Council of Financial Regulators Annual Report – 2002 3.Major Issues for the Council in 2002

The Global Environment

After weathering a series of unprecedented shocks in the latter part of 2001, the resilience of the global financial system was again tested in 2002, as signs of an apparent recovery in the global economy waned in the second half of the year and sentiment in global financial markets deteriorated. The Council continues to pay close attention to the impact of global developments on the stability of the Australian financial system.

At the beginning of 2002, a sense of optimism about global prospects had began to emerge on indications that the US economy, which had dipped briefly into recession the previous year, might be on the road to recovery. That optimism, however, proved short-lived as doubts surfaced over the durability of the US recovery, particularly in view of concerns about the underlying health of the US business sector. Revelations of corporate malfeasance in the wake of some high-profile corporate collapses, such as Enron and WorldCom, also undermined confidence. The global economy lost momentum towards the end of 2002, and this slowdown has continued into 2003. Geopolitical uncertainties over Iraq and the Korean peninsula at times weighed heavily on market sentiment, reflected in renewed weakness in equity prices and falls in bond yields.

Despite these developments, the global financial system continued to prove resilient, although the difficult environment revealed strains in some areas. Japanese banks struggled to repair their balance sheets after more than a decade of anaemic domestic growth and the legacy of high levels of non-performing loans. The larger German banks also performed poorly, a consequence of persistent economic weakness in Europe and structural impediments to profitability.

The global insurance industry came under renewed pressure during 2002, with exposures to falling equity markets compounding an already difficult business environment. General insurance companies have faced some substantial payouts in recent years and, although these costs are being partly recouped through higher premiums, many large global insurers saw their share prices marked down significantly. In some countries, problems facing life insurance companies were exacerbated by the difficulty of maintaining guaranteed nominal returns in an environment of low interest rates and weak equity markets.

Domestic Issues

Despite the difficult external environment, the Australian financial system has remained in strong condition. Its stability has been underpinned by the continued expansion of the Australian economy and by the absence of structural weaknesses that have created financial stresses in some other countries.

During 2002, one domestic issue to which the Council devoted particular attention was the continued strong growth in lending to households, particularly for housing. This has been associated with substantial and widespread increases in house prices. Consequently, the ratio of household debt to household disposable incomes had reached 125 per cent by the end of 2002, in the upper part of the range of other comparable countries. Over recent years, there has been a strong increase in demand for credit by property investors. Lending for investor housing now accounts for some 30 per cent of outstanding housing loans compared to less than 20 per cent a decade ago.

The RBA highlighted the growth of household debt and its implications in its regular Statement on Monetary Policy, its appearances before Parliamentary committees, in speeches by the Governor and Deputy Governor and in articles in its Bulletin.

The RBA noted that both demand and supply factors have been at work. On the demand side, the adjustment to a low inflation/low interest rate environment over the past decade or so has increased the affordability of housing finance for a wider range of households. A number of developments have acted to increase the supply of housing finance, including financial deregulation and the associated increase in competition in the lending market, spurred also by the entry of specialist mortgage managers; product innovation; and the development of securitisation markets. Some developments have specifically encouraged increased investor activity. In the mid 1990s, banks removed the premium they charged on investor housing loans and the advent of new products such as split-purpose loans, deposit bonds and home equity loans have made finance for investor housing more readily available.

The RBA has cautioned that the exceptionally fast increase in borrowing for investor housing has clearly increased risk and that the accompanying rapid expansion in apartment building shows all the signs of a seriously over-extended market. However, reflecting the general health of the housing sector, the overall financial condition of ADIs in Australia remains strong. The financial soundness indicators, which the RBA monitors – including asset quality, capitalisation, profitability and market valuation – suggest that a rise in household debt does not pose a significant danger of a financial crisis, such as occurred in the early 1990s after the build-up in corporate debt. The concern would be for a sharp jump in mortgage default rates that triggered a more substantial market correction – a scenario more likely to be associated with a deterioration in employment conditions and/or a sharp rise in interest rates.

