Wayne Byres of APRA in 2003 - 2016
Wayne Byres of APRA: banks less exposed to property bubble
In his most detailed comments this year on housing, which makes up two-thirds of bank lending, Australian Prudential Regulation Authority chairman Wayne Byres said the market was most vulnerable to a rise in unemployment and borrowers with small deposits, or high loan-to-value ratios.
He said APRA continuously scrutinised banks’ lending at high LVRs — usually considered to be above 80 per cent — to ensure there was “enough margin for error in there that it’s not necessarily fatal to anybody if there is a downturn in the market”.
“If we had some kind of shock … the key here is not that prices go down because in and of itself if people can continue to service their loans history tells us Australians will do that,” he told a House of Representatives economics committee yesterday.
“The key shock will be around if there was something that led to a significant increase in unemployment that would jeopardise people’s ability to service their loan. (And) banks have to resort to selling the properties to have the loan repaid, then it is the ones with a high LVR ratio which will inevitably be the source of the greatest losses.”
Amid a public fracas about negative gearing after Labor vowed to make changes if elected, Mr Byres said that while the “basic rule of economics” suggested reduced demand lowered prices, this was not always the case and was far too simplistic.
“Any change to policy will have an impact,” he said. “(But) it’s very difficult to work out what the impact will be.”
While property has long been viewed as the banks’ — and the economy’s — Achilles heel, concerns recently flared after a US research house claimed Australia had “one of the biggest housing bubbles in history” and prices would fall 80 per cent in mining towns and 50 per cent in parts of Sydney and Melbourne.
Mr Byres said while a slump in prices could not be ruled out, the banks’ “hardship mechanisms” would prevent “everyone being kicked out on the street immediately” when payments were missed.
“That is probably the most important thing because if you look at what happened in the US experience in the subprime crisis … customers can just hand back the keys and walk away from their debts,” he said.
“That’s not something an Australian borrower can do.
“That fire sale of properties (in the US) was the most damaging thing to household values because you had this flood of properties for sale in a very short period of time.
“But I think there are differences in the way our market operates that mean the damaging impact of a fire sale of lots of properties from distressed borrowers wouldn’t happen here in the same way it happened in other jurisdictions.”
As the housing boom gathered pace in recent years and bank lending standards slipped, APRA worked with the Reserve Bank to tighten policies and slow riskier loan growth, such as to property investors.
The efforts helped cool parts of the market, particularly in mining areas, and Mr Byres defended APRA’s actions, arguing promoting sensible lending was needed in frothy and slow growth periods.
APRA this week revealed that bank lending standards had improved and it would now also probe whether parties were skirting banks’ tighter policies.
In a speech in Sydney, Luci Ellis, the RBA’s head of financial stability, said so-called booms never “last forever” and she was actually “not too worried” if people were talking about a bubble.
“If it gives a few other people pause and makes them open their eyes to the real risks, it is not such a bad thing. I would rather that, than if everyone were egging the boom on,” Ms Ellis said yesterday.
She said the best way to avoid problems was not being overly leveraged by adding more capital, including banks that had “profited from the risk-taking on the way up”.
APRA alerts super industry to the drawbacks of hedge funds
5 Mar 2003
03.25
http://www.apra.gov.au/MediaReleases/Pages/03_25.aspx
The Australian Prudential Regulation Authority (APRA) today warned the super industry about its concerns over the use of hedge funds as an investment choice.
APRA General Manager, Mr Wayne Byres, said that hedge funds were growing in popularity because they ostensibly offer the potential for greater diversification in asset classes and absolute returns for less risk at a time when market returns were down.
“What is becoming obvious, however, is that while some hedge funds are professionally managed and regulated, they can still lead to significant losses in a relatively short space of time, particularly where gearing is used,” he said.
“Events in the late 1990s have shown that even the most carefully constructed investment strategies are not fool-proof and significant losses can be generated in a relatively short space of time where large, illiquid positions are involved”.
APRA’s main concerns are that hedge funds rely heavily on a single strategy, with broad delegations for the use of gearing and derivatives, and on a single individual to execute the investment management process; and are characterised by relatively short trading history and/or an absolute return rather than a benchmark return.
“APRA expects trustees to address a number of issues and analyse the risks inherent from an investment perspective before taking the decision to allocate a percentage of a portfolio into a hedge fund,” Mr Byres said.
