Tag: Basel III

Latest Global Basel III Monitoring Results Announced Today

The Bank for International Settlements has just released its latest Basel III Monitoring Report.  This included five banks from Australia, four group one, and one group two bank. This report presents the results of the Basel Committee’s latest Basel III monitoring exercise. The study is based on the rigorous reporting process set up by the Committee to periodically review the implications of the Basel III standards for banks. The results of previous exercises in this series were published in March 2015, September 2014, March 2014, September 2013, March 2013, September 2012 and April 2012.

Data have been provided for a total of 221 banks, comprising 100 large internationally active banks (“Group 1 banks”, defined as internationally active banks that have Tier 1 capital of more than €3 billion) and 121 Group 2 banks (ie representative of all other banks).

The results of the monitoring exercise assume that the final Basel III package is fully in force, based on data as of 31 December 2014. That is, they do not take account of the transitional arrangements set out in the Basel III framework, such as the gradual phase-in of deductions from regulatory capital. No assumptions were made about bank profitability or behavioural responses, such as changes in bank capital or balance sheet composition. For that reason, the results of the study are not comparable to industry estimates.

Data as of 31 December 2014 show that all large internationally active banks meet the Basel III risk-based capital minimum requirements as well as the Common Equity Tier 1 (CET1) target level of 7.0% (plus the surcharges on global systemically important banks – G-SIBs – as applicable). Between 30 June and 31 December 2014, Group 1 banks reduced their capital shortfalls relative to the higher Tier 1 and total capital target levels; the additional Tier 1 capital shortfall has decreased from €18.6 billion to €6.5 billion and the Tier 2 capital shortfall has decreased from €78.6 billion to €40.6 billion. As a point of reference, the sum of after-tax profits prior to distributions across the same sample of Group 1 banks for the six-month period ending 31 December 2014 was €228.1 billion.

Under the same assumptions, there is no capital shortfall for Group 2 banks included in the sample for the CET1 minimum of 4.5%. For a CET1 target level of 7.0%, the shortfall narrowed from €1.8 billion to €1.5 billion since the previous period.

The average CET1 capital ratios under the Basel III framework across the same sample of banks are 11.1% for Group 1 banks and 12.3% for Group 2 banks.

Basel III’s Liquidity Coverage Ratio (LCR) came into effect on 1 January 2015. The minimum requirement is set initially at 60% and will then rise in equal annual steps to reach 100% in 2019. The weighted average LCR for the Group 1 bank sample was 125% on 30 June 2014, up from 121% six months earlier. For Group 2 banks, the weighted average LCR was 144%, up from 140% six months earlier. For banks in the sample, 85% reported an LCR that met or exceeded 100%, while 98% reported an LCR at or above 60%.

Basel III also includes a longer-term structural liquidity standard – the Net Stable Funding Ratio (NSFR) – which was finalised by the Basel Committee in October 2014. The weighted average NSFR for the Group 1 bank sample was 111% while for Group 2 banks the average NSFR was 114%. As of December 2014, 75% of the Group 1 banks and 85% of the Group 2 banks in the NSFR sample reported a ratio that met or exceeded 100%, while 92% of the Group 1 banks and 93% of the Group 2 banks reported an NSFR at or above 90%.

Does Macroprudential Limit Risky Lending?

An interesting BIS working paper “Higher Bank Capital Requirements and Mortgage Pricing: Evidence from the Countercyclical Capital Buffer (CCB)”, examines the impact of implementing CCB on the mortgage market in Switzerland. Does the CCB have the potential to shift lending from less resilient to more resilient banks, and from riskier to less risky borrowers? This paper looks beyond just trying to control total credit growth. They conclude that the CCB does affect the composition of mortgage supply and raises the prices of more risky loans. In fact banks try to pass on the extra capital costs of previously issued mortgages to new customers. However, it does not stop more risky lending, because the link between borrower risk characteristics (here, loan-to-value (LTV) ratios) and capital requirements is too weak to actively discourage banks from offering mortgages to high-LTV borrowers after the CCB is activated.

Macroprudential policies have recently attracted considerable attention. They aim at both strengthening the resilience of the financial system to adverse aggregate shocks and at actively limiting the build-up of financial risks in the sense of “leaning against the financial cycle”. One reason for the appeal of such policies is that, by explicitly taking a system-wide perspective, they complement macroeconomic and prudential measures in seeking to address systemic risks arising from externalities (such as joint failures and procyclicality) that are not easily internalised by financial market participants themselves. Against this background, the new Basel III regulatory standards feature the Countercyclical Capital Buffer (CCB) as a dedicated macroprudential tool designed to protect the banking sector from the detrimental effects of the financial cycle. We provide the first empirical analysis of the CCB based on data from Switzerland – which became the first country to activate such a buffer on February 13, 2013. To reinforce banks’ defenses against the build-up of systemic vulnerabilities, the activation of the CCB raised their regulatory capital requirements, thereby contributing to the sector’s overall resilience. However, little is known about the CCB’s contribution towards the second macroprudential objective: higher requirements might slow bank lending or alter the quality of loans during the boom and thereby enable policy-makers to “lean against the financial cycle”. Up to now, policy debates have focused mainly on the quantity of aggregate credit growth. We aim to shift the focus of the debate towards the quality, namely the composition of lenders and how tighter capital requirements interact with borrower risk characteristics. Does the CCB have the potential to shift lending from less resilient to more resilient banks, and from riskier to less risky borrowers? Based on our findings, our analysis advances the understanding of some mortgage supply side aspects about whether the CCB can contribute towards the second objective of macroprudential policy, the “leaning against the financial cycle”.

