).

137 The first stage of licensing ensures that potential organisations can meet the prudential standards as well as having the ability to operate in Australia. Licensing is a robust process where APRA’s supervisory and risk specialists review applications from potential organisations. APRA tries to achieve consistency in its licensing process by setting up a cross-divisional licensing committee. Ongoing supervision takes up most of APRA’s time because APRA monitors the regulated organisations in the long-term to ensure that they are financially viable. PAIRS and SOARS provide APRA with a good set of risk analysis and supervisory response. As soon as APRA identifies the risks, it will act and provide appropriate supervisory solutions. APRA only uses enforcement measures when a regulated organisation encounters serious financial problems. If APRA issues an enforcement measure, the regulated organisation will either try to carry on trading under the ongoing supervision of APRA or if the financial problems are too grave, then APRA will supervise the winding-up of the regulated organisation (Coleman 2008).

APRA’s framework for prudential supervision is guided by three principles: flexibility; efficiency and effectiveness. APRA as the financial regulator has to adapt to changes in financial services and technology, so flexibility is important to the survival and reputation of the regulator. Flexibility is often combined with consistency when APRA decides whether it gives its approval to certain activities to be carried out by the regulated organisations. In addition, diagram 8 shows that APRA will construe legislation, prudential standards and guidance when conducting a risk assessment of the supervised organisation. APRA can make structural or prudential approvals. Structural changes can arise through a merger, a sale of business or internal restructuring. Structural changes can affect the staffing and the future financial viability of the business. Prudential approvals are given by APRA to supervised organisations in areas such as capital adequacy and operational risks.

138 Diagram 8: APRA’s Framework for Prudential Supervision (2013)

The principle of efficiency is to avoid any overlaps, which was a problem for DID and SID within the APRA initially when there was no common language or consistent risk-based supervisory framework. Efficiency is one of the key words mentioned in APRA’s mission statement. It fits in with APRA’s regulatory style based on risks, principles and outcomes because high risks organisations are given more resources and supervision so that risks are better managed and contained. APRA’s supervisory style and framework received positive feedback in the APRA Stakeholder Survey 2013. The survey was distributed to 312 regulated organisations and contains 45 rated items. Respondents had to give a rating of 1-5, where 1 means ‘strongly disagree’ and 5 means ‘strongly agree’. The response rate was 57.4% (Australian Prudential Regulatory Authority 2013a). From the survey, 24/40 items had 75% or more positive responses. Diagram 9 shows that the best scores were given to staff’s attitude at APRA; the single supervisory team for group companies; communication methods; prudential framework and enforcement of prudential requirements. These high scores confirm that APRA has addressed the weaknesses of structure, staff, resources and prudential regulation highlighted in the HIH Royal Commission Report and the Palmer Report. It is encouraging to see that the APRA framework for prudential supervision is considered as effective in achieving its mission.

139 Diagram 9: Strengths of APRA

140 Diagram 10: Weaknesses of APRA

Source: APRA Stakeholder Survey 2013

Conversely, weaknesses of the APRA are highlighted in diagram 10. The main weaknesses are first, the lack of consistency in supervision. Consistency is important to achieve effective enforcement. Secondly, the respondents did not think that there was successful haramonisation of the prudential framework across the regulated industries. Finally, the cost of regulating the indusry seems to have been neglected by APRA. This does not pursue the principle of efficiency or the APRA’s regulatory style based on risks, principles and outcomes. With regards to the APRA prudential framework, the respondents in general, believed that PAIRS provided a good reflection of their organisation’s risk profile. This criterion achieved a mean average of 3.8. With supervision, the respondents provided good scores for the risk-based and forward-looking supervisory approach. However, some respondents felt that APRA was more prescriptive than relying on principles in their supervision. A comparison between the results of 2011 and 2013 illustrate that APRA should focus on the following areas: improvements to a single supervisory team for group companies; more on principles than on prescription; better harmonisation of prudential standards across the regulated industries and be cost-effective (Australian Prudential Regulatory Authority 2013a). Diagram 11 illustrates these points:

141 Diagram 11: Comparison of APRA stakeholder results between 2011 and 2013

Source: APRA Stakeholder Survey (2013)

Overall, it is submitted that APRA has made significant improvements to its regulatory and supervisory structure as well as framework. The generally positive results from the APRA Stakeholder Survey 2013 confirms that APRA is doing its job and is well-received by the regulated organisations. APRA is able to identify risks and its PAIRS model has been identified as generally accurate. APRA’s supervisory responses are well supported by its single supervisory team, although APRA can focus more on principles than prescription. The eternal conundrum of balancing costs with effective regulation and supervision remains to be solved by APRA. Many respondents mentioned that the implementation of Basel III created

142 additional costs on banks to comply with such regulation (Australian Prudential Regulatory Authority 2013a). Banks argue that increasing capital levels also add to additional compliance costs. However, Admati et al submits that bank equity is not expensive. This is because banks, which are better capitalised, have fewer incentives to take excessive risks and are less affected by distortions created by ‘debt overhang’ (Admati et al. 2010). ‘Debt overhang’ refers to the condition that banks have so much debt that they have to decline further debt even though it may be profitable enough to decrease its overall indebtedness. Admati et al (2010) also argued that ‘better capitalised banks suffer fewer distortions in lending decisions and would perform better’. Yet, looking at the UK banking scene of 2013 provides some clues of the impact of regulation. Increasing the amount of liquidity and capital of banks make lending to business more expensive, since banks have to increase the amount of assets to hold against the loans. This is particularly difficult for smaller banks, where the Co-operative Bank had to stop lending to businesses and Nationwide are delaying business lending until 2016 (Ahmed 2013) It has been suggested that to reduce lending costs, banks should increase contestability and search for alternative financing models (Ahmed 2013). Contestability involves measures such as making it easier for customers to change accounts whilst alternative funding models include peer-to-peer lending. This will be analysed in greater detail in Chapter seven.

6.6 Divergence or convergence between the UK and Australian prudential supervisory