Australia must brace for a Basel handbrake

Australia's banks will be watching the attempts by international banking regulators to introduce greater consistency into assessments of risk with some trepidation.

It has been apparent for some time that regulators are concerned that some banks have exploited the discretions within the current prudential regimes to "game" the system, dressing up the appearance of their balance sheets and reducing their apparent capital requirements.

The Bank for International Settlements’ Basel Committee on Banking Supervision has been conducting a series of analyses of the way banks risk-weight their assets. After an earlier exercise that looked at the way banks treated market risks, last week the committee produced a report looking at the variations between banks of the way they approach the risk-weighting of credit exposures.

The exercise was in a sense theoretical. The committee gave a range of international banks a hypothetical portfolio of sovereign, bank and corporate credit exposures and asked them to use their own internal models to risk-weight the portfolio.

Not surprisingly, the results showed there was a considerable variation in the risk-weightings (and therefore the amount of capital each bank would have had to hold against the assessed risk).

It is almost inevitable that the inconsistencies in outcomes that the committee has found in its study of the banks’ risk-weightings will lead to a tightening up of the self-assessment elements of the capital adequacy regime. Banks already face the introduction of a simple leverage ratio, which could also have an exaggerated impact on Australia banks.

The reason the Australian banks will be sensitive to changes in the Basel regime for risk-weighting and ultimately leverage is that they are, among the world’s largest banks, quite unusual because of their disproportionate exposures to mortgage lending.

The four majors, for instance, all have more than half their balance sheets devoted to mortgage lending, ranging from about 53 per cent for ANZ to about 72 per cent for Westpac.

The Basel Committee created that major incentive for mortgage lending, and housing loans in particular, when it introduced the capital adequacy regime with its risk-weightings in 1988. In that initial, relatively crude version of the capital adequacy regime the amount of capital required to support a home loan was only half that of a corporate loan.

Since then the regime has been refined and the more sophisticated banks allowed to use their own risk modelling and experiences to self-assess (under the supervision of their prudential regulators) the risks within their portfolios and the capital needed to support them.

That has been a source of some angst among the smaller banks that have had to use a "standardised" approach that has seem them holding at least twice as much capital against their home loans as the majors, and consequently producing significantly lower returns on equity.

The extent of the impact of the risk-weightings can be seen in CBA’s numbers. It has total assets of around $721 billion and interest-earnings assets of about $550 billion – but risk-weighted assets of only $302 billion.

The Australian banks could and would argue, with justification, that their long experience of home lending, including periods of stress like the recession in the early 1990s, validates their assessments of risk. They are also subject to regular stress testing, using quite dire scenarios, by the Australian Prudential Regulation Authority.

Lending primarily against residential property in Australia is, or at least has been, demonstrably lower risk than home lending in Europe, the UK or US for a variety of reasons – including the nature of mortgage loans in some of those markets and the underlying fundamentals of supply and demand.

The concern for Australian banks, and not just the majors, would be if the international regulators decided to reduce or remove the flexibility and discretions in the existing risk-weighting regime and standardise the rules around settings designed for banks with more diversified and/or riskier credit exposures.

The simple leverage ratio – the relationship between a bank's asset and its tier one capital base – is a particular issue because the low risk-weighting for mortgages makes the Australian banks appear more leveraged than some of their international peers.

The Australian banks are solidly profitable and do create a lot of capital so conforming to whatever the new regime might ultimately be isn’t a particular problem, although a more rigid and less favourable treatment of mortgage lending would have an impact on their returns on capital.

More disconcerting is that the global regulators’ push towards a significantly more conservative regulatory regime for banks could have an impact on the banks’ capacity and willingness to lend.

The weak demand for credit from both households and business since the financial crisis has meant that the banks’ concerted efforts to reduce their exposures to offshore wholesale funding markets, exposed as a vulnerability during the crisis, hasn’t yet had much impact on the supply of credit.

As a study by the Australian Centre for Financial Studies into the future funding of Australian economic activity that was released today concluded, however, that’s not likely to be the case in future as demand for credit returns and other sources of funding may need to be developed.