Council of Financial Regulators Annual Report – 2001 2. Australia's Financial Regulatory Framework

Summary of Framework

Australia's current financial regulatory framework, the main elements of which were introduced on 1 July 1998, arose out of the findings of the Financial System Inquiry (the Wallis Committee). The Inquiry recommended wide-ranging reforms to the structure of financial regulation, designed to achieve a more competitive, efficient and flexible financial system.

The regulatory framework consists of three agencies, each with specific functional responsibilities:

• the Australian Prudential Regulation Authority (APRA), which has responsibility for prudential supervision;
• the Australian Securities and Investments Commission (ASIC), which has responsibility for market integrity and consumer protection across the financial system; and
• the Reserve Bank of Australia (RBA), which has responsibility for monetary policy and for overall financial system stability.

The Australian Prudential Regulation Authority is an integrated prudential regulator responsible for deposit-taking institutions (banks, building societies and credit unions) as well as friendly societies, life and general insurance and superannuation.^[1] APRA is charged with developing prudential policies that balance financial safety and efficiency, competition, contestability and competitive neutrality.

Deposit-taking institutions are regulated by APRA under a single licensing regime and are covered by the same ‘depositor preference’ provisions of the Banking Act 1959. This legislation gives APRA the power to act decisively in the interests of depositors, including the power to revoke licences, to make prudential standards or issue enforceable directions, to appoint an investigator or statutory manager to an authorised deposittaking institution (ADI) in difficulty or take control of the institution itself. If the difficulties prove intractable, APRA has the power to wind-up the institution and

Under the ‘depositor preference’ provisions of the Banking Act 1959, depositors have first claim to the assets of an ADI in a wind-up. To support depositors' interests, all ADIs are required to hold assets in Australia at least equal to their deposit liabilities in Australia. These arrangements, however, do not confer any form of guarantee of depositors' funds, and depositors have no recourse to APRA or the Government.

As in the case of ADIs, where the financial weakness of a life company, general insurer, friendly society or superannuation fund could have a detrimental effect on the interests of members and policyholders, APRA may intervene in the management of the troubled entity. In the case of superannuation, the Treasurer can compensate members of a fund for losses due to fraud, either from Consolidated Revenue or by levying other funds within the industry, where such compensation is judged to be in the public interest. Again, however, members' and policyholders' entitlements are not guaranteed by either APRA or the Government.

The Australian Securities and Investments Commission administers and enforces a range of legislative provisions relating to financial markets, financial sector intermediaries and financial products, including investments, insurance, superannuation and deposit-taking activities (but not lending). ASIC's aim is to protect markets and consumers from manipulation, deception and unfair practices and, more generally, to promote confident participation in the financial system by investors and consumers. With this in mind, ASIC also seeks to promote honesty and fairness in company affairs and securities and futures markets through adequate and timely disclosure of market information. ASIC also:

• develops policy and guidance about the laws which it administers;
• licenses and monitors compliance by participants in the financial system; and
• provides comprehensive and accurate information on companies and corporate activity.

As part of its consumer protection role, ASIC also monitors and assesses compliance with the Code of Banking Practice, the Credit Union Code of Practice, the Building Society Code of Practice and the Electronic Funds Transfer Code of Practice. ASIC also supervises a number of industry-based alternative dispute resolution schemes.

ASIC will also implement the provisions of the Financial Services Reform Act 2001 which introduces a new financial services disclosure and licensing regime.

The Reserve Bank of Australia has responsibility for monetary policy and for overall financial system stability. The RBA no longer has an obligation to protect the interests of bank depositors; rather, its task is to deal with threats to financial stability that have the potential to spill over to economic activity and consumer and investor confidence. In the event of such threats, the RBA retains its discretionary role of ‘lender of last resort' for emergency liquidity support. If it were to provide such support, the RBA's preference would be to make funds available to the market as a whole through its domestic market operations. In certain circumstances, however, the RBA would be prepared to lend directly to a financial institution facing liquidity difficulties. The institution would have to be one supervised by APRA; would have to be solvent; and the failure to make its payments would have to pose a threat to overall financial system stability. APRA's judgments about the fundamental soundness of a financial institution in distress would be critical to any RBA support.

