John LakerA prudent regulator Cover Story

  • Date:01 Aug 2005
  • Type:CompanyDirectorMagazine
Ensuring that the nation’s superannuation is in safe hands, that insurance policy holders will be paid and that institutions do not abuse the money deposited in accounts is not a job for the faint-hearted in a post-HIH environment.

john laker

A prudent regulator

Ensuring that the nation's superannuation is in safe hands, that insurance policy holders will be paid and that institutions do not abuse the money deposited in accounts is not a job for the faint-hearted in a post-HIH environment. It is why Australia's prudential regulator John Laker is drafting new prudential corporate governance standards. He tells John Arbouw how APRA will approach the new rules

No one would mistake John Laker as a daredevil high wire performer whom the crowd admires and applauds for the ability to maintain a delicate balance while moving forward. On the contrary, as a former Reserve Bank board member and as chairman of the Australian Prudential Regulation Authority (APRA), Laker's working life has been quite the opposite and is steeped in prudent economic judgment rather than risk.

Being in the spotlight of public attention is not something Laker relishes, considering that, since he was elevated from APRA board member to chairman after the HIH debacle, he has not given many interviews.

But learning to juggle the political expectations stemming from the failure of APRA in relation to HIH and, balancing the requirement for regulation to forestall further corporate disasters without adversely constricting enterprise and sensible risk taking, is a high wire act in itself.

The wording of the Australian Prudential Regulation Authority Act 1998 puts the issue in perspective: "In performing and exercising its functions and powers, APRA is to balance the objectives of financial safety and efficiency, competition, contestability and competitive neutrality".

APRA had its origins in March 1997 following the report of the Financial System Inquiry (known as the Wallis report). It recommended that an integrated regulator be created for the prudential supervision of all financial institutions, including banks, building societies, credit unions, superannuation funds, friendly societies, life insurers and general insurers.

On 1 July, 1998 APRA was created through a merger of the ISC and that part of the Reserve Bank which had been responsible for supervising the banking industry (Laker was the Reserve board member who had responsibility for this supervision and subsequently went on the APRA board).

HIH was the seminal moment in the short history of APRA.

According to the report into the HIH disaster prepared by Justice Owen, "APRA's performance in supervising HIH was not good. It missed many warning signs, was slow to act, and made misjudgments about some vital matters".

However, Justice Owen also pointed out that APRA did not cause or contribute to the collapse of HIH; nor could it have taken steps to prevent the failure of the company. A regulator cannot be expected to provide a guarantee that no company under its supervision will ever fail.

As well, APRA faced several handicaps in its supervision of the HIH group as a direct result of the implementation of the new regime.

"In particular, in APRA's early days, the move to full integration and its relocation from Canberra to Sydney created many managerial distractions for senior executives. The move also resulted in high levels of staff attrition and led to the loss of specialist general insurance skills.

As a result of the far-reaching and fundamental nature of the reforms, the supervisory regime was in varying degrees of transition throughout the period from 1 July, 1998 to 15 March 2001," Justice Owen wrote.

"During 2001 APRA commissioned an internationally recognised regulator, John Palmer, to assess its performance in the supervision of HIH. Palmer prepared a report and it was tendered in evidence to the commission.

"I have placed great weight on that report and I acknowledge the candid and open way that APRA has dealt with both it and the commission.

"In giving oral evidence, Palmer said that, given the handicaps APRA faced, it would have been a miracle if it had managed quickly to identify and act on the problems confronting HIH.

"But Palmer was also critical of many aspects of APRA's approach, both generally and in specific instances. I have formed much the same view.

"The systemic hindrances with which APRA was burdened go some way to explaining how and why it failed to supervise HIH adequately. But numerous questions are left unanswered. In many instances - even taking account of the constraints it was under - APRA did not react appropriately."

Understanding and appreciating what happened at APRA and the changes that took place following what Laker says was a "body blow" to the organisation is important in understanding the context of APRA's current approach to regulation.

At the moment APRA is in a face off with various parts of the financial services industry over its proposed corporate governance rules.