One particular development that has boosted competition in the housing market – for both owner-occupiers and investors – has been the substantial growth in the use of mortgage brokers. During 2002, both APRA and ASIC investigated aspects of this development. For prudential purposes, APRA undertook a survey of ADIs to gauge practices regarding the use of mortgage brokers. The survey showed that mortgage-brokered loans represented about 23 per cent of all ADI housing loans, with this percentage very likely to increase. While largely comfortable that ADI risk practices associated with lending are sound, APRA will be working with ADIs to develop and implement best practice risk management regarding the use of brokers. This includes, among other things, broker accreditation procedures, independent loan review and appropriate tracking systems. A fuller analysis of the survey is available on APRA's website (see page 28).

A report on the mortgage brokering industry – prepared by the Consumer Credit Legal Centre and released by ASIC in March 2003 – focused on issues facing consumers when using mortgage brokers. These issues included the poor quality of advice (with the increased costs of the inappropriate loans that might result); inadequate disclosure of fees, commissions and incentives; inconsistent documentation from brokers; consumer uncertainty about the nature and price of the service; and in a small number of cases, fraudulent activity such as manipulating loan applications. As a result, ASIC developed a guide to using a mortgage broker, which is available on its consumer website, and will develop an on-line ‘mortgage calculator’ to help consumers understand the costs of home loans.

Another aspect of the housing market investigated by APRA in 2002 was the use of mortgage insurance by ADIs. ADIs are able partly to insulate themselves from the risk of residential mortgage defaults by requiring certain borrowers – those with high loan-to-valuation ratios – to take out mortgage insurance. As part of its research into stress-testing the mortgage books of lending institutions, APRA reviewed the claims experience of the (then) three major mortgage insurance providers in the market. Recent default/loss experience in housing lending has been very benign and this, coupled with strong growth in residential property values in major urban areas, has led to a very low rate of claims.

It remains APRA's opinion that compliance by lending institutions with the conditions of mortgage insurance policies could be improved, and APRA intends to structure supervisory programs to highlight this. APRA's assessment is that, given the low rate of claims, mortgage insurers over the past few years had paid a number of claims essentially as a relationship decision. However, in an environment in which default rates were increasing sharply, the more lenient attitude of mortgage insurers could change quite quickly, and this could undermine the effectiveness of the insurance cover. It should be noted that mortgage insurance providers do not necessarily share APRA's view.

On a separate domestic issue, ASIC in December 2001 announced a new project to foster better disclosure of fees and charges in product disclosure statements for investment products. The first stage in the project was to engage Professor Ian Ramsay to prepare an options paper on how ASIC, industry and consumer groups could work together to produce effective disclosure of fees and charges for investment products. ASIC released the Ramsay Report, Disclosure of fees and charges in managed investments, review of current Australian requirements and options for reform, in September 2002. The report contains an overview of approaches to disclosure of fees and charges in Australia and a number of other jurisdictions, and options for improving the quality and comparability of disclosure. In consultation with industry and consumer representatives, ASIC is developing standards covering a number of aspects of the Report's recommendations that appear to have general acceptance among key stakeholders. These include:

  • use of common terminology:
  • standardised descriptions of fees;
  • disclosure of purpose of fees;
  • improved disclosure of entry/contribution and exit/withdrawal fees; and
  • improved disclosure of fees paid to advisers.

The model proposed a ‘see at a glance’ table format for the disclosure of all significant fees and charges. This should also assist consumers to make comparisons of fee structures between investment-linked products.

Reform of Financial Architecture

Over recent years, the collapse of Enron and WorldCom and other large corporate failures, including in Australia, have highlighted the need to strengthen the basic foundations of markets through sound practices of corporate governance, improved accounting standards and audit quality and more effective regulatory oversight. The ability of accounting and auditing standards and practices to deliver accurate and reliable published financial information that is disclosed to markets in a timely fashion is fundamental to good corporate governance, and pursuit of improvements in these areas has been a central focus of reform proposals. Council members participate in a wide range of international groupings dealing with these and other reform issues.

Reform of corporate governance is being pursued within individual countries and at the global level, as part of the development of international standards for good practice in sound financial systems. In the United States, for example, landmark legislation in the form of the Sarbanes-Oxley Act was passed in July 2002. This Act substantially strengthens the law surrounding audit processes and corporate governance in the United States, including by:

  • significantly toughening disclosure requirements, especially regarding off-balance sheet exposures;
  • increasing the independence of audit committees and promoting more independence between audit firms and their clients; and
  • discouraging improper behaviour by increasing custodial and financial penalties.

