Once the financial system inquiry’s interim report was issued in July it was evident the major banks were facing a potential two-pronged attack on their returns and competitiveness that unnerved them.
One dimension of that prospective threat was that the report, and subsequent comments by its chairman, David Murray, questioned whether the majors were as conservatively capitalised relative to their international peers as previously believed.
The other related to the competitiveness of the domestic system and whether the majors’ perceived advantage should be reduced by playing with the risk-weightings for residential mortgages to increase the amount of capital they hold against them or by reducing the amount of capital required to be held by their smaller competitors.
While some of the arguments around capital adequacy are extremely technical and the data that underpins them of dubious quality, the recommendations the inquiry makes in its final report have the potential to quite significantly change the prudential and competitive landscapes in the system and will therefore be of great consequence for the system, the economy and all the participants within them.
So concerned were the majors about the interim report’s conclusion that their capital ratios were “around the middle of the range” relative to other jurisdictions that the Australian Bankers’ Association commissioned an analysis from PricewaterhouseCoopers Australia.
While it can’t be definitive -- every system has its own variations from the international banking standards set by the Basel Committee, not all of which are visible to third parties -- PwC’s core conclusion was that the major Australian banks were at or above the 75th percentile in terms of the capital they hold relative to their risk-weighted assets.
The body with the best insight into the system is the Australian Prudential Regulation Authority, which also appears to be getting sightly nervous about what the inquiry might propose.
Second-round submissions to the inquiry closed last week and in its second submission APRA noted that the majors would, from 2016, face a capital surcharge because of their status as domestic systemically important institutions (D-SIBs). It has set that surcharge initially at one percentage point but said the calibration of the surcharge would be monitored having regard to future industry and international developments.
“Other proposals ultimately put forward by this inquiry, including those in relation to competitive issues and financial stability, may also impact the appropriate level of D-SIB capital requirements,” it said.
It said the inquiry was concerned with the perception of an implied government guarantee for the majors, or those perceived to be “too big to fail”.
“While this perception may be mitigated somewhat by providing greater clarity regarding the circumstances in which private sector stakeholders will bear losses should a large bank need to be restructured or recapitalised, achieving this objective will not be easy.”
While welcoming the inquiry’s support for exploring practical approaches “many of these proposals are new and untested” and a “degree of caution is warranted in proceeding too quickly to firm recommendations ahead of international developments”.
There is an underlying sense of nervousness in APRA’s submission that the quite sophisticated and nuanced regime it oversees might, at a time when the international banking regulations are evolving quite rapidly, be overlaid with some new and quite rigid domestic rules.
The question of whether the majors have enough capital isn’t just about the amount or quality of the capital they have but the risk-weightings of the assets they hold -- the capital adequacy rules tailor the minimum amount of capital required to the perceived risk in the banks’ loan books.
Because the Australian banks’ balance sheets are dominated by residential mortgages, which are perceived to be relatively low risk, their capital adequacy appears high relative to their peers -- but they are effectively quite highly leveraged and, because of the demand for housing loans in an historically low interest rate environment post-crisis, have become more leveraged -- against asset bases deemed less risky -- since the crisis.
The Basel Committee, concerned by the variability of risk-weightings across jurisdictions, is currently reviewing them to see whether they can be more standardised. It is also planning to introduce a simple leverage ratio.
The outcome of either initiative could be to effectively increase the amount of capital the major banks have to hold against their residential mortgage books and put an elevated floor under their average risk weightings.
That prospect flows into the competitive dimension to the arguments about capital. The smaller banks and non-banks want to use the inquiry to either handicap their big competitors or improve their own competitiveness.
The big banks use very sophisticated and granular modellings of their portfolios and risk to determine the appropriate risk weightings (although APRA also has its own overlays, some of which are specific to types of lending and others to the institution itself).
The smaller authorised deposit-taking institutions use a 'standardised' approach that appears to require more capital, although APRA’s submission says the two approaches aren’t directly comparable and that a higher capital required for smaller institutions can in any event be justified because of their high degree of geographic and product and business concentration relative to the majors, who also face other capital requirements the smaller institutions don’t.
APRA isn’t keen on making any changes to the prudential framework that would provide more incentives for encouraging residential mortgage financing over other forms of lending -- it has revealed some concern in recent times about the risks within the current 'hot' property market.
APRA could be entitled to feel somewhat aggrieved, as one of the world’s more respected prudential regulators, that the inquiry is trampling all over its turf and doing so at a time when the international framework for banking is changing and shifting to more conservative risk settings. APRA is deeply involved in that reform process.
It did make the point that its existing tools, processes and coordination mechanisms are adequate to address industry-level risks to financial stability and warned against creating new instruments “purely for macro-prudential purposes” when the tools were untested and the purpose for which they might need to be used was unclear.
No banking system can be made risk-free. Fiddling with the capital requirements and risk-weightings, or implanting “bail-in” rules for creditors in a crisis, might change the riskiness at the margin but ultimately it’s the prudence of the institutions and the sophistication and diligence and flexibility of the regulator to adapt requirements to the conditions that underwrites the stability of the system.
There is a sense in APRA’s second submission to the inquiry that it isn’t particularly comfortable about its ability to regulate effectively and prudently being questioned; nor about the quite prescriptive directions in which the committee’s interim report suggested it might be heading; nor the idea that prudential rules and tools should be used to promote particular competition policy outcomes.