THE ROLE OF SUPERVISION IN SEEKING A BALANCE
BETWEEN SAFETY AND EFFICIENCY
WAYNE BYRES
Executive General Manager, Diversified Institutions Division
Australian Prudential Regulation Authority
Paper presented to the UNSW Australian School of Business Conference on
Systemic Risk, Basel III, Financial Stability and Regulation
28 June 2011, Shangri-La Hotel, Sydney
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THE ROLE OF SUPERVISION IN SEEKING A BALANCE BETWEEN
SAFETY AND EFFICIENCY1
Thank you for the invitation to be part of this opening session: I‟m very pleased to
be able to be part of such an impressive program.
This morning I want to talk about balance, and the role that effective supervision
can play in the balance between safety and efficiency.
Much of the debate about the regulatory reform agenda post-crisis, both
internationally and here in Australia, has been about balance: the cost of financial
instability on the one hand, versus the cost that regulation to avoid instability
imposes on the other.
We know that it is pointless to create a zero risk financial system. A zero risk
system will have zero activity, and therefore generate zero value. On the other
hand, history tells us a zero constraint financial system will inevitably lead to
significant instability – certainly beyond the tolerance of the community to bear.
The ideal balance is obviously somewhere between zero constraint on risk, and
absolute prohibition of risk. As regulators, we seek to balance the financial safety
that we desire for the community with the costs that we impose to achieve that
safety.
But there‟s another debate on balance that is also important, although getting
much less attention. That debate is the balance to be found between better
regulation and better supervision. Indeed, I need no better evidence that the
value of supervision is often forgotten than its absence from the lengthy name of
this conference!
For today‟s purposes, I define „regulation‟ as the sum of the legislation, prudential
standards, and guidance material available to and produced by agencies like APRA.
In broad terms, these are the rules. „Supervision‟ is often defined as the process
by which we seek to ensure that regulated firms stay within the rules. Under such
a definition, regulation is the key, with supervision acting to police the regulations.
I suspect this is the view held in many parts of the world: that regulation is the
primary tool that ultimately determines the stability of the financial system, and
supervisors will play a secondary role by ensuring compliance with it. It is perhaps
best summed up by one foreign supervisor, who recently noted when asked to
describe his agency‟s supervisory approach prior to the financial crisis: “if
something is not prohibited by the rules, it‟s OK.”
APRA applies an alternate philosophy: we believe no set of rules can adequately
and efficiently deal with a system as complex as a financial system. Our approach
views supervision as the primary means by which we can promote long-term safety
and soundness of financial institutions. So we endeavour to establish regulation
that supports supervision, and then seek to use balanced supervision as the key to
long term financial safety and stability. We also expect this approach, which can
be tailored and take account of nuances and subtleties in individual circumstances
in a manner a rulebook cannot, will be more flexible and responsive, and therefore
hopefully less costly, than „regulation-first‟ philosophies.
1
I would like to acknowledge the significant contribution of my colleague Charles Littrell (APRA‟s
Executive General Manager, Policy Research and Statistics) to this paper.
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A prudential supervisor has two critical functions. First, it strives to identify the
risks emerging within each of its regulated flock, and more broadly at the industry
and economy level. Second, it must intervene as necessary to ensure that its
regulated firms protect themselves from all reasonably foreseeable risks, so that
they will be able to meet their financial promises in all reasonable circumstances.
To be successful, the supervisor requires a great deal of competence in risk
assessment, and an effective regime of supervisory intervention (which in turn
requires both an ability, and a willingness, to intervene – again, regulation is not
enough on its own).
Is there an optimal balance of competence and intervention? Can a supervisor with
a high degree of competence afford to be less interventionist? On the other hand,
can a supervisor with a high propensity to intervene at the slightest sign of trouble
afford to be slightly less concerned with the accuracy of its risk assessments?
This chart provides a neat way
of summarising where we see
the right balance.
On the
vertical axis is the degree of
competence the supervisor has
in risk assessment.
On the
horizontal
axis
is
the
supervisor‟s
propensity
to
intervene in a regulated firm‟s
affairs.