At the global level, the Technical Committee of the International Organisation of Securities Commissions (IOSCO), chaired by the Chairman of ASIC, issued a series of principles in October 2002 to guide securities regulators in dealing with three critical areas: audit independence; audit oversight; and the role of corporate governance and ongoing disclosure.[5] Under the CLERP 9 proposals discussed in Chapter 2, Australia would basically comply with the IOSCO principles. While CLERP 9 will require only the top 500 listed companies to have an audit committee, ASIC has suggested in its submission on CLERP 9 that consideration be given to alternative mechanisms that could be employed by small companies to achieve the same outcome as an independent audit committee.

The international harmonisation of accounting standards is a related reform initiative that is gathering momentum. In October 2002, the Financial Accounting Standards Board (FASB) of the United States and the International Accounting Standards Board (IASB) announced the issue of a memorandum of understanding (‘the Norwalk Agreement’) that marks a significant step towards formalising their commitment to the convergence of US and international accounting standards. The Norwalk Agreement aims to make reporting standards fully compatible as soon as practicable. In particular, the FASB and IASB expect to issue an exposure draft to address some, and perhaps all, of certain differences identified between the regimes by the latter part of 2003. However, it is recognised that some differences may remain beyond that time, and the accounting bodies are looking to remove or reduce those remaining by 1 January 2005 through co-ordination of their future work programs.

In Australia's case, the Government concluded in its 1999 report, Making Transparency Transparent: An Assessment, that Australia substantially adhered to the OECD's (non-binding) principles of corporate governance. Australia's corporate governance framework consists of a ‘matrix’ of legislation (mainly the Corporations Law), accounting standards that have the force of law, listing rules of the Australian Stock Exchange (ASX) and voluntary self-regulatory codes of practice.

Nonetheless, recent events have highlighted the need for continuing improvement in relation to corporate governance issues. In this light, ASIC in 2002 conducted its largest-ever accounting surveillance project, directed to areas of accounting abuse of the type uncovered in the United States. The project gave a high priority to the treatment of capitalised and deferred expenses, recognition of revenue and recognition of controlled entities and assets. The surveillance related to the full-year financial reports of selected listed companies for the financial year ended 30 June 2002. ASIC noted that, while it had no reason to believe that abuses such as those recently uncovered in the United States were prevalent in Australia, a targeted surveillance of these issues would assist to maintain confidence in the reliability of public company financial reporting in the Australian market.

The two major corporate governance initiatives underway in Australia are the CLERP 9 reforms, discussed in Chapter 2, and the Corporate Governance Council (CGC), convened in August 2002 by the ASX. The CGC is made up of 21 business and investor groups and is chaired by an ASX representative. The CGC has the task of developing, on the basis of consultation with the business community, a set of best practice corporate governance principles for the guidance of Australian listed companies.

The CGC issued a final set of principles and best practice recommendations on corporate governance in March 2003. Broadly speaking, the CGC's 10 essential principles require companies to respect the rights of shareholders; make timely and balanced disclosure; safeguard the integrity of financial reporting; recognise and manage risk; lay solid foundations for management and oversight; promote ethical and responsible decision-making; structure the board to add value; encourage enhanced performance; remunerate fairly and responsibly; and recognise the legal rights of stakeholders. The ASX has amended Listing Rules so as to require listed entities to adopt these principles or to disclose to their shareholders why they have not done so. Standards developed by the CGC are issued as a ‘co-branded’ statement by all the parties involved in their development and, as such, carry a strong endorsement of expected practice by companies.

International Co-operation

The Council acts as forum for sharing information and co-ordinating the participation of its members in various reform initiatives, which are directed at strengthening the resilience of the international financial system.

One of the key international groupings is the Financial Stability Forum, which was established in 1999. The Forum provides for the regular exchange of high-level views on potential vulnerabilities in the international financial system and helps to prioritise the reform efforts that are underway at any one time. The Forum's membership consists mainly of senior representatives from those national authorities that are responsible for maintaining stability in significant financial centres; it also includes representatives from international financial institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts. The Governor of the RBA represents Australia, and the Chairman of ASIC, as Chairman of IOSCO's Technical Committee, has been representing IOSCO since September 2002.

