By world standards, the Australian economy is doing very very well. Our unemployment rate was 5.8% in October, up from 4.3% a year ago. No banks have been bailed out. In May 2009, two Australian banks were in the world’s top 20 by market capitalisation (where Australia has around 1% of world GDP). While the government has provided a guarantee on deposits, there have been no equity investments from the taxpayer into banks (or any other financial institution). And According to the Reserve Bank (page 72 of their semi annual review), fewer than 1% of households with mortgages have negative equity, compared with 23% in the US, according to this report. So is it just Australia being the lucky country, or is there more to it? I’ve got a few ideas of what we’ve done well, and a few more about our luck.
First, what have we done right?
Loan to valuation ratios – conservative lending
Australian mortgage holders, and mortgage providers have always been pretty conservative on loan to valuation ratios. A normal mortgage has a maximum of 80% of the home valuation. More than that, and you must take out mortgage insurance – which only benefits the bank if you default. That’s a statutory requirement. So while there were people borrowing more than 100% of the valuation, they weren’t that common. So our banks were not as aggressive as banks world wide. They tended to stick to lower risk lending and securitization.
Quite a lot of pundits give credit to for this conservative lending to the four pillars policy – the top four banks cannot be taken over by each other so banks knew they were relatively safe from takeover, so could afford to rest on their laurels and not take enormous risks.
On corporate lending, there was some poor lending. But none that has taken the banks down.
The Australian Prudential Regulatory Authority (APRA) has a few things going for it. First, it regulates all retail deposit taking entities (as well as all insurance companies). So it catches, in a single institution, a large proportion of the financial services sector. Second, it had a near death experience in 2001, with the collapse of HIH. HIH was one of Australia’s biggest general insurers, and in Australia’s biggest corporate collapse (at least at the time) it fell apart with a $5 billion shortfall. That was on APRA’s watch.
APRA had been following a path of fairly light touch regulation – setting principles based rules, and enforcing them at a fairly high level. This is what the HIH Royal Commission had to say about their performance:
By 20 September 2000 APRA was on notice that HIH was potentially overstating its statutory solvency position by including pledged assets in the solvency calculation of its licensed insurers. Within weeks APRA had realised that HIH was also overstating its statutory solvency by means of a netting‑off process and incorrect reporting of its related body assets. At around this time APRA also learnt of the serious deterioration in HIH’s UK and US businesses. But, in spite of the mounting evidence of HIH’s problems, APRA did comparatively little in response. It grappled poorly with the information in its possession, either failing to recognise its significance or failing to analyse it thoroughly. It lacked commitment in enforcing in its requests for further information and explanations from HIH. It did not recognise the seriousness of the situation until it was too late for effective intervention.
Early in December 2000 APRA received a copy of the Ernst & Young report that was mentioned earlier. Later in December the officer to whom the report was delivered perused it. He passed it to his superior. That officer did not read it until late February 2001. He immediately recognised its significance but by then it was too late.
APRA paid attention to that report. Not only did they introduce a new supervisory regime for general insurance, but in a move that wasn’t particularly obvious outside APRA and regulated financial institutions, they changed their style of regulation. John Trowbridge, one of the three Members of APRA, has given a number of speeches in which he outlines the APRA approach to supervision, and why it has been very effective. Here is one:
Our prudential standards are built around capital adequacy, effective risk management and good governance. A fundamental plank of our approach is that we hold the boards of regulated institutions accountable for meeting the standards. We normally work through management but we reserve the right to deal directly with the board and we do so whenever we think we need to.As I see it, our system does work effectively because APRA is a vigilant and effective supervisor. It was not always so, but APRA now has the resources comprising the experience, culture, competence and strategy to operate effectively.The quality of active supervision of individual institutions is a critical success factor. Prevention is not only better than cure, it is also better than punishment after a failure. Active supervision is a pre-requisite and a sine qua non of an effective prudential regulatory system.
As someone who has been supervised by APRA, there is a lot to that. Their sticks don’t seem that large from a distance, but they can come in to a company at any time and demand any set of documents. If they think that you aren’t doing things properly, they can demand a lot of documents and management time. And if they don’t understand something, they are unlikely to let you do it, if they have any part of their regulatory armoury they can invoke to stop you. Each “visit” will result in a letter with some requirements, recommendations, and suggestions. The Board is expected to see that, and follow up on them. And if you are laggardly, they will keep visiting.
If you’d asked me two years ago, I’d have said they were excessively intrusive. There is definitely a cost to being regulated so intensively. But it does seem that that cost is a reasonable one to pay, given the place of financial institutions in our economy.
In common with everyone else, the government stimulated the economy heavily 9 and 6 months ago with various one-off handouts. In the Australian economy, we had the advantage that the budget wasn’t already in deficit, which means that the stimulus hasn’t damaged government finances to the extent it has in other economies. So while the government could have chosen that approach regardless, Australia will not have to slash the budget too far in future.
Exports to Asia
Economic success isn’t just about financial institutions, of course. It’s also about the real economy. And Australia has the huge advantage of being the natural resources supplier to the Asian economy, particularly China. While the WA (the resources heavy state) economy took a sharper tumble than the rest of the country six months ago, it’s pretty much back to boom times now. So the real economy is in good shape.