In today’s FSI report, there is a strong focus on the capital buffers which banks need to hold. We had expected this development.
- Australia’s banking system is highly concentrated, with the four major banks using broadly similar business models and having large offshore funding exposures. This concentration exposes each individual bank to similar risks, such that all the major Australian banks may come under financial stress in similar economic and financial circumstances.
- Australia’s banks are heavily exposed to developments in the housing market. Since 1997, banks have allocated a greater proportion of their loan books to mortgages, and households’ mortgage indebtedness has risen. A sharp fall in dwelling prices would damage household balance sheets and weigh on consumption and broader economic growth. It would also reduce the quality of the banking sector’s balance sheets and the capacity of banks to extend new credit, which would compromise the speed of a subsequent economic recovery.
A severe disruption via one of these channels would have broad economic and financial consequences for Australia. Indeed, interconnectedness within the financial system and the economy would be likely to propagate distress and heighten other risks and vulnerabilities. Even a modest banking crisis could cost 900,000 jobs.
Whilst Australian banks have strong capital structures, they are not in the top quartile of large internationally active banks. The report highlighted that the top quartile level was increasing as other banks “caught up” and on latest levels the average 9.1 per cent capital levels of the Australian banks was below the median of 10.5 per cent and below the 12.2 per cent required to get into the top quartile. Current global initiatives will raise this further. The FSI said any increases in capital should take the form of common equity capital.
This statement effectively rejects the claims of some submissions arguing the banks were already in top quartile position! The Inquiry believes that top-quartile positioning is the right setting for Australian ADIs.
“ADIs should maintain sufficient loss absorbing and recapitalisation capacity to allow effective resolution while mitigating the risk to taxpayer funds — in line with emerging international practice”
This would require the raising of considerable extra capital, and impact bank profitability and product pricing. Drawing on multiple sources of evidence, the Inquiry calculates that raising capital ratios by one percentage point would, absent the benefits of competition, increase average loan interest rates by less than 10 basis points which could reduce GDP by 0.01-0.1 per cent.
In addition those banks who use the advanced IRB capital calculations should expect their ratios to be lifted higher, reducing the competitive advantage they have experienced recently. The major banks, using their “advanced” modelling systems, can set aside less capital against home loans by generating risk-weights of 18 per cent, compared to 39 per cent for small banks like Suncorp and Bank of Queensland. The recommendation is the major banks should increase their average risk weight to between 25 to 30 per cent. This translates to a one percentage point increase in major bank’s common equity Tier I levels from currency levels. The higher funding costs would be born by shareholders and consumers. As a result, as well as products costing more, we expect this to translate into a more level playing field, allowing players on standard capital ratios to compete more strongly.
A final point. The report recommended an additional ratio measure, banks are subject to a minimum of 3 per cent to 5 per cent “leverage ratio”. This ratio would be something like true value of their equity capital divided by the value of their assets. This ratio should never fall below this level. While the majors would currently not be compliant, if they adjusted their capital as recommended by 1-2 per cent, then they would be compliant with this leverage ratio. This approach nicely skirts around the “risk weighted assets” as calculated by Basel.
For background on capital, you can read my earlier posts.
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