The majority of the value of Australia’s financial service exports are banking and insurance services (chapter 3), which are subject to prudential oversight by APRA. Many of Australia’s largest banking and insurance groups operate across several international jurisdictions. The ANZ (sub. 23) operates in 15 markets in Asia including India, China and Indonesia. Similarly, Westpac operates throughout the Asia–Pacific, and has operations in markets including the United Kingdom and the United States (Westpac 2015). Insurance Australia Group (sub. 10) has operations in China, India, Malaysia, Thailand, Vietnam and New Zealand, and QBE insurance has about 70 per cent of its premium income sourced from outside Australia (FSI 2014b).
APRA supervises deposit taking institutions and insurance companies with the intent of promoting financial system stability and protecting consumers of financial products. This regulatory framework is being increasingly driven by international standards (FSI 2014b) (box 6.4). Prudential regulation can include:
• minimum capital adequacy requirements — a regulated institution must maintain a minimum ratio of capital to its total risk-weighted assets
• risk management frameworks — for example, regulated institutions must maintain a board-approved risk appetite statement and risk-management strategy, and must notify APRA of any significant breaches of its risk-management framework
• governance frameworks — for example, regulated institutions must meet specific requirements in regard to board size and composition, and must have an independent chairperson.
Stringency of Australia’s prudential standards
The FSC (sub. 20), the Insurance Council of Australia (sub. 12) and Insurance Australia Group (IAG, sub. 10) raised concerns with APRA’s approach to setting Australia’s prudential regulation framework. Both the FSC and the Insurance Council of Australia raised concerns with capital adequacy requirements for insurers in Australia, noting that APRA has set capital adequacy requirements that are higher than those for Australia’s competitors.
The FSC (sub. 20) recommended that APRA should regularly review capital requirements in the context of promoting international competitiveness. Similarly, IAG (sub. 10) recommended that regulators should be encouraged to take a global view in their considerations. IAG noted that one instance where competitiveness was not adequately considered is in relation to APRA’s view of joint venture investments in Asia, where it excludes almost all the economic value of joint venture investments in its capital adequacy calculations. IAG stated that this decision made expansion more financially difficult for Australian insurance companies relative to EU and US companies.
The costs and benefits of modifying prudential regulation
As noted by the IAG (sub. 10) there are tradeoffs when balancing the objective of promoting financial integrity against the need to minimise any adverse effects on competition and efficiency. Changes to prudential regulation to address the FSC’s and IAG’s concerns about international competitiveness would have ramifications that are broader than those specific to service exports and should be assessed in a manner that gives appropriate consideration to communitywide effects. For this reason, and because prudential regulation was considered in the Financial System Inquiry in 2014, the Commission has not made any recommendations or findings regarding prudential regulation in this study.
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Box 6.4 International standards for prudential regulation Basel Committee on Banking Supervision
The Basel standards on the prudential regulation of banks were first agreed in 1988 (Basel I) and are currently being updated through the Basel III standards. The Basel standards include standards for banking regulation in relation to:
• minimum capital requirements
• supervisory review processes
• measurement of risks in relation to securitisation and trading book exposures
• liquidity requirements
• frameworks for ‘systemically important’ banks.
The Basel committee published a report on 28 of its member jurisdictions (including Australia), which indicated that all have adopted the standards (to varying degrees) (Basel Committee on Banking Supervision 2015). The Basel standards have also been implemented by many countries (also to varying degrees) that are not members of the Basel Committee (FSI 2015).
International Association of Insurance Supervisors
The International Association of Insurance Supervisors (IAIS) was established in 1994 and represents insurance supervisors in nearly 140 countries. The purpose of the IAIS is to promote effective and globally consistent regulation of the insurance industry, and contribute to global financial stability.
The IAIS has standards across 26 areas of insurance regulation. The adoption of these standards by member countries varies.
• Insurance Core Principle (ICP) 1 relates to the objectives, powers and responsibilities of the supervisor — including that the responsible authority and its objectives are clearly defined in legislation, and that these objectives promote a fair, safe and stable insurance sector. Of 82 jurisdictions surveyed in 2013, all observed or largely observed this standard.
• ICP 2 relates to ensuring that the supervisor is independent and transparent, has adequate resources and meets high professional standards. Of 82 jurisdictions surveyed in 2013, all either largely observed or partly observed this standard.
• ICP 23 requires that the supervisor supervises insurers on a group-wide basis. Most jurisdictions surveyed in 2013 either partly observed or did not observe this standard (IAIS 2013).
In 2012 the International Monetary Fund noted that Australia had, in general, a high level of conformance with the IAIS principles. The Fund made several recommendations designed to increase Australia’s conformance with the principles, such as restricting the ability of Government minsters to give directions to APRA or ASIC on supervisory policy (IMF 2012b).
The Commission considers that prudential regulation should not be set solely on the basis of maintaining or increasing international competitiveness of Australian providers. The costs of complying with regulation should be a consideration for APRA when setting prudential regulation, alongside other factors such as the stability of the Australian financial system and consumer protection. APRA has a conservative approach to
prudential regulation, which it considers has helped to maintain the stability of the Australian financial system, including in relation to the global financial crisis.
… as APRA sees it, its most enduring contribution to the resilience of regulated institutions during the [global financial] crisis came from its efforts to promote their financial health prior to the crisis. Tough decisions were taken in good times, including establishing more conservative … capital requirements relative to overseas peers, developing a risk-based capital framework for general insurers consistent with leading practice globally, and introducing meaningful governance requirements. (APRA 2014, p. 6)
The Reserve Bank of Australia (2014) has also noted that the prudential framework in Australia played an important role in ensuring that the Australian financial system coped successfully with the global financial crisis. Similarly, the International Monetary Fund (2012a) has noted that a proactive response to financial supervision in Australia has helped to maintain financial stability.
