Regulation shapes bank returns

For other articles in this series, see:

1. The building blocks of banking

3. Home truths for the big banks

Banks play a vital role in the economy. They provide loans and other financial services to people and businesses, and give them somewhere to park their cash. But with those activities comes great responsibility: if a bank fails it threatens those deposits, while lending clampdowns can cause widespread economic pain.

Worse still, the failure of one bank can lead to a cascade of collapses – a so-called ‘banking panic'. History has been littered with them, but you only have to go back ten years for the most recent examples overseas.

In a bid to protect deposits and prevent these panics – or at least reduce their frequency and severity – regulators impose a catalogue of rules and regulations. These rules can shape the competitive landscape between the banks.

It's a difficult balance between encouraging growth and mitigating risk. As a result, the regulatory landscape is in a constant state of flux, being loosened and then wound back again. This happens over a number of years and often after a major crisis – the quintessential shutting of the stable door after the horse has bolted.

Regulation basics

As with many other areas of government, the tendency is to add rules rather than take them away and the result is a vast collection of rules and regulation covering a range of risks, such as governance, liquidity and capital adequacy.

In terms of governance, for example, the Australian Prudential Regulatory Authority (APRA) will soon implement some constraints around bank executive remuneration..

Liquidity is governed by a range of detailed rules such as types of funding sources, and the amount of liquid assets required to survive stressed conditions (a period with high cash outflows).

The primary focus of regulation, though, is to ensure that banks have enough capital to act as a buffer for the risks they're taking (largely through loans; see the first part in this series, The building blocks of banking, for more on the basics). This is also the area that has the greatest impact on the competitive landscape, so it will also be our focus.

CET1ng the rules

The regulators use the ‘common equity tier 1 ratio' (the ‘CET1 ratio' for short) to define the necessary capital levels. To work it out, we need two other numbers: the common equity tier 1 (CET1) capital and risk-weighted assets (RWA).

The first of these – common-equity tier 1 (CET1) capital – defines the money put in by shareholders. This includes the money put up in the first place, plus any further share issues over the years, plus retained earnings (the profits that haven't been paid out in dividends). Intangible items such as goodwill are removed from capital calculations as they can't be used to absorb any losses (you can't convert goodwill to cash).

There are additional forms of capital, such as hybrids, which get swept up in other portions of Tier 1 and Tier 2, but regulators are less keen on these nowadays and the focus is very much on CET1.

The second metric – risk weighted assets (RWA) – adjusts a bank's assets to account for their risk. Every asset is assigned a risk weighting. The risk weights attached to assets can vary between banks (as we'll explain shortly) – but the starting point is notes and coins, deposits with the Reserve Bank of Australia and Australian government bonds, all of which have a weighting of 0%.

These assets are considered to have zero risk and, as such, banks can borrow all the money they like and put it in these assets, without it adding to their RWA, and therefore without any need to back it up with any of their own capital. Of course they'd have a hard job making any money by doing this. But to the extent that they hold these items in the normal course of their business, they don't add to RWA and they don't need to be backed by capital.

At the other end of the scale are things like unlisted and listed equities, which can have risk weights of 400% and 300% effectively. Somewhere in the middle are unsecured loans that are more than 90 days past due (150%), premises, plant and equipment (100%), and a catch-all for any assets not given a specific risk weighting (also 100%).

For Australian banks, residential mortgages are of particular importance, and they have different weightings depending on their risk. A basic mortgage with a loan-to-value ratio (LVR) of less than 80% is weighted at 35%, but ‘sub-prime' loans, and/or those with higher LVRs are rated higher. In some circumstances, some (larger, more sophisticated) banks are also permitted to rate some loans lower (more on this in a moment).

After a bank's assets have been appropriately weighted, they can be pooled together to give a total figure for RWA. Regulators also require buffers in the RWA for operational and market risks. Armed with the figures for CET1 and RWA, we can work out the CET1 ratio by dividing the former by the latter. The result is that the more assets you have and the riskier they are, the more CET1 you will need to hold to maintain a particular ratio.

You can see a simple example in Table 1. Home Loan 1 has $100,000 outstanding and, with a risk weight of 35%, its RWA is $35,000 ($100,000 x 35%). We follow a similar process for the other loans leading to total RWA of $215,000.

The bank has CET1 of $25,000. Dividing that by the total RWA, yields a CET1 ratio of 11.6%. If the small business loan went beyond 90 days past due, though, and needed to be reweighted to 150%, then the RWA would jump to $265,000 and the CET1 ratio would fall to 9.4%.