Some of the questions APRA says trustees must ask in relation to hedge funds include:
- Is the hedge fund a regulated entity? What are the disclosure requirements of the fund and what legal jurisdiction is the fund subject to, and is that legislative environment comparable to the Australian system?
- Has the trustee developed confidence in the adequacy and robustness of the fund’s resources and risk management systems?
- Has the trustee assessed, and formed confidence in, the integrity of key service providers of the fund such as the prime broker, dealers, auditors, legal advisors and external administrators?
- What is the level of due diligence performed on the underlying fund manager, especially where the investment is via a fund of hedge funds structure? Has external professional advice been taken?
- What is the level and frequency of reporting received by the trustee from the fund? For example, if the fund is an equity long/short strategy, are short and long positions disclosed to the investor? Are the number and value of positions disclosed? Is the level of gearing reported? Will the extent of reporting from the fund enable the trustee to manage and monitor the level of risk inherent in the fund’s portfolio?
- What disclosure statements are trustees receiving from hedge funds with respect to the use of derivatives? Is the derivative charge ratio disclosed? Does the use of derivatives adhere to APRA Circular II.D.7?
- How are hedge funds classified in the fund’s investment strategy in terms of asset classes? That is, does an investment in a hedge fund represent a component of equities or is it classified into a separate asset class?
- Is there a lock-up period for the investment in the hedge fund? Can the investment be redeemed within an acceptable period of time? What is the regularity of the fund striking a unit price?
- What benchmarks do trustees utilise to measure the risk weighted performance of a hedge fund? Are performance fees set at realistic levels?
- Is the trustee confident that the hedge fund will not impair the ability of the trustee to comply with reporting obligations to Australian regulatory bodies, including APRA?
Mr Byres added: “Trustees who are unable to answer all of the above questions need to seriously reconsider whether they have made an informed and appropriate investment decision on behalf of their members.” “If APRA is not satisfied that an investment in hedge funds is to the benefit of fund members, it will step in to protect their interests,” he said.
APRA is the prudential regulator of the financial services industry including banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, friendly societies, and most members of the superannuation industry. It currently regulates $1.5 trillion in assets for 20 million Australians.
BACKGROUND
The Hedge Fund dilemma
In the Australian superannuation environment, superannuation trustees face increasing pressure to find new strategies and investment opportunities offering good rates of return. Particularly when faced with weak equity markets and low interest rates over the short to medium term, non-traditional investments are coming under increasing scrutiny as a possible avenue for improving fund performance.
APRA is witnessing a growing awareness, and acceptance, on the part of trustees of the benefits of alternatives investment strategies, and in particular, hedge funds. These investments and funds usually offer trustees the potential for greater diversification in the asset classes, and negative or low correlation with existing investments. Furthermore, with a number of hedge funds offering an absolute return at a time when market returns are negative, and at the same time claiming to expose the fund to less risk, it is no wonder that many trustees are willing to explore the potential of these investment opportunities. This article examines hedge funds from the perspective of a superannuation portfolio, and outlines some of the considerations that APRA would expect trustees to examine before entering into investments in hedge funds.
What is a Hedge Fund?
Although the term is widely used, there is no clear definition of what constitutes a hedge fund. For the purposes of this article, hedge funds are regarded as funds that have some of the following characteristics:
- funds that rely heavily on a single strategy, with broad delegations for the use of gearing and derivatives;
- funds that have a reliance upon a single individual to execute the investment management process;
- a relatively short trading history; and/or
- target an absolute return rather than a benchmark return.
What are the Risks of Hedge Funds?
The decision to allocate a percentage of a portfolio into alternate investments requires a trustee to undertake an analysis of risks inherent in these vehicles from an investment perspective, as well as the credit risk involved in dealing with the manager. Even a cursory assessment will often identify that the trustee is faced with:
- high levels of leverage used by the fund, often from 2 to 10 times;
- unregulated entities incorporated in traditional tax and legal safe havens;
- single person risk;
- an unproven performance history;
- extensive use of derivatives;
- a lack of disclosure about the fund’s assets and strategies;
- no investment mandates and a wide range of investment possibilities; and
- no relevant benchmark to compare performance.
Some of these risks are common to the assessment of traditional fund managers, but many are unique to hedge funds. For example, equity long/short hedge funds employ a strategy of short selling not found in traditional equity fund managers. This strategy is more sophisticated and the risks involved in the fund will vary depending on both the number and value of short positions versus long positions. Regular monitoring of the net long and short positions is important for a trustee to understand the level of risk inherent in the fund. While many hedge funds are professionally managed and regulated, it remains the case that they can, particularly where gearing is involved, lead to significant losses in a relatively short space of time. Events in the late 1990’s – for example, the demise of Long-Term Capital Management – have demonstrated that even the most carefully constructed investment strategies are not fool-proof, and significant losses can be generated in a relatively short space of time where large, illiquid positions are involved.
