Beware the unintended banking effect

Just how much tier-one capital is enough for Australian banks? Second-guessing APRA's advice on that question risks triggering a complex matrix of consequences.

It isn’t surprising that the four major Australian banks are paranoid about any discussion about increasing the amount of capital they have to hold. There are a range of players out to “get” them.

This is not a new discussion. It has raged since the onset of the financial crisis and so far the major Australian banks, despite coming through that period relatively unscathed, have been on the losing side.

Partly due to the relatively conservative nature of their asset bases but also to the conservative approach adopted by the Australian Prudential Regulation Authority, the major banks already hold more high-quality capital than most of their international peers, face a further one percentage point capital surcharge in 2016 because of their “too-big-to-fail” status and are ahead of most systems and the Basel Committee’s timelines in implementing new and more conservative international prudential settings.

The Financial System Inquiry’s interim report and comments by its chairman, former Commonwealth Bank chief executive David Murray have, however, alarmed the majors because of the potential for the inquiry to recommend even more conservative capital requirements.

Last month Murray rejected the view that the banks were being treated more harshly by APRA than their peers elsewhere and said they would need to prove that argument.

The inquiry’s interim report discussed the cloudy issue of the majors’ capital requirements and concluded that they were “around the middle of the range” relative to other jurisdictions with a similar level of financial development and therefore were not excessively high.

The Australian banks have always argued that APRA’s approach to calculating their capital ratios is more conservative than their peers and understates how much capital they have.

A Basel Committee review of Australia’s implementation of the Basel III framework did, however, conclude that there were 27 areas in which APRA was more conservative than the committee’s minimum capital requirements framework but there were “several” areas where Australia wasn’t as conservative as the baseline. Regulators are allowed to factor their national circumstances into their application of the committee’s rules.

The majors try to calculate their “real” internationally-harmonised common equity tier one capital (CET1) ratios, which on their numbers says the average difference between the ratio produced using APRA’s approach and the Basel committee’s framework -- the amount to which APRA’s rules understate their ratios relative to the international standards -- is about 235 basis points.

According to APRA’s submission to the inquiry, the difference is actually more like 190 points – a CET1 ratio under the international standards of 10.17 per cent versus 8.28 per cent under its own – with the major differences the definitions of capital and floors for loss-given-default estimates for residential mortgage exposures under their advanced internal ratings approach to evaluating credit risk.

It is virtually impossible to compare the regulatory frameworks of different banking systems because every system has its own variations and departures from the Basel committee’s standards, not all of which are visible. APRA has said that it also imposes non-public specific capital requirements on individual institutions that aren’t readily observable.

In other words, while it is probably fair to conclude from experience and observations that APRA has demonstrated it is a more conservative (and effective) regulator than most of its peers and that the Australian banks’ capital ratios are under-stated relative to their own peers, it is impossible to say anything much more precise than that.

The Basel Committee is trying to develop more comparable statistics and more consistent treatments of risk-weighted assets, the denominator in the capital ratios, after an analysis showed quite major variations in risk-weightings for banks with the same assets.

At some point there might be higher quality data to compare banks with; in the meantime the Australian banks are taking David Murray’s advice and are planning to make more detailed submissions on the issue to the inquiry.

The issue is very important for them because the amount of capital they are required to hold affects them in several dimensions.

Obviously the more capital they are required to hold the lower their prospective returns on equity. In theory, because more capital means less risk, that ought to leave their cost of capital unchanged or even lowered.

Tell that to bank shareholders facing lower ROEs – and lower dividend rates. The sharemarket and, indeed, debt markets tend not to adjust for risk, in either direction, until after-the-fact.

An efficient debt market wouldn’t price Spanish government bonds at yields below those of US Treasuries, which occurred in June, and would probably ask for more than the 12 basis point yield premium at which Spain’s 10-year bonds are currently trading over US bonds.

The amount of capital the majors hold also affects their competitiveness, both within the domestic system against smaller banks and non-banks and against their international competitors in this system and offshore.

That’s why the smaller banks and non-banks (and the Greens) argue for bigger capital surcharges or levies on them for their too-big-to-fail status or changes to their risk-weightings that would have the same effect.

Apart from potentially distorting the competitive playing field to tilt it towards smaller banks, non-banks and foreign institutions, with unknown consequences, there are segments of their lending bases where there are significant barriers to entry, like small and medium-sized enterprises.

Inevitably the majors would seek to offset the opportunity cost of holding more capital by raising the cost of funding wherever they could – passing the cost on to borrowers – and therefore making the system less efficient.

There is, therefore, a complex matrix of implications for the banks, their shareholders, their customers and the wider economy that flow from any conversation about further strengthening the prudential framework, particularly when the changes are restricted to a part, albeit the major part, of the system.

There is also a further question of just how much capital is enough, given that there would never be enough capital required to provide a guarantee that no major bank could ever fail. The quality of the regulator, rather than stated capital ratios and asset quality, was demonstrated by the crisis to be arguably the most important factor in the stability of a banking system.

The inquiry is the right forum for the discussion and APRA, which is rightly adamant that the Australian system needs to stay at the leading edge of conservatism, the most credible participant in the debate.

Given that the big end of the system, and the quality of APRA’s supervision, were severely stress-tested by the financial crisis and came through it with their reputations for conservatism enhanced, however, one would hope that the inquiry is mindful of the risk of unintended consequences if it tries to second-guess APRA’s view of what’s required and recommends something more than fine-tuning of the prudential framework of the sector.

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