Amongst a range of recent activities, the Forum has been seeking to reinforce international crisis management arrangements. It has improved crisis contacts among its members and has been involved in field-testing methods for managing the failure of a large and complex financial institution. The Forum has also supported international efforts to combat terrorist financing and has commissioned a compendium of recent corporate governance initiatives in its constituent countries.

The Forum also discusses current developments in financial markets and the global economy. Over the past year, these discussions have centred on the performance of key financial sectors, such as the insurance and reinsurance industries, which have been adversely affected by the weakness of the global economy and the sharp decline in equity markets. The Forum also reviewed the growing use of credit derivatives by both the banking and insurance sectors and urged speedy action to identify and close the information gaps that seemed to exist in credit risk transfer markets.

A Working Group on Credit Risk Transfer, established by the Committee on the Global Financial System at the Bank for International Settlements, also investigated credit risk transfer instruments. The RBA participated in this Working Group, which released its report in January 2003.

A second international grouping with which Australia is associated is the G20, which was also established in 1999. The G20 brings together representatives of a cross-section of systemically significant economies, and of the IMF and World Bank; the aim is to promote sustainable and equitable economic growth through international co-operation.[6] The Ministerial meeting, attended by the Treasurer and the Governor of the RBA, is held annually while Deputies' meetings are held twice yearly.

The G20's primary focus over the past year has been to examine members' experiences with globalisation and market reform, in order to develop a better understanding of the benefits and costs involved. G20 members finalised individual case studies outlining their experiences with globalisation and, building on this work, the RBA and the Australian Treasury co-hosted a conference on ‘Globalisation, Living Standards and Inequality: Recent Progress and Continuing Challenges’ in Sydney in May 2002. G20 members agreed that the benefits of globalisation can be maximised and the risks mitigated through appropriate domestic policies, strong domestic institutions and enhanced international co-operation. The G20 agenda also included work on combating the financing of terrorism, crisis prevention and resolution, measures to improve the effectiveness of international development assistance, and other policies to promote higher global economic growth and prosperity.

APRA remains active in various international fora, including those directed at developing the international supervisory framework. In particular, APRA contributes to the work of the Basel Committee on Banking Supervision. APRA is a member of the Basel Committee's Core Principles Liaison Group (CPLG), which is the main vehicle for establishing links between G10 and non-G10 countries. As well as developing, and providing guidance for implementing, the Core Principles for Effective Banking Supervision, the CPLG provides a forum for banking supervisors to discuss other issues of interest. Topics discussed during the year included loan classification and provisioning, the impact of proposed new international accounting standards, supervision of foreign currency positions and the need to balance supervisory independence and accountability.

Non-G10 members of the CPLG have established a Capital Working Group, which focuses on the development of the new Basel Capital Accord (Basel II). The Capital Working Group provides a forum for non-G10 countries to discuss the development of Basel II and to feed views and opinions into the Committee's discussions on its development. Given Australia's relatively advanced banking system, APRA is an active contributor to this group. During the year, APRA seconded a member of staff to the Basel Committee Secretariat to assist with work on the development of Basel II. One important aspect of this work is a global Quantitative Impact Study, which analyses the possible impacts on banking sectors of the various options in Basel II. APRA is a regional co-ordinator for this work. APRA is also a member of the Basel Committee Electronic Banking Group, which over recent times has focussed on cross-border electronic banking issues.

On insurance matters, APRA is active in the work of the International Association of Insurance Supervisors (IAIS). Over 2002, an APRA executive was Deputy Chair of the Executive Committee (and was subsequently appointed Chair of the IAIS Technical Committee). APRA was also represented on the Sub-Committees for Accounting (work included revisions to international standards), Solvency (stress testing, appropriate forms of capital and convergence of solvency standards) and Investments (credit risk transfer and investment risk management) and participated in the IAIS Task Force on Revisions to the Insurance Core Principles and Methodology. APRA also provided support to the IAIS Secretariat.

APRA is a member of the Joint Forum, which brings together the IAIS, the Basel Committee and IOSCO to discuss cross-sectoral issues. Over the year, the Joint Forum has been reviewing the methods used in determining economic capital across global conglomerates and the disclosures made by banking groups.