The RBA, under the auspices of its Payments System Board, also has a mandate to promote the safety and efficiency of the Australian payments system, and has the backing of strong regulatory powers. If the RBA, for example, assesses there is scope to improve access to, or the efficiency or safety of, a particular payment system, it can ‘designate’ that system as being subject to its regulation. It may then, in the public interest, impose an access regime on that system and/or set standards for efficiency or safety. The Government envisaged that these powers would be exercised within a broad co-regulatory approach, with safeguards for private-sector operators. The RBA also remains responsible for conducting Exchange Settlement Accounts for participants in the payments system and in 1999 it announced new arrangements that liberalised access to these Accounts.

Annual Reports and Internet sites of the individual Council members (see page 22) contain further details about their responsibilities and activities.

Developments in the Regulatory Framework

Since its establishment, APRA has given priority to developing a more integrated and harmonised supervisory framework for ADIs, and a comprehensive framework for the prudential supervision of conglomerate groups that include an ADI. These frameworks are now largely complete.

APRA has also undertaken a significant overhaul of the prudential framework for the general insurance industry, which had been little changed since the Insurance Act 1973 was introduced. The emergence of substantial losses in the industry over recent years reinforced the need for reform and added urgency to the process. Accordingly, APRA developed, published for comment and, following industry consultation, recommended to the Government a comprehensive and modern set of reform proposals for the prudential supervision of general insurance companies. These proposals were approved by the Government in November 2000 and amendments to the Insurance Act 1973 to give effect to new prudential standards were passed by Parliament in August 2001. The final new prudential standards were tabled in Parliament in February 2002 and come into force on 1 July 2002. Some key aspects ofthe new standards follow.

Under the previous regime, general insurers had considerable discretion in how they valued their insurance liabilities. APRA's new Liability Valuation Standard seeks to ensure that insurers value their insurance liabilities in a realistic and consistent manner, drawing on written advice from an approved actuary. The Board of Directors of an insurance company will have the power to override the actuary's advice but should disclose this in the company's published annual financial accounts. The standard also requires that insurers include a risk margin to ensure that the value of insurance liabilities is established at a sufficient level.

The Capital Adequacy Standard aims to ensure that insurers can meet their insurance obligations under a wide range of circumstances by maintaining at least a minimum amount of capital. The standard defines the minimum capital requirement to be at least $5 million (up from $2 million); above $5 million, regulatory capital requirements are risk-based. Insurers writing long-tail liability business, for example, face greater uncertainty and need more capital than do those writing short-tail property business. The standard will mean an increase in regulatory capital requirements on average, but the industry as a whole already holds a significant buffer of capital over the minimum requirements.

The Risk Management Standard aims to ensure that an insurer is well managed, has access to appropriate independent advice and has systems for identifying, managing and monitoring risks. The Board of Directors of an insurer must develop a risk management strategy aimed at mitigating all material financial and operational risks. Each insurer also needs to ensure that persons occupying key positions have the degree of probity and competence commensurate with their responsibilities. The standard sets out various requirements as to the composition of the Board and Audit Committee. In addition, each insurer must provide APRA with an annual Board Declaration certifying that it has complied with all relevant legislative and prudential requirements and addressed all material risks.

Under the Reinsurance Arrangements Standard, the Board of Directors of an insurer must develop, implement and maintain a high-level reinsurance management strategy appropriate to the operations of the insurer. The strategy needs to have regard to diversification and the creditworthiness of counterparties and consider the extent and use of financial reinsurance and alternative risk transfer products.

APRA's new liability valuation and capital adequacy standards are aimed at strengthening the ability of general insurers to meet their policyholder obligations, while the new risk management and reinsurance standards are aimed at good governance. In combination, the new prudential standards should significantly reduce the likelihood of failures in the general insurance industry.

The appropriate regulatory framework for superannuation became a major reform issue in 2001. The triggers were financial losses experienced by a small number of superannuation funds and a growing recognition of the need to improve existing legislative and prudential arrangements to deal with weaknesses, in particular, in small and medium-sized funds.

Early in 2001, amendments to the Superannuation Industry (Supervision) Act 1993 (SIS Act) gave APRA an array of more effective enforcement options. Various ‘fault liability’ offence provisions, where the prosecution needed to prove that an act or omission was reckless or deliberate, were changed to ‘strict liability’. APRA now has the power to declare persons to be disqualified if they have been associated with breaches of the superannuation legislation of such seriousness or frequency that APRA considers they should be disqualified; persons can also be disqualified if APRA determines that they are otherwise not ‘fit and proper’ to fulfil such roles. APRA also now has the power to accept an enforceable undertaking under the SIS Act. Other amendments improved the capacity of a replacement trustee appointed by APRA to take control of the affairs of a superannuation fund, and make it an offence for persons without the requisite qualifications to claim they are an approved auditor or actuary. APRA has exercised these powers several times and has noted a greater willingness on the part of trustees to address matters of serious concern in a prompt and effective manner.

