APRA Confirms Banks Will Need More Capital To Achieve FSI Recommendations

APRA released their comparative capital study today. Overall, whilst it shows that on an international comparison basis Australian banks are well placed, they are not placed in the top quartile of their international peers, so confirms the observation made  by the FSI Inquiry. For the purpose of this analysis, APRA has used the 75th percentile (i.e. the bottom of the fourth quartile) as a benchmark. This provides an estimate of the minimum adjustment needed if the FSI’s suggestion is to be achieved. However, it is clearly a moving target, as Banks around the world are lifting capital, and further changes to the Basel framework are in the works.

APRA says positioning CET1 capital ratios at the bottom of the fourth quartile would require an increase of around 70 basis points in CET1 capital ratios; and to simultaneously achieve a position in the fourth quartile for all four measures of capital adequacy, the increase in the capital ratios of the major banks would need to be significantly larger, albeit that there are more substantial caveats on the ability to accurately measure the relative positioning of Australian banks using measures other than CET1.

However APRA also says the conclusions of this analysis are, on balance, likely to provide a conservative scenario for Australia’s major banks, given:

• limitations on data availability have meant that certain adjustments that might otherwise have unfavourably impacted the relative position of the Australian major banks have not been possible. These relate to (i) the exclusion of upward adjustments to the capital ratios of some foreign banks, and (ii) the exclusion of the impact of the capital floor on the capital ratios of the Australian major banks;
• anticipated changes arising from the Basel Committee on Banking Supervision’s (Basel Committee) review of variability in RWAs will possibly lead to a relatively lower position for the Australian major banks; and
• international peer banks are continuing to build their capital levels – over the past couple of years, the major banks have seen a deterioration in their relative position, despite an increasing trend in their reported capital ratios.

We note that while APRA is fully supportive of the FSI’s recommendation that Australian ADIs should be unquestionably strong, it does not intend to tightly tie that definition to a benchmark based on the capital ratios of foreign banks. APRA sees fourth quartile positioning as a useful ‘sense check’ of the strength of the Australian capital framework against those used elsewhere, but does not intend to directly link Australian requirements to a continually moving benchmark such that frequent recalibration would be necessary.

APRA will be responding to the recommendations of the FSI, bearing in mind the need for a coordinated approach that factors in international initiatives that are still in the pipeline. This will mean that, whilst APRA will seek to act promptly on matters that are relatively straight-forward to address, any final response to the determination of unquestionably strong will inevitably require further consideration. In practice, this will be a two-stage process as:

• APRA intends to announce its response to the FSI’s recommendation regarding mortgage risk weights shortly. To the extent this involves an increase in required capital for residential mortgage exposures of the major banks, and the banks respond by increasing their actual capital levels to maintain their existing reported capital ratios, it will have the effect of shifting these banks towards a stronger relative positioning against their global peers; and
• other changes are likely to require greater clarity on the deliberations of the Basel Committee (unlikely to be before end-2015) before additional domestic proposals are initiated.

As a result of these factors, and the broader caveats contained in this study, an accurate measure of the increase in capital ratios that would be necessary in order to achieve fourth quartile positioning is difficult to ascertain at this time. A better picture is likely to become available over time as, in particular, international policy changes are settled. Based on the best information currently available, APRA’s view is that the Australian major banks are likely to need to increase their capital ratios by at least 200 basis points, relative to their position in June 2014, to be comfortably positioned in the fourth quartile over the medium- to long-term. This judgement is driven by a range of considerations, including:

• the findings of this study;
• the potential impact of future policy changes emerging from the Basel Committee; and
• the trend for peer banks to continue to strengthen their capital ratios.

In instituting any changes to its policy framework, APRA is committed to ensuring any strengthening of capital requirements is done in an orderly manner, such that Australian ADIs can manage the impact of any changes without undue disruption to their business plans. Furthermore, this study has focussed on the Australian major banks; the impact of any future policy adjustments, if any, is likely to be less material for smaller ADIs.

The benefits of having an unquestionably strong banking sector are clear, both for the financial system itself and the Australian community that it serves. Furthermore, Australian ADIs should, provided they take sensible opportunities to accumulate capital, be well-placed to accommodate any strengthening of capital adequacy requirements that APRA implements over the next few years.

So no clarity yet on the amount of additional capital banks will need to hold, nor timing of changes. Here is DFA’s view of how these outcomes will translate in the Australian context:

1. Banks need to raise $20-40 bn over next couple of years, – that is doable – assuming they will be able to access functioning global markets. It will be ratings positive.
2. Smaller banks will be helped by the FSI changes to advanced IRB, if they translate, but will still be at a funding disadvantage
3. Deposit rates will be cut again
4. Mortgage rates will lift a little, and discounting will be even more selective – Murray’s estimates on the costs are about right
5. Lending rates for small business will rise further
6. Competition won’t be that impacted, and the four big banks will remain super profitable
7. We will still have four banks too big to fail, and the tax payer would have to bail them out in the event of a failure (highly unlikely but not impossible given the slowing economic environment here, and uncertainly overseas). The implicit government guarantee is the real issue.

APRA is concerned about financial stability, not about effective competition, or balancing the interests of shareholders and banks customers.