Let‟s start with the worst case
in the lower left corner. Supervisors positioned here have limited competence and
limited ability to intervene, and could reasonably be called ornamental. In this
scenario, a supervisory regime exists but in fact has no practical value. The less
kind would call such a regime useless. In fact, supervisory agencies are often
called useless after a major financial failure or string of failures.
The reality is often more complex. Some supervisors may find themselves in the
upper left corner. That is, they can see the emerging risks, but struggle do much
about them. Supervisors in this position are ineffective; they wring their hands
and fret, but without doing much to change the direction their flock is heading in.
What about if we move towards the lower right corner? Here we get intervention
that will be increasingly frequent but poorly directed, creating a supervisor that is
unpredictable at best, and dangerous at worst. Much intervention will be
unwarranted, but without any guarantee that material risks will be detected and
averted.
Having ruled out the other three corners as unsuitable, I‟m afraid the top right
corner is unsuitable for day-to-day supervision as well. The top right corner I‟ve
characterised as dictatorial, and generally is not the optimal setting either.
Unless you think supervisors are generally better qualified to run regulated firms
than their Boards and management – which I do not – then the upper right corner is
not the place to position a supervisory system either.
My experience suggests that a supervisor should seek to adopt a balanced position,
combining a high degree of competence in risk assessment with continuous but
generally mild intervention. Very few Boards or executives, after all, run their
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institutions on the basis that they are happy with a material risk of failure. When
our supervisors point out deficiencies in a given firm‟s approach, this is from the
basis of our advantaged position of observing not only that firm but all its
Australian competitors, and also with our focus primarily upon risks and their
management. Most are happy to take this free advice on board and respond
accordingly.
That is not to say we don‟t
sometimes adopt a firmer
approach. Occasionally – and
thankfully only occasionally we encounter a firm run by
people
who
are
less
competent, cooperative, or
honest than we might prefer.
In such circumstances, the
dictatorial approach might
well be needed. But even
here, balance is necessary:
we might still be able to deal
cooperatively with a struggling but honest management team, but a firm run by
competent but dishonest management will leave us no choice but to intervene
quickly and harshly.
How does regulation tie into this model, and our focus upon finding the appropriate
supervisory balance? As it happens, rather neatly.
Good access to information is vital for the supervisory risk assessment process. So
a great deal of APRA‟s regulation is therefore directed to ensuring that our
supervisors routinely receive a wide range of information from regulated firms,
including statistical returns, attestations from responsible persons, audit and
actuarial reports, business plans, capital plans, and the like.
In addition to the large body of regular reports, our regulatory infrastructure also
ensures that supervisors can access, in essence, the same data that is available to
the senior management and Board of each regulated firm. There are some
limitations relating to legal privilege, but these rarely hinder our work.
Furthermore, we can and do require regulated firms and their responsible persons
to produce new data and analyses, when this is necessary for supervisory purposes.
Ease of information access should be taken for granted by prudential supervisors.
In the Australian case, we are fortunate in possessing highly developed information
access powers which, as I have said, are a foundation for good risk assessment.
Among our intervention tools, we possess two that are not necessarily always held
elsewhere, but which turn out to be extremely useful.
The first tool is the ability to set individual capital requirements for regulated
firms.
This tool currently applies to authorised deposit-taking institutions,
including banks, and general insurance companies, and APRA has reforms in process
that will extend this tool to the life insurance sector. My experience is that the
ability to set individual capital requirements under the so-called „Pillar 2‟ approach
to supervisory discretion is a powerful force for change. When a supervisor says,
for example, “we have reviewed your loan loss provisions and are not convinced
they are adequate”, some regulated firms are more responsive than others. When
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the supervisor instead says “we have reviewed your loan loss provisions and you
haven‟t convinced us they are adequate, so your minimum capital requirement will
be increased by 50 basis points until you do”, then effective action is remarkably
facilitated. APRA routinely sets and varies Pillar 2 adjustments for banks, building
societies, and credit unions, and this approach has a good track record. Here
again, however, balance is necessary. APRA neither sets nor varies a firm‟s capital
requirements without careful consideration and a substantial internal review. This
ensures the intervention is based on sound risk assessment, and keeps us in the
balanced, rather than unpredictable, territory on my chart earlier.
