Wayne Byres APRA Chairman spoke at Finsia’s ‘The Regulators’ event, Melbourne. He discussed risk culture, profitability and returns in the financial system, and Basel risk capital. We focus on the capital discussion, because he warned that the IRB banks are re-calibrating their models to get closer to the 25% risk weighting. As a result there could be some “noise in the system”. Also it appears Basel III won’t really be complete in 2017.
The Basel Committee needs to complete the final work on Basel III. All the key components of the capital framework are still under review in one way or other, with the ambitious goal to:
- improve the risk sensitivity of some parts of the framework;
- reduce excessive variability in others; and
- not significantly increase capital requirements overall.
If the Committee achieves all these things to everyone’s satisfaction, it will be a miracle!
I’ll be happy to just get some finality to the deliberations. The Committee meets again in a couple of weeks, and hopefully an agreement will be reached that will allow the complete package of reforms to be endorsed by the Governors and Heads of Supervision of Basel Committee member countries in January. If that happens, our return to work in the New Year should be accompanied by the revised international capital framework. That process sounds relatively orderly, but behind the scenes there is still much horse trading to do.
However, the Basel framework doesn’t purport to deliver ‘unquestionably strong’ capital. It is simply the minimum international standard. In Australia, we have long applied more robust requirements1 – an approach that has stood us in good stead. Even without the reinforcing view of the FSI, there’s no reason why we would take a different path now. I mention this to dampen any enthusiasm that might be generated when the new rules are released, by calculating what would happen if APRA was to simply apply the new Basel framework to Australian ADIs. I can tell you the answer now – it would produce a material reduction in capital requirements. Before anyone gets too excited by that, I can also tell you we won’t be pursuing that course.
Once the Basel Committee has set out the minimum requirements, the task for APRA is to think through how and where we build further resilience into the new Basel framework to deliver ‘unquestionably strong’ capital ratios. But that’s not our sole objective. As we make policy choices, we’ll also be considering:
- how we make the framework more flexible, so that it is better able to respond to business and financial cycles;
- how to improve transparency, so that investor understanding of capital strength is enhanced; and
- heeding the message of the FSI, how to take account of the competitive impacts of differing approaches (albeit that any differentiated approach will inevitably lead to different capital requirements at a product level).
The key issue, of course, is how we might calibrate the new requirements. The FSI gave us one guidepost – top quartile positioning relative to international peers – but we’ll also use others. For example, we’ll assess capital positions against rating agency measures of capital strength. The results of stress tests are also informative: banks that have difficulty demonstrating their ability to survive plausible adverse scenarios without severely curtailing lending and/or emergency capital raisings are unlikely to be seen as unquestionably strong. As with top quartile positioning, none of these are intended to be definitive benchmarks, but they do give some useful guidance against which to calibrate the final requirements.
I’ll just say a quick word on timing. Given the number and potential impact of the changes that will be proposed, 2017 will be a year of consultation. We don’t expect to have final standards before this time next year. And even if that is the case, they would not take effect until at least a year after that. But while there’s time for the changes to be worked through, that shouldn’t lead to complacency in the current environment. In that sense, the message I’ve given previously still holds: capital accumulation remains the appropriate course for most ADIs, but with sensible capital planning the actual implementation of any changes should be able to be managed in an orderly fashion.
Before I conclude on capital altogether, I want to say a few words on the FSI recommendation regarding mortgage risk weights. In July 2015, we announced higher mortgage risk weights for banks using internal model-based approach to capital. This was an interim step, but a step we were comfortable we wouldn’t need or want to materially unwind, regardless of the outcomes in Basel.
All other things being equal, we expected to raise the average mortgage risk weights for banks using internal models from around 16 per cent to at least 25 per cent. Unfortunately, in the world of internal models, all other things are rarely equal. Banks constantly refine their models, often at their own initiative but also sometimes at the request of APRA. We noted earlier this year that the impact of a range of modelling changes in the pipeline, when combined with the adjustment proposed in July 2015, would have produced an average risk weight well in excess of our interim objective of 25 per cent. So we’ve had to slightly recalibrate the adjustment, with a view to ensuring the outcomes were broadly consistent with the target we announced.
I mention this because, for those who follow these numbers closely, there will be some noise in the system over the next few quarters. As various modelling changes come on stream, the average risk weight across all IRB banks will fluctuate somewhat, and will impact different banks at different times. But these differences will narrow over time.
