The Big Four get a small taste of things to come

While APRA's capital requirements are conservative by global standards, a good look at the effects of increased regulation around the world may help mitigate unintended consequences.

The four major Australian banks would have been well aware of the likelihood that the Australian Prudential Regulation Authority would be the Grinch that spoiled their Christmas. And so it proved, although it could have been a lot worse.

On the eve of the eve of Christmas, APRA has released its framework for “domestic systemically important banks in Australia”. Those systemically import banks – ‘D-SIBS’, in regulators’ shorthand – are, of course, the ANZ Bank, Commonwealth Bank of Australia, National Australia Bank and Westpac Banking Corporation.

APRA’s framework flows from work done internationally by the Basel Committee on banking. It issued a framework for globally systemically important banks (G-SIBS) two years ago and then moved on to D-SIBS just over a year ago.

The Australian majors weren’t considered important within the global system, despite their size, but are obviously of systemic importance within the Australian financial system. They are very clearly banks that are too big to be allowed to fail, which also raises the problem of moral hazard and the extent to which taxpayers are exposed to it.

The conclusion of the international regulators was that systemically important banks should hold higher loss absorbency capital requirements – more common equity tier one (CET1) capital – than their not-so-important competitors.

The Australian majors knew that APRA was looking at the issue of whether or not they should face a capital surcharge and anticipated that one would be imposed, albeit at a modest level.

Just ahead of their results announcements, however, they became somewhat more concerned when APRA signalled to them to be cautious about any new capital management measures or special dividends because the impost was likely to be greater than they expected.

Internationally, the D-SIB surcharges have ranged from about an extra 1 per cent of CET 1 capital to 5.5 per cent (in Switzerland, where the regulators are trying to force a reshaping of their major banks).

APRA said today that a range of methodologies and benchmarks had suggested that an appropriate range for the capital surcharge would be between 1 per cent and 3 per cent. It opted for 1 per cent.

The Australian regulatory capital adequacy requirements imposed by APRA are, by international standards, quite conservative and the Australian banks have added an additional layer of their own conservatism. As APRA said, the banks have traditionally held a higher quality capital base than their offshore peers.

Commonwealth Bank, for instance, has a CET 1 capital adequacy ratio of 8.2 per cent on an APRA basis. On an international basis the ratio is 11.9 per cent – the difference is very material. Its peers report similar discrepancies between domestic and international definitions and outcomes.

Because they hold substantial amounts of capital in excess of APRA’s minimum requirements and are highly profitable and therefore are continuously generating new capital, the majors are already in a position to absorb the new risk buffers, although that will leave them with less discretionary capital and flexibility.

The surcharge for D-SIBS is on top of the additional capital and liquidity and lower leverage that the global regulators have imposed in response to the global financial crisis. It is also separate to the issue of levies on banks deemed too big to fail as de facto insurance premiums for taxpayers to compensate for their effective underwriting of that risk of failure.

With Joe Hockey’s financial system inquiry looming next year the majors will be concerned that they could face more new restrictions and costs, both in response to the ‘too big to fail’ argument and the reduced competitiveness of the system since the financial crisis.

There has also been a lot of discussion about the use of ‘macro-prudential’ tools – direct regulation of lending through, for instance, limits on loan-to-valuation ratios or loan-servicing limits or tinkering with the capital adequacy regime to inhibit lending to particular asset classes. That would mean regulators, rather than bankers and markets, would have to make assessments of the relatives risks within the economy.

The underlying fear within the major banks would be that, in an effort to promote greater competition, they will be handicapped relative to their non G-SIB competitors – smaller banks and less-regulated institutions.

Indeed the issue of unintended consequences generally is a broader concern among global regulators.

In toughening up the capital and liquidity requirements for banks, particularly systemically important banks, there is a risk that it drives activity and risk towards smaller institutions and unregulated institutions – the so-called shadow banking system.

One of the terms of reference in the financial system inquiry is to consider international financial regulation in the context of the opportunities and challenges likely to drive future change in the global and domestic systems.

A deep look at the implications of the disparate tide of international and local regulation that is now coursing through the global system would help provide a better insight into what has occurred and what the ultimate net effects – and the potential unintended consequences – of the myriad of regulatory changes might be, given that the costs of extra capital and liquidity and regulation are inevitably borne by customers and shareholders.

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