Banks lift their grade in Basel's report card

The latest Basel Committee report card on the state of the world’s banks issued this week shows that they are still short of capital and liquidity, but that overall their position is improving quite rapidly.

Not surprisingly, the region with the banks that represents the larger part of the shortfall is the eurozone. However, even there the shortfall in capital required has been shrinking to more manageable proportions.

The Basel Committee studied 223 banks, 101 large and internationally active institutions (Group 1 banks, with more than $4.3 billion of tier one capital) and 122 others (Group 2). The committee assessed the banks against the minimum capital, liquidity and leverage requirements that will be phased in by 2019.

Using December 2012 data, the committee found that the aggregate shortfall on common equity tier one capital (CET 1) for the Group 1 banks when set against the minimum requirement of 4.5 per cent was only about $3.2 billion — about $2 billion less than it was at June last year.  The four major Australian banks were included in the study.

At the higher target CET 1 level of 7 per cent plus surcharges for globally systemically important banks, the shortfall was about $165 billion. In the space of six months, the Group 1 banks had reduced the shortfall by about $120 billion. The average bank comfortably met the target level.

The Group 2 banks had capital shortfalls of about $16.5 billion at the minimum level and about $37 billion at the target level.

Both groups surpassed the minimum liquidity coverage ratio of 60 per cent and 68 per cent of them are already holding liquidity above the 100 per cent level targeted for 2019.

The 42 largest European banks were, in aggregate, about $100 billion short of the target capital requirement despite significant capital raisings by the German banking sector. The outcome was about $42 billion better than six months earlier.

The European results, disclosed by the European Banking Authority, are of particular interest because the EBA is handing over its supervisory authority to the European Central Bank next year.

The ECB is conducting its own stress-testing of the banks (the EBA’s tests have lacked credibility). It is expected to take a much more stringent approach to issues of capital adequacy and liquidity and a more aggressive approach to forcing the under-capitalised banks to raise or retain more capital.

It’s not possible to come to any conclusion about the quality of the capital or the assets it supports from the Basel Committee’s study. There have been concerns about the inter-relationships between banks in parts of the Eurozone and their governments, and what a more rigorous examination might reveal about the real capital and liquidity they hold. The banks themselves provided the committee with the information on which the study was based.

Nevertheless, it is positive that the banks have taken advantage of the relative calm in economies and financial markets over the past year to improve their position, mainly through retention of their earnings and not by expanding their balance sheets, which is a source of frustration for some economic authorities.

Europe, which accounts for about 60 per cent of the shortfall in capital, is regarded as a potential flashpoint for any fresh financial crisis in the near term, primarily because of the state of its banks and their inter-connectedness with highly indebted governments.

To the extent that they can continue to raise or create capital and liquidity at the rate they did in the second half of last year, the risk of a eurozone banking crisis recedes, the global system is strengthened and the ability of the eurozone authorities to deal with sovereign debt issues without precipitating a concurrent banking crisis is reduced.

Until the actual resilience of the eurozone’s banks is tested — which may come quite soon now that the German elections are out of the way —we won’t know how stable their condition actually is.

But given that the tests the Basel Committee has been undertaking at six-monthly interval have shown consistent and significant improvements, it would appear certain that the banks are in significantly better shape than they were a year or so ago.