APRA’s Discussion Paper on Implementing Basel III Capital Reforms makes for interesting reading mostly for what it does not address rather than the few important reforms that it does. APRA has certainly made an attempt to put enough strength into our banking system to withstand the inevitable crisis to come, but whilst tougher capital requirements will have an effect on curbing some risk taking, the inevitable systemic risk issues are not addressed.
Firstly I’ll summarize in plain language the positives provided by APRA in the discussion paper.
- Establishing a Common Equity Tier 1 (CET1”) of 4.5% from 1 January 2013
- Introducing an additional Capital Conservation Buffer (“CCB”) of 2.5% from 1 January 2016
- Requiring a minimum 6% Tier 1 (“T1”) capital from 1 January 2012
- Therefore there is a CET1 plus T1 requirement of 8.5% from 1 January 2016
- Minimum Total Capital remains at 8% but increases with the addition of CCB to 10.5% from 1 January 2016
- Phasing out certain capital instruments that no longer qualify as T1 or T2 capital
- The introduction from 1 January 2016 of a countercyclical buffer of up to an additional 2.5% CET1 which is intended to be imposed when excess credit growth is adjudged to be associated with a buildup of system wide risk
- Introduction of a Leverage Ratio which is calculated as the minimum amount of capital relative to total assets. This is being set at a minimum requirement of T1 of 3% from January 2013.
In accordance with Basel III requirements, APRA has increased the capital requirements of banks with the increases in Minimum Total Capital, T1 and the introduction of the CCB. However, the Leverage Ratio and the countercyclical buffer need a little more scrutiny.
As APRA states:
The Basel Committee identified that one of the underlying features of the global financial crisis was the build-up of excessive on- and off-balance sheet leverage in the global banking system, despite the fact that many banks still showed strong risk-based capital ratios. During the most severe part of the crisis, the market forced the banking system to reduce its leverage in a manner that amplified downward pressure on asset prices, further exacerbating the positive feedback loop between losses, declines in bank capital and contraction in credit availability
To address this, Basel III introduces a simple, transparent, non-risk based leverage ratio that is calibrated to act as a supplementary measure to the risk-based capital requirements. The leverage ratio is intended to:
• constrain the build-up of leverage in the banking system, helping to avoid a destabilising deleveraging process that can damage the financial system and the economy; and
• reinforce the risk-based requirements with a simple ‘backstop’ measure that provides additional safeguards against model risk and measurement error.
APRA proposes to introduce the Basel III leverage ratio in its prudential capital regime.
I have no criticism of the Leverage Ratio in itself and APRA’s words tell the story. However, the Leverage Ratio could go further as it applies only across a bank’s entire balance sheet. The ratio should be applied to segments of a bank’s assets where those segments have specific methodology for calculating risk weighted assets on which CET1 is based. For instance residential mortgages where our 4 major banks use an IRB Approach to calculate risk weighted assets. As I have posted on a number of occasions, the average minimum amount of Total Capital against total residential assets held by those banks is less than 2%. How relevant is the Basel III quote above?
The countercyclical buffer from Basel III and APRA is an interesting addition and gives APRA a fair amount of extra power. From the discussion paper:
APRA proposes to introduce the Basel III counter-cyclical buffer in its prudential capital regime. Broadly speaking, the application of the buffer would have the following main elements:
• APRA will continuously review the need for the counter-cyclical buffer, in consultation with the Reserve Bank of Australia (RBA);
• in addition to macroeconomic indicators of excessive credit growth such as the credit-to-gross domestic product (GDP) gap28, APRA’s review will be informed by input from the supervisory visits it conducts…
APRA is going to announce publicly when it introduces the buffer and presumably this would be with the total support or even advice of the RBA. So the RBA has finally got another mechanism besides interest rates to control credit growth even if they have to wait until 2016 for the privilege. My only question is why is it not being introduced immediately? Although I do applaud the initiative.
Now to critique what is missing from the discussion paper. There is no mention or discussion on TBTF or regionally significant financial institutions. The elephant has been left out.
There is no doubt that Australia’s 4 major banks are TBTF and therefore enjoy the benefits of an implied government guarantee. This guarantee reduces funding costs, increases credit ratings and gives these banks a competitive edge over their smaller rivals. It also leads to bad behavior and systemic failure.
Implied guarantees are stronger than explicit guarantees and never discussed by guarantor or the beneficiary of the guarantee.
Why is the governments implied guarantee stronger than if it was a written contract? Because as the world has witnessed in other jurisdictions, when the crap really does hit the fan everyone and anyone remotely at risk of losing money demands support and normally gets it. Therefore the benefit of the implied guarantee to our banks is great and it comes at no cost.
No one talks about the implied guarantee because to do so raises the question of accountability. Who is accountable on both sides of the equation is fundamental to system stability. Where there is no accountability a system is ripe for gaming and that’s one thing the banksters are great at. Simply paying themselves huge bonuses from the benefits of taxpayer support is a great game.
Smaller Australian ADI’s must be able to properly compete with the majors on equal footing. Under all the proposed Basel III changes proposed that is unlikely to occur. In fact it’s likely the opposite is occurring. APRA also has a minimum Prudential Capital Requirement (“PCR”) that it can impose on any ADI. This is at the discretion of APRA and is described as follows:
Under the Basel II Framework, the supervisory review process (known as Pillar 2) is intended to ensure that ADIs have adequate capital to support all the risks in their business and to encourage ADIs to develop and use better risk management techniques in monitoring and managing their risks. Based on this process, APRA sets a PCR for Tier 1 and Total Capital for each ADI, which must be met at all times.26 The PCR is set at a level proportional to each ADI’s overall risk profile.
Seems to me that the PCR will add to the capital requirements of all but the majors but how will we know because APRA’s current policy of prohibiting the disclosure of PCRs will continue. Why? Discouraging sustainable competition by smaller ADI’s especially in the mutual sector is not healthy for our financial system. My personal experience of many ADIs apart from the major banks is that they are much stronger credits than either APRA or the rating agencies give them “credit”. Big in credit world has never necessarily meant better.
This all brings me to my most important critique of APRA’s Disclosure Paper.
APRA’s new Basel III capital requirements are still mainly based on risk weighted assets (“RWAs”), the exception being the leverage ratio. Capital ratios are meaningless if the basis of how RWAs are determined is unknown. Where an Australian ADI uses APRA’s standard approach to calculating RWAs, this is not really an issue as APRA publishes the standard approach requirements. However, as pointed out above, Australia’s 4 major banks use internal risk based (“IRB”) approach to calculate RWAs. What is wrong with using an IRB approach? Nothing if a shareholder, depositor or lender knows the detail of what the IRB approach is based on. Under the Pillar 3 requirements of Basel II, banks are required to disclose enough detail so that anyone can understand how RWAs are calculated. As I have posted before, none of Australia’s 4 major banks disclose enough information to be able reengineer their IRB approaches. This is in clear breach of Pillar 3 standards and makes most of APRA’s capital reforms meaningless for the majors.
Well, not quite meaningless for this writer. The major banks disclose enough on their IRB approaches to residential mortgages to determine that RWA are primarily calculated based on historical defaults by loan to value band. Any approach that determines risk solely on those parameters will eventually fail.
But am I underestimating APRA? Does the following statement mean that our banks will be forced to more fully comply with Pillar 3? I hope so but doubt it.
The Basel Committee will issue more detailed Pillar 3 disclosure requirements in 2011. When these are released, APRA will consult on the detailed amendments to be made to Prudential Standard APS 330 Capital Adequacy: Public Disclosure of Prudential Information (APS 330).