APRA is also a member of the OECD Insurance Committee and the OECD Working Group on Private Pensions. The Committee's work over the year included terrorism insurance, environmental risk and governance structures in insurance firms. The Working Group focussed on guidelines for superannuation supervision and prepared a template for assessment of pension systems for the IMF/World Bank Financial Sector Assessment Programs. APRA supports the OECD-sponsored International Network of Pensions Regulators and Supervisors and is a member of its Technical Committee and Asia/Pacific Regional Group. APRA is also a member of the International Actuarial Association (IAA) and participates in several IAA Committees.

APRA supports a range of regional initiatives to promote development of supervisory infrastructure, deepening of the skills of supervisors and the sharing of information. This includes participation by APRA staff, either as presenters of papers or as delegates, in various regional conferences and workshops. Together with the RBA, APRA is a member of the Working Group on Banking Supervision of the Executives' Meeting of East Asia-Pacific Central Banks (EMEAP), a grouping of regional central banks and monetary authorities. The Working Group provides a forum to discuss financial developments in the region as well as progress on the new Basel Capital Accord. During the year, APRA extended its involvement in the Financial Regulators Training Initiative, a joint initiative of APEC, AusAID and the Asian Development Bank for life insurance and pensions regulators.

ASIC continues to play an active role in international co-operation efforts in financial market regulation, mainly through its membership of IOSCO. This role was enhanced when the Chairman of ASIC was elected in May 2002 as Chairman of IOSCO's Technical Committee. This Committee has overseen a number of new mandates as well as the establishment of special project teams in response to issues such as the terrorist attacks of September 11 2001 and major corporate collapses. The Committee also established a high-level sub-committee, ‘the Chairs' Committee’, to co-ordinate and focus IOSCO's response to the regulatory issues highlighted by Enron and other high profile business failures around the world. The Chairs' Committee published two papers on auditor independence and oversight in October 2002: Principles of Auditor Independence and the Role of Corporate Governance in Monitoring an Auditor's Independence and Principles of Auditor Oversight.

ASIC participated in one of the Technical Committee's initiatives in settling the terms of the IOSCO Multilateral Memorandum of Understanding Concerning Consultation and Cooperation and the Exchange of Information. The main objective of this MOU is to encourage co-operation among regulators in a global securities market. In addition to settling the terms, ASIC was also involved in determining the process for verifying MOU implementation and, through its Chairman, confirming applications from various jurisdictions to become signatories to the document. In October 2002, ASIC became one of the first signatories to the MOU. More generally, ASIC regularly contributed to IOSCO reports and papers and attended various Standing Committee and Project Team meetings. In early 2002, ASIC hosted two Standing Committee Meetings in Melbourne.

ASIC undertook considerable work in 2002 on cross-border financial services regulation. It released Principles for cross border financial services regulation in November 2002, which addresses issues relating to the regulation of foreign markets, products and services across international borders. ASIC also released three policy proposal papers: 1. Australian market licences: Overseas operators, to address the way ASIC proposes to regulate overseas markets that wish to operate in Australia; 2. Foreign collective investment schemes, to address the way ASIC intends to regulate scheme operators seeking to attract Australian investors; and 3. Licensing: Discretionary powers – Foreign financial services providers, to facilitate the entry of foreign financial service providers that are regulated by overseas regulatory authorities into the Australian market. In all cases, ASIC sought input from its major regulatory counterparts in the region.

ASIC also negotiated an MOU with the Securities and Exchange Commission of Sri Lanka, and commenced negotiations for an MOU with the Financial Services Agency of Japan and a Protocol of Information Sharing and Co-operation with the Securities and Futures Commission of Taiwan. By the end of 2002, ASIC had entered into 25 MOUs with overseas counterparts.

A number of senior ASIC officers also gave presentations at various international seminars, such as an International Regulators Conference in the United Kingdom in June 2002. ASIC personnel attended regional and local seminars hosted by the Asian Development Bank and gave presentations on a wide range of subjects, including financial services reform in Australia and ASIC's enforcement policies and practices.


The principles are available on IOSCO's website ( ). [5]

Members include the G7 countries plus Argentina, Australia, Brazil, China, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey and the European Union. [6]