Hedge Funds as an Investment for Superannuation Monies
As noted above, the competitive nature of the Australian superannuation environment, and the emphasis on out-performance of peers over a relatively short timeframe, is leading trustees to consider a range of non-traditional investment classes. Superannuation portfolios, which have traditionally been fairly conservatively managed, are now more likely to be searching for maximum returns through innovative fund managers and alternative asset classes offering ever increasing returns. Hedge funds, one of the new “alternate investments” are slowly finding their way into superannuation portfolios, notwithstanding that in some cases they can be high risk vehicles with the potential to detract from the investment strategy of the fund and even place members’ funds at risk.
Hedge funds are traditionally marketed as investment vehicles for sophisticated, high net worth individuals. It is open to question as to the extent to which they are an appropriate investment for the retirement savings of all members of the general public. To ensure the trustees of superannuation monies are fulfilling their duties, it is important that this issue is carefully considered.
Whether trustees are able to firstly identify, then mitigate the risks associated with hedge funds is of critical importance to APRA. This is where APRA’s main focus will be when reviewing such investment decisions. APRA’s approach to the investment of funds within the superannuation industry will always be more cautious and measured than when compared to private retail investments. This is because superannuation, by its very nature, is meant to be an investment aimed at achieving a reasonable level of consistent returns over the long term (eg 40 years) for the provision of retirement income. With this perspective in mind, it is questionable whether superannuation monies should be on the cutting edge of financial innovation.
Important Questions for Trustees
Where APRA encounters trustees that have entered into alternative investments, including hedge funds, it is important for trustees to be able to demonstrate that they have carefully consider the risks of the investments, and satisfied themselves that such investments are consistent with the investment objectives and strategy of their particular superannuation fund.
Issues which APRA will expect trustees to have addressed will include:
- Is the hedge fund a regulated entity? What are the disclosure requirements of the fund and what legal jurisdiction is the fund subject to, and whether that legislative environment is comparable to the Australian system?
- How has the trustee developed confidence in the adequacy and robustness of the fund’s resources and risk management systems?
- How has the trustee assessed, and formed confidence in, the integrity of key service providers of the fund such as the prime broker, dealers, auditors, legal advisors and external administrators?
- What is the level of due diligence performed on the underlying fund manager, especially where the investment is via a fund of hedge funds structure?
- What is the level and frequency of reporting received by the trustee from the fund? For example, if the fund is an equity long/short strategy, are short and long positions disclosed to the investor? Are the number and value of positions disclosed? Is the level of gearing reported? Will the extent of reporting from the fund enable the trustee to manage and monitor the level of risk inherent in the fund’s portfolio?
- What disclosure statements are trustees receiving from hedge funds with respect to the use of derivatives? Is the derivative charge ratio disclosed? Does the use of derivatives adhere to APRA Circular II.D.7?
- How are hedge funds classified in terms of asset classes? That is, does an investment in a hedge fund represent a component of equities or is it classified into a separate asset class?
- Is there a lock-up period for the investment in the hedge fund? Can the investment be redeemed within an acceptable period of time? What is the regularity of the fund striking a unit price?
- What benchmarks do trustees utilise to measure the risk weighted performance of a hedge fund? Are performance fees set at realistic levels?
- Is the trustee confident that the hedge fund will not impair the ability of the trustee to comply with reporting obligations to Australian regulatory bodies, including APRA?
Trustees who are unable to answer all of the above questions need to seriously reconsider whether they have made an informed and appropriate investment decision.
Concluding Comments
The hedge fund industry in Australia is still in its formative state of development. Indeed, many of the players within the industry are still working through operational issues. Trustees themselves are still deliberating over the appropriateness of such investments in their portfolio and what exposure limits are acceptable. Whilst hedge funds may provide the opportunity for lower overall portfolio risk, APRA would like to see trustees recognise that the riskier strategies often inherent in hedge funds require careful scrutiny and analysis – and in many cases, more rigorous review than most traditional products. APRA recognises that there may be a place for hedge funds and other alternative investments within superannuation funds, but only where trustees have very carefully considered the risks to which they are exposing their memb