With boards reeling from a raft of new regulation over the past few years, there is little doubt regulation fatigue is starting to set in. It is also why there is concern that APRA's current process of formulating corporate governance rules for its regulation sector is not only duplicating what is already in place but in some instances (the rules governing independent directors) it is adding new dimensions.

APRA is in a unique position in regards to other regulators in that there is a sizeable chunk of its jurisdiction that is not publicly listed. It is therefore inevitable that the rules needed for smaller unlisted entities flow back up to the larger listed companies that already have a swag of corporate governance rules in place.

John Laker is prepared to listen to genuine concerns and adapt some of the proposed new rules but there is little doubt that he is determined not to have another corporate disaster on his watch.

"I have seen the evolution of APRA from its genesis," Laker says. "I have seen the role of APRA from both sides in terms of a Reserve Banker and as an APRA board member. I have been there from day one and what I saw over that five-year period was an institution that was very committed to its goal of world's best practice. It was one of the new breed of prudential regulators that was forming.

"During this time we tried to apply a consistent framework across the whole of the regulated sector and break away from the silos of the past. It was an institution that wanted to deliver on the promise of the Wallis report.

"I saw that evolution and I also saw that we got king hit by the failure of HIH. That was a major body blow. It was a profound disappointment the way it unfolded and I have said publicly that as an ongoing supervisor you don't have much time to wallow. We just have to dust ourselves off and get up on our feet."

In the wake of HIH and Justice Owen's report the Government revised the prudential requirements of the Insurance Act 1973 which even APRA said at the Owen inquiry were "inadequate - being limited in scope, inflexible and open to evasion and manipulation".

The most important provision of the post HIH Insurance Act is the power for APRA to issue Prudential Standards (section 32). Pursuant to this section APRA has issued four key Prudential Standards that impact on the financial soundness and the corporate governance of authorised insurers.

These standards significantly upgrade the rigour with which insurers must value their insurance liabilities and assess their capital adequacy but more importantly - imposes much higher standards of governance on an insurer's board and management.

It is APRA's view a major weakness of the prudential and accounting regime under which HIH operated was that an insurer's board and management had too much discretion in valuing their insurance liabilities.

This in part explains APRA's determination to press ahead with its corporate governance rules. In fact a fall-out from HIH was that the governance arrangements for APRA were also changed including replacing the non-executive board with an executive group comprising of a CEO and two or three commissioners and discontinuing the involvement of representatives from ASIC and the Reserve Bank of Australia on the board of APRA.

"There were three main lessons to come out of the HIH episode and one was the importance of having a regulatory framework that gave APRA the power of intervention," says Laker.

"The second lesson was for us to have a more effective radar to pick up early warning signals. This meant building up our ability to assess risk.

"The third lesson was that APRA was just too thinly staffed on the front line. We benchmarked ourselves against comparable regulators and it showed we were at the light touch end and this is not where the Government or the community expected us to be."

It was the classic case of too many chiefs and not enough hard-nosed Indians on the front line. Since 2003, APRA has taken steps to rectify this, not least in having an executive group charged with specific roles.

"We have an ongoing supervisory relationship with each of our regulated institutions carried out by our front line supervisors but backed up by specialists," says Laker. "This doesn't just look at whether the institution is meeting the requirements - rather it looks at how the institution is managing the risk and how appropriate are their business strategies.

"We have an ongoing dialogue and monitor the information provided by the various institutions and form a risk rating for that institution. Once we have determined a rating for that institution - not unlike a Standard & Poor's rating - it will determine the supervisory response.

"These are not matters of discretion. If an institution has reached a risk rating of sufficient concern we must respond."

But herein lies the dilemma for APRA and the institutions it monitors. If red flags start appearing at the listed end of the institutions it supervises the market would have already woken up to this and made its own judgments.

"We have always said that market discipline is an ally of the prudential supervisor. The reason a prudential regulator exists is that we are dealing with a very precious commodity called confidence.

