2. Regulatory Framework Jeff Carmichael Chairman Australian Prudential Regulation Authority

3. APRA Topics for The Session  Contributions & risks from NBFIs  Effective regulation:  Powers  Rules & Regulations  Internal Practices & Procedures  Regulatory Structure

4. APRA Financial Services Payments services Liquidity Divisibility Store of value Information efficiencies Risk pooling

5. APRA NBFI Roles Broaden spectrum of risks Encourage savings and investment Foster risk management Enhance systemic resilience Fill the gaps Provide competition for banks

6. APRA Empirical Evidence Growing evidence that: Financial development contributes to economic development Contribution is increased where NBFIs are involved

7. APRA Sources of Risk from NBFIs 1.NBFIs can circumvent the intention of banking regulation, eg Asian experience Thai finance companies Hire purchase in Malaysia Korean Merchant Banks & ITCs Plus: Pseudo-banks in Latin America

8. APRA Sources of Risk from NBFIs 2.NBFI associations with banks through conglomerates, eg Asians again Korea and Indonesia State banks in Australia Latin America also

9. APRA Community Expectations oMarket conduct: –Policemen role –Severity of penalties less important that likelihood of being caught oPrudential: –Doctor role –Prevention rather than prosecution

10. APRA Characteristics of Prudential Regulation 1.Intervention is graduated: –Breaches are a warning –Process involves cooperation 2.Regulators are not infallible: –The process increases risk –No regulator can guarantee no failures

11. APRA The Road to Effectiveness Stronger powers Stronger policies Stronger internal practices and processes

12. APRA Powers - Conduct & Prudential Licensing Information Examinations Investigations Standards/regulations Administrative sanctions Directions Prosecution

13. APRA Prudential Powers Ownership & Control Appoint experts “Whistleblower” provisions Statutory management/inspector Transfers of business Liquidation

14. APRA Australia - Prudential Powers

15. APRA Solvency Vs Risk Australian Insurance Act 1973 – Capital set at greater of: $2 million 15% of OCP 20% of Premium Income New framework (2002) requires: More capital for higher risks Capital for asset risks

16. APRA Dangers of Over-Prescription US Vs International Accounting standards Same issue in Prudential Regulation Prescription leads to: oLegalistic responses oQuestions of who is responsible oInflexibility

17. APRA Australian Changes New risk-rating system Escalation procedures Wide circulation of high-risk assessments Dealing with informants Greater enforcement orientation

18. APRA Priorities Start with internal practices and processes Push your laws to the limit Never miss an opportunity to push reform Learn from failures and from each other

19. APRA Objectives of Regulation Ultimate Goals Efficiency Fairness Safety Stability Market Failures Anti- competitive behaviour Market misconduct Information asymmetry Systemic contagion Regulatory Actions Anti trust Anti collusion Disclosure Education Financial law enforcement Governance Licensing Capital adequacy Liquidity Risk management Failure management Macro economic policy Payment system

20. APRA Approaches to Structure Industry: Separate agencies for each industry group Pure form: One agency for each group but responsible for all 4 market failures Objectives: Separate agencies for each market failure Pure form: One agency for failure but responsible for all institutions Reality: Nearly all are hybrid

21. APRA The Traditional Industry Approach Pressure from: Convergence in financial markets and the emergence of financial conglomerates The need for greater regulatory neutrality Better use of scarce regulatory skills and resources

22. APRA Rationale for Integration 1Aligns the regulatory structure with the industry structure 2Resource efficiencies 3Maximize regulatory neutrality Integrated regulation is objectives-based

23. APRA Choosing Among Structures There is no single regulatory structure that is ideal for all countries and for all points in time Ultimately a matter of judgement

24. APRA The Pure Objectives-based Model Case for: –Maximizes regulatory focus –Minimizes cultural clashes –Reduces confusion about safety nets Case against: –Still requires inter-agency cooperation –Resolution of conflicts can be a problem Responses: –Resolution mechanisms –Clear demarcations –Higher level of aggregation of objectives

25. APRA Combining Prudential & Conduct Case for combining: –One umbrella regulator for all parts of conglomerates –Bigger and more powerful agency –Can resolve regulatory conflicts internally Case for separation: –Cultural clashes –Loss of focus - from multiple objectives –Potential misperceptions about the safety net –Failure in one area can erode credibility in others No definitive answer but most so far have elected to combine

26. APRA Combining Prudential & Systemic Case for combining: –Synergies in systemic stability regulation –Last resort lending needs knowledge of banks –Avoids crisis management by committee –C banks are more independent and better staffed Case for separation: –C bank with 2 objectives - loss of focus –Supervisory staff not always equal C banks –C banks lack the expertise for NBFI regulation –Cultural clashes Most have elected not to combine so far

27. APRA Latin American Structures COUNTRYStructure No. ARGENTINAInstitutional 7 BAHAMASInstitutionalIntegrated5 BARBADOSInstitutionalFSA4 BOLIVIAFSANBFI2 BRAZILInstitutionalOther1 CHILENBFITotal19 COLOMBIAIntegrated COSTA RICAFSA ECUADORIntegrated EL SALVADORIntegrated GUATEMALAIntegrated HONDURASFSA JAMAICANBFI MEXICOBanks & Securities NICARAGUAFSA PANAMAInstitutional PERUIntegrated TRINIDAD AND TOBAGOInstitutional VENEZUELAInstitutional

28. APRA What Does IR Really Offer? oIntegrated regulation does not: Automatically correct regulatory failures (though it can contribute) oIntegrated regulation does: Help with conglomerates Reduce regulatory arbitrage Make better use of scarce resources

29. APRA Regulatory Neutrality Simply putting different regulators together is not enough ‘Integration’ needs: An integrated staff structure A harmonized set of powers and Laws A common approach to standards A common approach to analysis and inspection

30. APRA Regulation by Risk 5 Fundamental Risk Types: Credit risk Market risk Insurance risk Liquidity risk Governance (operational) risk

31. APRA Conglomerate Regulation Integration eliminates “turf” wars Single set of definitions (controllers, affiliates etc) Consistent set of powers across industry groups

32. APRA Summary  NBFIs offer risks and rewards  Risks need sound regulation  NBFI regulation in the region is underdeveloped  Areas for improvement:  Powers  Policies  Practices & procedures  Extracting the benefits from integration is a big challenge

33. Regulatory Framework Jeff Carmichael Chairman Australian Prudential Regulation Authority