APRA has contributed significantly to a number of recent reviews and inquiries into the superannuation industry. These include the Productivity Commission's National Competition Policy review of certain superannuation Acts; various reviews by the Senate Select Committee on Superannuation and Financial Services chaired by Senator Watson; and the Superannuation Working Group established by the Federal Government to conduct public consultation in relation to an Issues Paper on ‘Options for Improving the Safety of Superannuation’. In its submissions, APRA has highlighted the challenges it faces in supervising superannuation – in particular, the large number of superannuation funds involved and the lack of some key supervisory powers under the current legislation.

APRA supports the introduction of a licensing regime for all APRA-regulated superannuation funds under which APRA would have the power to grant and revoke licenses. APRA has also argued for powers to make prudential standards in superannuation similar to its powers in other regulated sectors. APRA has outlined a number of areas where standards could be appropriate, including superannuation fund investments, risk management, capital adequacy and outsourcing.

The final element of the reform agenda promoted by the Financial System Inquiry – dealing with the regulation of financial markets – was bedded down when the Financial Services Reform Act 2001 (FSR Act) was passed by Parliament in August 2001. The new arrangements came into force on 11 March 2002, with a two-year transition period. ASIC is responsible for implementing the FSR Act. It has dedicated a significant amount of resources to the implementation of the Act in order to enable a smooth and effective transition to the regime, which is essential to the integrity and confidence of markets.

The FSR Act introduces a streamlined regulatory regime for market integrity and consumer protection across the financial services industry. It provides for a harmonised licensing, disclosure and conduct framework for financial service providers, and a single statutory regime for financial product disclosure. At the same time, the framework allows for flexible treatment of different financial products where appropriate (eg basic deposit products will be subject to less intensive regulation than more complex investment products).

The multiple routes to licensing of securities and futures exchanges, and of clearing and settlement systems, have been replaced by a single licensing regime for an Australian financial market and for a clearing and settlement facility. Under the new arrangements, licensees have primary responsibility for the operation of markets and of clearing and settlement facilities; ‘the responsible Minister’ has overall responsibility for licensing such entities. ASIC is empowered to advise the Minister on licensing matters and is also required to undertake assessments of the compliance of market and facility licensees with their legislative obligations, and to take enforcement action where necessary.

Under the new arrangements, the RBA has responsibility for ensuring that clearing and settlement facilities conduct their affairs in a way that is consistent with overall financial system stability. As part of this role, the RBA has the power to set and monitor compliance with financial stability standards for clearing and settlement facilities. ASIC has responsibility for all other matters relating to these facilities, such as those covering corporate governance, market integrity and investor protection, and for enforcing compliance with the RBA's standards if this becomes necessary. The RBA and ASIC signed a Memorandum of Understanding (MOU) in March 2002 which sets out a framework for co-operation between the two agencies in relation to licensed clearing and settlement facilities. The MOU is intended to promote transparency, help prevent unnecessary duplication of effort and minimise the regulatory burden on facilities; it covers information sharing, notification and other arrangements intended to achieve these aims.

As part of its role in implementing the FSR Act and giving guidance on implementation, ASIC prepared a suite of policies and process guides and a licensing kit. ASIC also conducted industry consultation visits, ASIC Speaks seminars and provided extensive information on its web site.

A new Electronic Funds Transfer Code of Conduct was also launched by ASIC. The Code covers all forms of electronic banking, including telephone and internet banking and stored value cards such as smart cards.

Co-ordination between Council Members

Australia's financial regulatory structure includes mechanisms to ensure effective co-ordination and co-operation between the three regulatory agencies. These mechanisms aim to provide full and timely exchange of information, the avoidance of duplication and a clear delineation of responsibilities, particularly when dealing with matters such as a financial disturbance.

The liaison framework, which is overseen by the Council itself, is a multi-tiered one. At the highest level is a structure of overlapping Board representation and regular senior meetings between the regulatory agencies. The legislation provides for both the RBA (two members) and ASIC (one member) to have representation on the APRA Board and for APRA (one member) to have representation on the Payments System Board. In addition, the APRA Board meets formally with the ASIC Commissioners at least once a year, and senior APRA and ASIC representatives meet every six months to discuss matters of mutual interest.

