Protecting taxpayers from systemic risk should be at the heart of APRA changes

Had it come out five years ago, APRA’s consultation paper could have left taxpayers footing the bill for BankWest’s collapse in 2008. AAP

At first glance, a consultation paper released by Treasury last week aimed at strengthening the crisis management powers of the Australian Prudential Regulation Authority, could pass for a routine tidy-up of legislative detail.

But amidst the mundane detail are several explosive proposals that could actually leave taxpayers at greater risk of picking up the cost of a bank bailout, while ignoring growing international research on how best to deal with systemic risk in the banking system.

The consultation paper, called “Strengthening APRA’s Crisis Management Powers”, purports to develop ideas on how APRA could resolve problems arising from a future financial crisis.

Much of the 200 page document reads like a shopping list of changes APRA obviously feels necessary to tidy up the fringes of banking, insurance and superannuation legislation.

For instance, almost 100 pages is devoted to detailed legislative changes to APRA’s mandate to cover, for example, the introduction of the new MySuper regime.

However, hidden in the detail there is a proposal to give APRA the power to suspend “continuous disclosure” requirements.

Continuous disclosure is essential to the proper functioning of efficient financial markets, and suspending these requirements would place one set of shareholders (for instance, bankers) in a more favourable position than others (e.g. ordinary shareholders).

The Treasury paper recognises disclosure as “fundamental to market integrity and investor protection” but nonetheless, justifies this draconian proposal because “the disclosure of the entity’s distress before APRA and the Government have had the opportunity to develop options for resolution is likely to exacerbate the distress situation”.

But in what situation, other than regulatory incompetence, would such distress come as a surprise to a regulator whose job is, after all, to anticipate and head off such an eventuality?

One can just imagine the multiple investor class actions there would be the first time that such an exception was invoked. And of course, the taxpayer, rather than the regulator, would be on the hook for any settlements arising from such litigation.

This, however, is not the only draconian power being ceded to APRA in the proposals. For example, in the section entitled “The Financial Claims Scheme”, where taxpayers are on the hook for a failure of a bank or insurer, it is proposed that, rather than at the discretion of an elected minister, the FCS would be activated automatically when APRA applied for a winding up of a firm.

The paper does refer to consultation between the Treasurer and APRA on these matters but nonetheless raises the issue of Moral Hazard, whereby banks and insurers may choose to invoke the insolvency path, sooner rather than later, safe in the knowledge that the taxpayer will be automatically forced to pick up the bill.

This is not a mere academic debating point. Take, for example, the acquisition in 2008 of BankWest by CBA at a knockdown price of some $2 billion, after its parent, HBOS, was forcibly taken over by the UK government during the GFC.

In future, why would any bank bother taking over a distressed rival? Just allow the rival to go insolvent, let the taxpayer pick up the costs through the FCS and then buy the carcase for a dollar.

But what the Treasury paper says is less interesting than what it does not say.

In a summary of international actions to improve banking supervision, the report concentrates on “resolution frameworks” - or so-called “living wills” - whereby banks are required to plan ahead for their own funerals (rather than let the family pick up the bills).

Earlier this year, the first batch of these “resolution roadmaps” was released in the USA, to lukewarm reviews.

Far from being ahead of the game, the first set of wills from Australian banks are rumoured to be in the pipeline, but their exact purpose remains somewhat dubious.

What the Treasury paper fails to point out is a large body of work being done overseas on how to attack so-called “systemic risk”, or the risk that problems in one bank will cause others to fail.

The conclusion arrived at by other governments is that systemic risk should be handled by specialised “macro-prudential” regulators. The new Treasury proposals overwhelmingly address not “macro” but “micro-prudential” regulations - or how APRA should interact with individual firms. There is nothing addressing the important subject of system-wide macro-prudential regulation, except by implication.

In Europe, the European Systemic Risk Board (ESRB) has been created to look across the region’s financial system as a whole, leaving national regulators to concentrate on regulating individual firms.

In the UK, the existing banking regulator, the FSA, has been broken up with new systemic responsibilities being given to the Bank of England. In the USA the issue is as yet unresolved but there is a very thoughtful debate on the need for new macro-prudential regulatory structures.

In Australia, there is nothing. Unlike regulators around the world, APRA has yet to publish a research paper on this critical issue.

Partly this is because APRA prides itself on taking a systems-wide view already, but also maybe it is because the approaches taken by other regulators pose a threat to its current structure?

Does Australia have systemic risk? Most decidedly, yes! The Australian banking system is strong for many reasons, not least the Four Pillars structure, which assumes that not all of the four major banks will fail at the same time.

But one of the lessons from the GFC is that banks do not have to become insolvent to be at risk. In extreme circumstances, there will be a “flight to quality” and banks with the same business model as a failing bank will, as in Ireland, come under undeserved but severe pressure.

The major banks in Australia all have the same fundamental business model and if one is under attack by speculators, the others will almost certainly be tarred with the same brush.

The failure of one of Australia’s major banks would be very painful to the economy; the failure of more than one - or all four - would be catastrophic, which is why governments would always choose to step in to prop them up in a crisis.

Does Australia need a specific regulator to address systemic risks? Because of the potential economic costs of systemic failure, probably - yes. But who should the systemic regulator be?

Other governments have concluded that it is best to separate macro-prudential from micro-prudential regulation, mainly to provide focus, but also because the perspectives and tools used are quite different.

Unless a very clear case is made for the uniqueness of the Australian system, there is a strong argument for a systemic regulator, separate and distinct from APRA, as it is currently structured.

APRA’s scope is enormous. It is not only the (micro) prudential regulator for banks, credit unions, general and life insurers and superannuation funds, it has made a none too subtle pitch in the Treasury proposals to be the new regulator for Financial Markets Infrastructure (FMI), which will in future cover stock exchanges and clearing systems.

But there are already large gaps in the current system. While APRA is the superannuation regulator, the fastest growing segment of super is in self-managed superannuation funds (SMSFs), which is, due to an historical anomaly, regulated by the Australian Tax Office (ATO).

This is clearly unsatisfactory from a systemic risk perspective. Nor is APRA responsible for regulating the so-called “shadow banking” sector, consisting of hedge funds and unregulated finance companies, which was in part blamed for the GFC.

It is easy to criticise regulators when things go wrong, but it must be remembered that financial regulators are chartered by government to perform their roles.

If there is a gap, it is not the regulator’s fault; it is the government’s. Regulation is just one (albeit very important) part of the banking system and in order to improve regulation government needs to consider the banking system, as a whole.

As I have written before, this is best done by a broad banking inquiry initiated by government, rather than piecemeal tinkering at the edges.