There may be scope to improve prudential regulation in ways that could reduce the regulatory burden on Australian firms, while maintaining the stability of the financial system. The Financial System Inquiry concluded that there was no evidence to suggest that Australia’s compliance burden is larger than in comparable jurisdictions overseas, but made recommendations to improve Australian regulatory processes. Of most relevance to financial service exports, the Inquiry recommended that the state of competition in the financial sector should be reviewed externally every three years, including identifying barriers to cross-border provision of financial services. The Inquiry considered that the effects of regulatory proposals on competition should be explained explicitly in consultation documents and annual reports (FSI 2014a). Implementing this recommendation would help to identify any barriers to financial service exporters imposed by prudential regulation.
Differences in prudential regulation across countries
As noted above, there are international standards in place for the regulation of financial services but the adoption of these standards can vary. Many jurisdictions, particularly in Asia, set higher minimum capital standards than is required under the Basel framework (Byres 2013). In assessments of the implementation of the Basel III capital adequacy requirements, the Basel Committee noted that there were material deviations from the Basel requirements in several countries including the United States and the European Union (Basel Committee on Banking Supervision 2014a, 2014b).
Many countries have implemented stringent financial regulation as a response to the global financial crisis, some aspects of which have been identified by participants as imposing barriers to financial service exports. For example the United States implemented the Dodd–Frank reforms as a response to the financial crisis (box 6.5). The Banking Reform Act 2013 in the United Kingdom included reforms to ‘ring fence’ banks whose interruption would have a significant effect on the local economy.
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Similarly, differing regulations across jurisdictions has been an issue raised in the insurance sector. The FSC (2015) noted that India uses a different method to Australia to calculate capital reserves. In addition the FSC (2015) noted that changes to the way unit link insurance products (products where the premium paid covers both insurance and investment in debt and equity instruments) are regulated in India have detrimentally affected the market for life insurance products.
Box 6.5 Dodd–Frank reforms
The Dodd–Frank Wall Street Reform and Consumer Protection Act was adopted in the United States in 2010, and contained several reforms designed to prevent another financial crisis.
These reforms included creating a new independent authority with a consumer protection role, creating a council to identify and address systemic risks imposed by large companies, corporate governance reforms and increasing transparency for ‘exotic instruments’.
The Dodd-Frank reforms led to a rule requiring foreign firms with substantial operations in the United States to establish a US intermediate holding company. This rule was approved by the Federal Reserve in 2014. These holding companies are required to comply with US risk and capital standards established through the Dodd–Frank reforms, including:
• a requirement to employ a US risk officer and risk committee
• entities must have a debt to equity ratio of no more than 15 to 1 if they are considered to be a grave threat to US financial stability
• US requirements in relation to capital adequacy, risk management and liquidity, and conduct liquidity stress tests.
Foreign banks must also comply with the ‘Volcker rule’, which was included in the Dodd–Frank reforms. This rule prohibits commercial banks (with some exceptions) in the US from trading and investing in hedge funds and private equity funds.
Source: Code of Federal Regulations (US), part 252.
Differences in prudential regulation can impede service exports
Submissions to this study, and previous reports, have stated that differences in prudential regulations add to the costs of doing business for financial services firms. For example:
• AFMA (sub. 14) stated that inconsistent regulation of financial services is a barrier to service exports, and highlighted the need for greater regulatory harmonisation.
Similarly, APEC (2012) stated that inconsistent regulation of financial services can impose onerous costs on businesses with cross-border operations
• ANZ (sub. 23) noted that prudential standards vary greatly across jurisdictions in the Asian region, which can restrict market entry and, in some cases, entrench existing domestic banks’ positions
• the Australian Bankers’ Association (2014) has highlighted the Dodd–Frank reforms as adding to compliance costs — in particular, it highlighted the ‘Volcker rule’ (box 6.5) as having considerable compliance costs and burdens for Australian banks
• Byres (2013) noted that regulatory consistency can have benefits, including supporting cross-border trade by promoting international financial markets. He also noted that moves toward ring fencing risk introducing a degree of fragmentation in global markets
• the Financial System Inquiry stated that divergent international regulatory requirements
‘increase compliance costs, create legal risk and limit the costs efficiencies of scale businesses’ (FSI 2014b, p. 4-93).
Costs and benefits of greater consistency in prudential regulation across countries The key benefit of addressing regulatory inconsistencies in prudential regulation across countries would be a reduction in costs (both upfront and ongoing) for financial service providers that are currently required to comply with both foreign and Australian regulatory requirements. In addition, to the extent that simplifying cross-border regulation leads to a greater international presence for Australian financial service providers, there may also be benefits for other Australian exporters that require financial services to support their activities (FSI 2014b).
In some cases there are legitimate reasons for prudential frameworks to differ across jurisdictions — full regulatory consistency is unlikely to be optimal. For example, as noted above, Australia’s more conservative approach to financial regulation was cited as beneficial in the context of the global financial crisis. Byres (2013) noted that variation in prudential regulation can be optimal as different financial systems are at different stages of development, financial regulation needs to be blended with tax, accounting and legal frameworks, and there is a need to adjust regulatory arrangements to account for different risks across jurisdictions.
There are limited policy tools available to the Australian Government to achieve greater regulatory harmonisation (FSI 2014b). Where possible, there would be benefits in the Australian Government working in relevant international forums to achieve greater regulatory consistency, while being mindful of the need for jurisdictions to tailor prudential regulation. General approaches to achieve greater regulatory consistency are considered in chapter 9.