At the operational level, co-operation arrangements have been set out in three Memoranda of Understanding (MOUs) which have been signed between the RBA and APRA, between APRA and ASIC and, more recently, between the RBA and ASIC. The MOUs cover such matters as information sharing, prompt notification of any regulatory decisions likely to impact on the other agency's area of responsibility and consultation arrangements in the event of financial disturbances. The first two MOUs also establish bilateral Co-ordination Committees which aim, among other things, to avoid overlaps and gaps in regulatory coverage. Of course, at the broader level, this remains very much a focus of the Council.

The three MOUs are reproduced in Appendix B.

The value of co-operation between the regulatory agencies was highlighted by the events of September 11 in the United States, a matter which is discussed in the following Chapter. The agencies also co-operate on a range of more routine issues. One of these is the implementation of enhanced statistical reporting by Australian financial institutions. During the year, APRA completed the first phase of a major statistics project designed to improve financial data collections. This project has involved the development of a new computer system to collect, analyse and store data from regulated entities and the introduction of new statistical reporting forms. The successful implementation of this project is fundamental to APRA's own responsibilities; it is also important for the provision of aggregate data to the RBA, in pursuit of its monetary policy and financial stability objectives, and to the production of economic data by the Australian Bureau of Statistics (ABS). As a result, both the RBA and the ABS were members of the steering group in the initial phase of the project and, along with APRA, now form a tripartite committee to provide ongoing co-operation on statistical issues.

The new computer system, known as Direct to APRA (D2A), provides a flexible, secure and user-friendly means of data collection. Following testing in mid 2001, the use of D2A was phased in from the September quarter, commencing with building societies and credit unions and with banks following in the first half of 2002. The forms will later be introduced in the insurance and superannuation sectors.

In designing its new reporting forms, APRA has sought to ensure that the information collected is relevant and useful to the needs of the respective agencies. Information collected for prudential purposes is intended, whenever possible and where prudential interests are not impaired, to reflect the way financial institutions themselves examine their businesses and to be consistent with accounting standards, rather than being a set of unique requirements. Because of their flexible design, the new reporting requirements can be changed to incorporate industry and international standards to make it easier for institutions to extract required data automatically from their own systems. In some cases, where industry practice diverges but use of the data for macroeconomic purposes requires consistency, standard definitions will be prescribed across all sectors. This will enable APRA to become the central repository of financial information on regulated entities, to which the RBA and ABS will have secure access when needed. Future requests for changes to reporting requirements will be dealt with in a predictable annual cycle, under the direction of the tripartite committee.

The year 2001 saw continued interaction between APRA and ASIC to achieve the appropriate level of regulatory co-operation. Both agencies aim, in particular, to co-ordinate actions while having due regard for their differing regulatory emphasis and practices. Liaison arrangements were reviewed in 2001 to better match organisational structures in each agency. Regular meetings are now held every two months on both a national and regional basis, with ad hoc meetings arranged to deal with specific operational matters as and when they arise.

Operational level liaison groups continue to focus on areas of common interest such as enforcement, compliance, disclosure and jointly regulated entities in the insurance and superannuation sectors. The agencies aim to share relevant findings of on-site reviews and surveillance where such information could assist the other in carrying out its supervisory functions. A number of joint visits to financial institutions were conducted in 2001 as part of an APRA review of unit pricing in the superannuation industry.

A joint workshop between APRA and ASIC in March 2001 dealt with issues surrounding the licensing of superannuation and funds management entities regulated by both agencies. The workshop examined the different aims and methodology of each agency's supervisory processes and agreed to explore the scope to expand information sharing. A second joint enforcement workshop is planned in 2002 for frontline supervisors from both organisations.

ASIC and APRA are also committed to co-operating in the implementation of the FSR Act, particularly for those entities regulated by both agencies. Since late 2001, ASIC and APRA have held meetings specifically to deal with issues that arise during the transition period under the Act; their purpose is to share information on APRA-regulated licensees and to avoid duplication of responsibilities. Implementation of the FSR Act has also required liaison in other areas, such as the regulation of unauthorised foreign insurers and updates to superannuation audit requirements.

APRA and ASIC also consult in respect of business transfers under the Financial Sector (Transfers of Business) Act 1999.

In September 2001, the ASIC/APRA Enforcement Referrals Protocols were revised. The Protocols provide a summary of operational procedures for referral of existing, or anticipated, enforcement matters between APRA and ASIC. Regular meetings were held to discuss general enforcement issues, with case-specific liaison occurring as necessary. During the year, a joint task force between the two agencies was established in order to closely co-ordinate a particular enforcement action. This operation included the sharing of staff resources between the agencies.