New research comparing capital requirements of banks and insurers in Australia

New research into regulatory standards for banks and insurers has found that improved transparency would bring benefits and that some differences exist in the treatment of products that are economically equivalent. Such differences may create regulatory arbitrage opportunities and market distortions. The research, conducted by Ernst & Young, is intended to inform debate about the local impact of proposed regulatory reforms following the global financial crisis, including higher capital standards for banks and life insurers.

APRA, Challenger Limited, Ernst & Young, the Institute of Actuaries of Australia, Suncorp Metway and Westpac Bank jointly sponsored the research project. The project, chaired by leading actuary Tony Coleman, considered the potential for market distortion or arbitrage due to current inconsistencies in standards, and the potential for systemic risk arising from the current frameworks.

The research was aligned with the current international agenda for proposed future regulation of banks and insurers. In a recent keynote speech on this subject, Adair Turner, Chair of the Financial Supervision Committee of the Financial Stability Board, noted the need for regulation to be “sufficiently consistent across sectors to guard against regulatory arbitrage” and for a “continually updated” regulatory understanding of the inter-connected nature of the financial system and systemic risks that may result.

“The aim of our research is to make a meaningful contribution to ongoing work aimed at better understanding differences in regulation between banks and insurers, while using the opportunity offered by the G20 process to identify situations where regulatory arbitrage, market distortion and systemic risk could arise,” said Tony Coleman. “In some instances, inconsistencies may result in a product provider choosing to manage a product from a part of a group where lower capital standards apply and therefore where a higher return on equity could be achieved,” he said.

The paper finds that materially different regulatory capital requirements currently exist in the area of term deposits and term certain annuities. In this case, both products provide a similar outcome for consumers (i.e. effectively an assured return of income and capital) but annuities have significantly higher capital requirements because they are provided by life insurers rather than banks. Higher capital requirements have the effect of lowering the overall return and relative attractiveness of term certain annuities. This outcome needs to be considered in the context of broader public policy.

In another instance, at a framework level, provisioning is treated differently between banks and insurers, despite conceptually seeking to achieve a similar purpose.

“The research also sought to recognise that any proposed regulatory reforms focused on greater consistency must also consider the inter-connected nature of the financial system and potential for systemic risks,” Mr Coleman said.

Ernst & Young noted that achieving consistency between sectors is not straightforward. In particular, APRA is constrained by history and by international regulatory developments that do not necessarily have the same objectives. However, APRA’s proposed conglomerate reforms provide an opportunity to achieve a higher level of consistency where appropriate.

The research also found that banking and insurance sectors would benefit from increased transparency in the calculation of provisioning and regulatory capital as this would:

• Allow a better understanding of the impact of current regulatory reform by providing clarity around the extent of potential increased conservatism of Basel III and the overall impact of insurance reforms
• Highlight areas of potential regulatory arbitrage by identifying the most capital efficient entity for bearing a given risk
• Enhance decision making by increasing awareness of best practice across internal modeling and highlighting areas of regulatory inconsistency
• Give a greater understanding of the quantum of capital buffers which would assist in risk/reward decisions