Financial Stability in a Low Interest Information 2022

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Luci Ellis and Charles Littrell*
1. Introduction
This paper examines two periods in which the RBA and APRA worked cooperatively to
moderate potentially dangerous Australian home lending booms. The first intervention, with
the benefit of hindsight, proved successful; time will tell whether the second intervention
proves equivalently successful.
This paper is also, to some extent, a personal reflection from two people who had been
deeply involved in the policy response to financial stability risks in the post-global financial
crisis period. Charles Littrell was Executive General Manager at APRA – first for the Policy and
Statistics division and later for the Supervisory Support division – during the entire pre- and
post-crisis period; Luci Ellis was head of the Reserve Bank’s Financial Stability Department from
October 2008 until December 2016. In many respects, the evolving views and relationship of
the agencies described below are also the authors’ own story.
To start the story, the next section gives some background on the evolution of Australia’s
institutional arrangements for financial regulation. The paper then discusses how the
institutional arrangements and past experiences of the agencies influenced their thinking
about the implications of low interest rates for financial stability. That thinking helped frame
the agencies’ responses to two episodes of strong housing market and household borrowing
activity, which are detailed in Section 5. A brief conclusion follows.
2. Background to Australia’s Institutional Arrangements
The financial stability policy framework in Australia in the post-crisis period was shaped by
some crucial prior decisions and events. Its institutional context had as its starting point
the recommendations of the Wallis Inquiry (Financial System Inquiry 1997). This set up the
institutional framework of an integrated prudential regulator (APRA), separate from the
central bank, and a central bank with a more general financial stability mandate. Subsequent
events, specifically the failure of the insurance company HIH, spurred some modifications
to these arrangements (HIH Royal Commission 2003). APRA’s governance was changed;
its resourcing was increased; and its mandate was clarified in a way that empowered it to
respond to broader risks. Consequently, in the period leading up to the global financial crisis,
* Luci Ellis is from the Reserve Bank of Australia (RBA) and Charles Littrell, at the time of the RBA Conference, was at the Australian
Prudential Regulation Authority (APRA) and is now Inspector of Banks and Trust Companies at the Central Bank of The Bahamas.
Thanks to Fiona Price for research assistance.
Financial Stability in a Low
Interest Rate Environment:
An Australian Case Study

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Australia had a set of institutional arrangements that allowed policymakers to be proactive
and empowered them to respond to financial stability risks.
In the initial phase after separation, APRA and the Bank set up formal and informal structures
to ensure effective cooperation in achieving shared goals. The two agencies entered into
a memorandum of understanding (MOU) that, among other things, set up a coordination
committee made up of senior staff from each agency. These more formal arrangements were
assisted, in the first instance, by existing personal relationships between RBA staff and former
RBA staff at APRA. Over time, with turnover and attrition, these existing links could no longer
be relied upon. The expectation of a duty to forge good working relationships had, however,
already been set up. It was also supported by specific measures, such as the inclusion of a
key performance indicator in the job description of the Bank’s Head of Financial Stability
Department requiring the incumbent to build and maintain good relationships with APRA.
One of the key decisions in the post-Wallis setting that turned out to be remarkably helpful
was that the Bank elected not to retain a residual supervisory function once it was no longer
the prudential supervisor of banks. Many other central banks in countries that had made
similar institutional changes around the same time instead retained an independent on-site
inspection function, on the grounds that the central bank needed this capacity for financial
stability purposes. A common effect, unfortunately, was that the new supervisory agency
and the central bank commenced operations as rivals rather than colleagues, and the new
supervisory agency suffered from a lack of experienced bank supervisors.
The MOU between APRA and the Bank contemplated that Bank staff could accompany APRA
staff on supervisory visits, which has indeed occurred. The Bank has also engaged in its
own non-supervisory liaison meetings with selected banks ahead of the drafting of each
half-yearly Financial Stability Review. But the Bank refrained from setting up a rival source of
supervisory intelligence and influence, and therefore avoided diminishing the authority of the
actual prudential supervisor. This marker of mutual respect between agencies seems to have
been helpful in building relationships and cooperation, and avoiding misunderstandings or
‘turf wars’.
Another useful decision in the post-Wallis environment was the government’s allocation of
a legislated financial stability mandate to APRA. (The Bank’s financial stability mandate has
never been explicit in legislation, but was referenced in the Treasurer’s second reading speech
for the Australian Prudential Regulation Authority Bill 1998. It was subsequently included in
the Statement on the Conduct of Monetary Policy agreed between the Governor and the
Treasurer.) Much of the post-crisis international policy debate has pointed to the limitations
of a purely ‘microprudential’ approach to prudential regulation and supervision (FSB, IMF and
BIS 2011a, 2011b; IMF 2013). Under this approach, the supervisor is assumed to be narrowly
focused on the safety and soundness of individual financial institutions, rather than taking
responsibility for the broader financial stability and risk environment (a ‘macroprudential’
approach). Regardless of whether or not this was a fair characterisation of the conduct of
prudential supervision in other countries, it did not describe APRA’s mandate or its approach.
To give some examples:

1 3 7CO N F E R E N C E V O LU M E | 2017
F I N A N C I A L S TA B I L I T Y I N A L O W I N T E R E S T R AT E E N V I R O N M E N T: A N A U S T R A L I A N C A S E S T U DY
• APRA conducted its first banking industry stress test in 2002/03, called ‘Project Panama’,
which among other things led to substantial strengthening of bank capital requirements
for home loans, and to stronger capital and reinsurance arrangements for lenders
mortgage insurance (LMI) companies (Coleman et al 2005).
• APRA warned off the banking industry from material participation in subprime lending.
• From 2003, APRA amended its supervisory approach to ensure that the most resources,
and the earliest responses to indications of weakness, would be applied to the largest,
systemically important institutions (Littrell 2004). This is precisely the ‘cross-section’
dimension of macroprudential policy, as described in Borio (2003), though arrived at
independently of the literature that identified it.
• APRA’s policy infrastructure, notably in adopting International Financial Reporting
Standards (IFRS) in 2005 and Basel II from 2005 to 2008, followed a consistently
conservative line, which (along with other decisions) has led to Australian bank capital
rules that are materially ‘super-equivalent’ to (i.e. stricter than) the international minimum
standards (APRA 2016).
The adjustments to regulatory arrangements in the wake of the failure of HIH were also crucial
to the resilience of these arrangements during the crisis. The Wallis Inquiry recommendations
had been predicated on presumptions common in the North American and European
regulatory debate: that market discipline would be superior to bureaucratic intervention;
and that traded markets and investments would come to dominate banking. One implication
of these presumptions was that, as market-based finance gradually supplanted the role of
financial intermediation the prudentially regulated sector would fade in importance. Another
implication was that smaller institutions, being relatively insulated from market discipline,
required more prudential scrutiny than larger ones. The failure of HIH challenged those
presumptions, prompting a rethinking of the importance of prudential supervision generally,
and of the attention given to large entities in particular. A new Australia-specific consensus
developed in favour of a strong and inquiring supervisor. The HIH Royal Commission
recommended that APRA ‘develop a more sceptical, questioning and, where necessary,
aggressive approach to its prudential supervision of general insurers’ (Recommendation 26).
This more aggressive approach was not limited to general insurance: in Recommendation 28,
the Royal Commissioner recommended that APRA ‘develop systems to encourage its staff
and management continually to question their assumptions, views and conclusions about
the financial viability of supervised entities, particularly on the receipt of new information
about an entity’ (HIH Royal Commission 2003).
By the time the financial crisis began to hit major financial centres abroad, Australia had
a reasonably well-developed framework for thinking about broader risks to the economy
emanating from the financial sector. It also had mature arrangements for interagency
cooperation, and these deepened further in response to the crisis. Therefore, unlike the
authorities in some other countries, the Australian agencies did not have to change their
approach significantly in response to the experiences of the crisis.

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Some changes were nonetheless needed, mainly to adjust to the greater degree of post-crisis
international policy activity. Both agencies were invited to join the Basel Committee on Banking
Supervision (BCBS) in 2009. This required the Bank to develop a deeper understanding of the
prudential framework, after a decade of being little involved in formulating prudential policy.
In addition, the Bank’s participation as a member of the Financial Stability Board (FSB) became
more intensive, in line with the increased activity of the FSB relative to its predecessor, the
Financial Stability Forum. As well as the direct implications of this for resourcing and the
activities of senior Bank staff, this also necessitated more interagency cooperation with
APRA and the other member agencies of the Council of Financial Regulators: the Australian
Securities & Investments Commission (ASIC) and Treasury. Because much of this work involved
the same senior staff, it tended to reinforce the strength of the relationships needed for
effective day-to-day management of domestic risks.
3. How Institutional Arrangements and History Shaped the
Philosophy of Financial Stability Policy in Australia
The institutions and events described in the previous section shaped the Australian agencies’
approach to financial stability policy in a number of ways. Firstly, as noted above, APRA’s
financial stability mandate and approach meant that it was never narrowly microprudential
in its outlook. Both the micro (institution-specific) and macro (industry- or system-level)
perspectives were at play in the supervisory priorities APRA set over the past 15 years. More
broadly, the Australian authorities came to understand that prudential tools were not the only
ones available and necessary to the pursuit of financial stability. Macroprudential supervision
was defined in Australia as being ‘subsumed within the broader and more comprehensive
financial stability policy framework’ (RBA and APRA 2012), and a broader ‘macro prudence’
approach was articulated, being ‘[t]he way in which the public sector works collectively to
promote financial stability’ (Littrell 2013). This broader perspective became stronger and more
explicit following the HIH failure. That experience had taught the authorities that even the
biggest and most prominent institutions could fail, and that such failures could be very harmful.
Related to this, over the post-crisis period, the Australian authorities began to see their
financial stability mandates as being more closely related to conditions in the non-financial
sectors, especially households, rather than focused primarily on the financial sector. The RBA
was already putting relatively more resources than some other central banks into analysing
household and housing developments’ implications for financial stability, even before the
crisis (Ellis 2014b). That emphasis was validated by the experience of the crisis and by a careful
reflection on the legislated mandate the Bank actually had – the economic prosperity and
welfare of the people of Australia – in place of an explicit financial stability mandate.1 Towards
the end of this period, the Bank’s public statements about its financial stability mandate were
making it clear that its role was not to ‘care about asset prices or credit for their own sakes’,
but rather, to improve the welfare of society, which is comprised of people (Ellis 2014c).
1 See Clause 10(2)(c) of the Reserve Bank Act 1959 (https://www.legislation.gov.au/Details/C2015C00201).