The second tool, used far less commonly, is our directions power. Under this
power in the banking and insurance Acts, APRA possesses the broad ability to direct
firms. The trigger for this power is a regulated firm‟s inability to observe its
regulatory requirements, or APRA‟s consideration that the firm is operating
unsoundly, or in a manner that could reasonably lead to its failure. Importantly,
the directions power triggers well before actual or imminent failure by a regulated
firm, so in need our supervisors can issue directions in time to hopefully avert
failure.
The fundamental precept behind the directions power is that at the end of the day,
if there is a material difference of opinion between APRA and a regulated firm,
then APRA‟s opinion is the one that counts. This is clearly an extraordinary power
and is only deployed in exceptional circumstances. This is a good example of the
adage „speak softly, and carry a big stick.‟ The concept that our opinion is the one
that ultimately counts changes the supervisory conversation with firms from
negotiation about whether they will improve, to how and how quickly they will
improve. Sensible managers and directors understand that they never want to put
themselves in this position, so the directions power is valuable, even though it is
seldom used.
This speech‟s topic is the balance between supervision and regulation. As I‟ve
said, our experience indicates that the optimal mix is structured in such a way as
to ensure regulation empowers supervision.
In other regimes, we see instances in which regulation can restrict supervision. For
example, take a rule that says something along the lines of “when a firm‟s capital
falls below a certain level, then supervisors can intervene.” While ostensibly
supporting supervisory intervention, this rule also says, in essence, that as long as
the firm‟s capital is above the critical level, then supervisors can‟t intervene. This
is contrary to the Australian approach, which sanctions intervention whenever the
supervisor, based on a thorough risk assessment, considers it necessary.
Of course, there is a risk that supervisors could overuse their powers, and could
become dictatorial when there is no reason to do so. But the global experience of
recent years has demonstrated that the risk of overly empowered supervisors is
very much less than the risk of insufficiently supervised financial institutions. And
certainly in APRA‟s case, there are external appeal mechanisms for a firm that
wants to challenge our decisions, except in the most extreme circumstances.
To be successful supervisors, and to adopt the optimal mix of supervision
empowered by regulation that we advocate, supervisory agencies need three things
from government: sufficient funds to undertake the job, sufficient statutory
powers, and moral support. APRA has been well served on all three fronts.
Amongst the world‟s advanced countries, it is difficult to see any agencies that
were materially under-funded, or that lacked reasonable powers expressed in black
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letter law. Pre crisis, however, there was a large difference in the degree of moral
support given to their activities. This is a critical issue, and I would like to
highlight a quote from the US Financial Crisis Commission to make the point:
“we do not accept the view that regulators lacked the power to protect the
financial system. …. Too often, they lacked the political will – in a political
and ideological environment that constrained it – as well as the fortitude
to critically challenge the institutions and the entire system they were
entrusted to oversee.”2
In short, all the funding and legislative power in the world won‟t help a supervisor
prevent financial failures if the supervisor lacks the self-confidence to undertake
early, constant, and effective intervention.
Prudential regulators often state that financial failures are inevitable. This is true,
but the frequency and impact of failure can be greatly improved by effective
prudential regulation and supervision. Please don‟t take my message today the
wrong way: I believe that strong regulation is an essential pre-condition for
financial stability and institutional safety. But it must also be the right sort of
regulation: that is, it must empower and not inhibit active prudential supervision.
The reaction globally to the GFC has, to date, largely been focussed on regulation:
a push for more and higher quality capital, restrictions on proprietary and
derivatives trading, and a greatly enhanced regulatory regime for liquidity risk.
APRA supports the need for, and the direction, of this reform agenda. In parts of
the world, supervision clearly did not do its job as well as we might have hoped.
But we need to be wary of an outcome which says we should have more rules to
deal with supervisory inadequacies. And it is outright dangerous if it leads to the
view that more rules will allow a weak and non-interventionist supervisory regime
to be continued. Rather, now that we have broken the back of the major
regulatory reforms, we should think hard about the optimal mix of regulation and
supervision, and make sure we have the right sort of regulation to empower our
supervisors into the future.
Thank you for your attention, and I look forward to the remainder on the
conference.
2
Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the
United States (January 2011), p. xviii