Welcome to Basel

Since 1998 APRA has been charged with regulating the banking industry in Australia, producing the rules and regulations and setting the required capital levels. It does this, however, with close reference to the guidelines established by the Basel Committee on Banking Supervision, a global panel of bank regulators and central banks.

The original Basel rules (drawn up in 1988) were rudimentary by current standards. Residential mortgage loans, for example, had a blanket risk weighting of 50% despite different risk profiles. Since a greater margin could be earned on riskier mortgages, this effectively incentivised banks to take on a disproportionate amount of them. In any case, banks were becoming more sophisticated in their assessment and management of risk.

A boon for the big four

The Basel 2 Accord, implemented in Australia in 2008, set out to address this.

‘Basel 2' established more precise risk weightings and also allowed for banks to be split into categories of ‘advanced' and ‘standardised'. Those with sufficiently sophisticated risk management systems and processes could apply to be considered ‘advanced' and largely determine their own risk weightings.

The majors (as well as Macquarie Bank) spent tens of millions of dollars developing these capabilities and were duly approved by APRA, but the smaller ‘standardised' banks have lacked the resources to do the same.

The ‘advanced' accreditation gives the majors a significant competitive advantage, because they're able to lend more per dollar of capital. Lower cost structures, largely due to economies of scale, have compounded this benefit.

The impact has been most noticeable in the residential mortgage market. Risk weights for high-quality residental mortgages, for example, dropped to around 17% for the big four, while the ‘standardised' banks have been limited to a minimum of 35%.

Rules around capital levels were complex under Basel 2, with a variety of tiers and qualifiers. Banks had to maintain overall capital above 8% of RWA, with CET1 equivalent (which was defined more loosely) comprising at least 50%.

So Basel 2 reduced mortgage risk weights for all, but the major banks benefited more. Using the 8% capital ratio, one of the big four might need to hold only $13,600 (8% of $170,000) in capital to support a typical $1m home loan with a low LVR; a smaller bank, by contrast, would have to hold $28,000 (8% of $350,000).

Not surprisingly, the majors gorged on residential mortgage lending and snapped up brokers to increase their reach. Their ‘capital light' businesses could price mortgages more aggressively than smaller banks, and earn fatter profits doing so. Big four market share for home loans soon grew from 70% to more than 80% (supported by some acquisitions).

Stricter rules

The global financial crisis showcased Basel 2's shortcomings, even if the Australian banking system fared well relative to other regions. Among other deficiences, CET1 equivalent levels were simply too low, and the regulatory pendulum has since swung back to stricter rules.

The revised rules – known as Basel 3 (no-one ever accused regulators of being too creative) – have been implemented in stages starting from 2013, with more to come. The Australian version, though, has some unique measures thanks to the 2014 Financial System Inquiry, which recommended that local banks should be ‘unquestionably strong'.

All up, the big four have been hit with a double whammy. The first hit came from an increase in the risk weighting for residential mortgages from around 17% average to 25% minimum (it has stayed at a 35% minimum for the other banks). The second hit was an increase in the minimum CET1 ratio requirement to 10.5% (in force from 2020) from 8% (Smaller peers are required to hold at least 7.5% but they hold considerably more). The chart shows the steep increase in capital levels over time (of particular note is the rise in CET1 and Tier 1 capital).

So, for that hypothetical $1m home loan, the big four banks would now need to hold $26,250 (10.5% of $250,000), or around double the levels under Basel 2 and more commensurate with the smaller banks.   

Australia's major banks now have some of the highest capital ratios in the global banking industry. Regulation has impaired their ‘capital light' business model.

So the big four still have a sizable advantage, but the gap has narrowed. We expect it to narrow further in coming years, with APRA introducing various new rules and other banks achieving advanced status. Only a few weeks ago APRA granted that status to ING Bank (Australia) and we expect others to be approved in time.

Strategy adjusting

The strategic response from the majors has been to trim their lower-returning business, most notably their institutional (large business lending) and wealth management operations.

Compared to home loans, institutional lending has higher risk weights, lower net interest margins and higher operating costs. The majors still plan to increase institutional and business lending, though it appears to be on a more selective basis.  The big four banks (with the exception of Westpac) have also sold their life insurance operations, and disposals of various wealth management businesses are expected following recent divestments such as the sale of ANZ Wealth Management to IOOF.

Changes to the regulatory landscape have brought revisions to the major banks' business models. They are better protected against financial panics than they were a decade ago, but they're unlikely to be as profitable.

Yet all this change has left the banks more exposed to home loans – which is perhaps what regulators are most concerned about. And this will be the focus of our third article in this series about the banking industry.

For other articles in this series, see:

1. The building blocks of banking

3. Home truths for the big banks

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