"The fact is the majority of the institutions APRA regulates are not listed. While the ASX has a public disclosure regime, a prudential regulator tends to prefer working behind the scenes. It is our ability to operate effectively in the interest of depositors and policy holders without undermining confidence that is paramount."

This is where the high wire and juggling comes in.

How does a regulator ensure consistency and fairness across a very diverse sector that is both listed and unlisted?

"Our approach starts out by looking at the deposit taking sector as a whole," Laker says. "It doesn't divide it into listed and unlisted. We look at the principles of prudent management of the institutions in that sector and the standards we believe should be in place.

"In developing new standards we look at what is in place including the Corporations Act and the ASX Corporate Governance Principles. We clearly have regard to what other regulators require but we are the only regulator charged with promoting sound and prudent behaviour that protects people's money or their assets.

"The clear mandate we have been given by Parliament is that the standards of prudent behaviour are to be higher than in other sectors. We have full regard for the Corporations Law and the ASX guidelines but in the APRA regulated sector we make no apologies for the fact that we set our standards at the higher end.

"That's what the prudential regulator's mandate is and that's what Parliament expects us to do. But clearly how we go about implementing those standards require us to be careful."

Laker is mindful that there is a view that there is regulation overkill and says he read the June issue of Company Director "Irrational exuberance and corporate regulation" with interest.

"We have heard the concerns in regard to over-regulation and reform fatigue. This is abundantly clear from the consultations we have had with industry. What we need to do as APRA is balance those concerns.

"If we take APRA's corporate governance proposals that are up for discussion in particular they do not conflict or go further than the ASX guidelines or the Corporations Law.

"The prudential standard makes it very clear that when a board forms a view about whether a director is independent it must have regard to the ASX guidelines. The difference is that with the ASX guidelines it is on a 'if not, why not' criteria in terms of compliance."

What Laker is proposing is that if a board believes that there are extenuating circumstances in which a director may not meet formal independence guidelines that in addition to explaining the "if not, why not" reason to the ASX and shareholders, he also wants the board to explain that to APRA - and APRA will be the judge and make the ruling.

"If a board believes that a director is not independent but there are other reasons why that person should be treated as independent, we simply want them to run the 'if not, why not' arguments past us and persuade us.

"In the first instance a board relies on shareholders to provide discipline. The difficulty for us is that the majority of our companies are not listed and not subject to the ASX guidelines. Therefore the depositor or policy holder doesn't have the opportunity to vote.

"In almost all circumstances that I can envisage the ASX guidelines and what we require will dovetail very straightforwardly. But there may well be special cases and we will have to wait and see what arguments are put to us."

But the issue of certainty remains. The end result is that a company in the prudential regulation sector has to jump three different hurdles when proposing an independent director on an "if not, why not basis" - shareholders, the ASX and APRA.

"Look there is several ways we can respond to that particular concern. One is that we consult very thoroughly before we introduce prudential standards. The draft standards that are out there at the moment are the result of 18 months of consultation.

"But let's presume that they are introduced in that form. How do the institutions then reconcile explaining to shareholders and then explaining to APRA? This should not be a source of tension for the major players who are already meeting a range of prudential and corporate governance requirements.

"If an entity wishes to depart from the ASX guidelines and put up an "if not, why not" reason they would have to have a pretty good argument to win over shareholders. In the long term you would think the interests of shareholders and depositors would coincide. But what may well be very good for shareholders in the short term may not be good for depositors and that's where there are natural tensions."

While Laker is prepared to have a flexible approach if circumstances warrant this he is absolute in his view that a company's board of directors are the main decision makers and therefore should be held accountable.

Just how much accountability and legal liability a board comprised of part-time directors should take on is a subject of current debate. Laker has no reservations about this.

"I don't see that what is being proposed in the governance standards changes in any substantive way in how we are doing our job since inception. We have always held views on how well a board is performing.

"Our prudential framework is based on the basis that the board is the primary decision maker of the company. We do not accept the argument that the board can somehow cast off the responsibility.

"The reality is that with a few minor exceptions the boards of our major institutions have already met the standards being proposed. We are seeking to reinforce throughout the industry what is already good practice."

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