To answer these questions, we examine how the CCB affects the pricing of mortgages. Our unique dataset obtained from an online mortgage platform allows us to separate mortgage supply from demand: each mortgage request receives several binding offers from several different banks, and, each bank can offer mortgages to many different households with distinct borrower risk characteristics. To identify the CCB effect on mortgage supply, we exploit lagged bank balance sheet characteristics that might render a bank more sensitive to the regulatory design of the CCB. To examine whether risk-weighting schemes that link borrower risk characteristics to capital requirements do, in fact, amplify the CCB effect, we use comprehensive information as specified in the mortgage request. The procedures of the online mortgage platform warrant that banks submit independent offers that draw precisely on the same set of anonymized hard information observed by their competitors (and available to us), undistorted by any private or soft information.

Two sets of results stand out. First, the CCB affects the composition of mortgage supply. Once the activated CCB imposes higher capital requirements, capital-constrained banks with low capital cushions raise their mortgage rates relatively more than their competitors. Further, after the CCB is activated, specialized banks that operate a very mortgage-intensive business model also raise their mortgage rates to a greater degree in relative terms. In fact, the CCB applies to new mortgages as well as to the stock of all mortgages held on a bank’s balance sheet. Our results for specialized mortgage lenders thus suggest that banks try to pass on the extra capital costs of previously issued mortgages to new customers. Both insights are indicative of changes in the composition of mortgage supply. Based on the assumption that, ceteris paribus, households prefer lower mortgage rates over more expensive ones,2 we conclude that the CCB tends to shift new mortgage lending from relatively less well capitalized banks to relatively better capitalized ones, and from relatively more to relatively less mortgage-exposed banks. For these reasons, both changes in the composition of mortgage supply are broadly supportive of the second macroprudential objective in that they tend to allocate new mortgage lending to banks that are more resilient.

Our second set of core findings incorporates the borrower side and the effectiveness of common risk-weighting schemes that translate borrower risk into bank capital requirements. We find that banks generally claim extra compensation for granting riskier mortgages (ie, by charging higher mortgage rates). However, these risk-weighting schemes do not appear to amplify the effect of the CCB on mortgage rates or mortgage creation. Apparently, the link between borrower risk characteristics (here, loan-to-value (LTV) ratios) and capital requirements is too weak to actively discourage banks from offering mortgages to high-LTV borrowers after the CCB is activated.

Our paper contributes to the literature in three different respects. First, our empirical setup allows us to advance the understanding of the effects of the CCB as a macroprudential policy tool, particularly in the context of Basel III. More generally, our insights also contribute to a better understanding of how higher capital requirements impact the pricing of loans to private households. Second, our dataset allows us to disentangle mortgage supply from mortgage demand. By merging bank-level information with the respective offers, we can attribute changes in the composition of mortgage supply to distinct bank balance sheet characteristics that shape a bank’s pricing of mortgages. These dimensions of our data set our approach apart from standard analyses based on mortgage contracts, which have a blind spot with respect to the spectrum of all offered (but non-concluded) rates. Third, our analysis informs the debate on the effectiveness of risk-weighting schemes, a standard concept in bank regulation.

Note that BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.

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.

Basel III Stable Funding Disclosure Standards Will Improve Bank Transparency – Moody’s

According to Moody’s, the Basel III disclosure standards which were finalised recently, are positive for creditors of internationally active banks because they will improve transparency into bank funding, allowing investors to assess the adequacy and reliability of funding for a bank’s least-liquid assets, including loans.

Detailed NSFR disclosure is positive for bank investors evaluating a bank’s liquidity and stable funding position since the ratio is distinct from the LCR, measuring a different type of funding risk. The LCR measures whether banks hold enough high-quality liquid assets (HQLA) that could be liquidated to cover stressed cash outflows (e.g., deposit outflows and maturing liabilities that cannot be rolled over) over a 30-day period. The NSFR measures whether funding of longer duration adequately supports less liquid longerterm assets such as loans.

The NSFR template aligns with the LCR disclosure template, which for investors provides some consistency in evaluating short- and long-term liquidity risks. Both, for example, require disclosure of stable and less stable retail deposits, and wholesale deposits used for operational purposes. These disclosures are used to calculate stressed cash outflows in the LCR, and in the NSFR are categories of available stable funding. The Basel Committee noted that in formulating the template, it balanced usability of disclosure with “undesirable dynamics during stress.” Although the Basel Committee did not specify exactly how it achieved the trade-off in the disclosure framework, this has likely restricted funding transparency to some degree.

In addition to a standardized reporting template, the NSFR disclosure standards require qualitative disclosures that are important in evaluating a bank’s stable funding position. The disclosure of interdependent assets and liabilities, which are assigned 0% required stable funding and available stable funding factors in the NSFR calculation, is key because the interdependency is judged by national discretion and could drive significant differences in ratios across banks. The disclosures also will describe drivers of changes in the NSFR categories across reporting periods, which should help investors understand how a bank’s NSFR has changed over time.

RBNZ Updates On Basel III

The NZ Reserve Bank today published an article in the Reserve Bank Bulletin that describes the Reserve Bank’s implementation of the Basel III capital requirements. It is one of the clearest articulation of Basel III that we have read, and is recommended to those seeking to get to grips with the complexity of the evolving capital requirements. In addition, you can read our article on Basel IV (the next iteration) here.

The GFC highlighted several shortcomings in the policies and practices of some financial institutions, particularly in North America and Europe, and in the regulatory requirements for banks in respect of capital. In the lead-up to the GFC, some financial institutions were highly leveraged (that is, their assets were funded by high levels of debt as compared to equity), with capital that proved insufficient to absorb the losses that they incurred. In several countries, governments provided funds to support failing banks, effectively protecting holders of certain capital instruments from bearing losses, which came at a cost to taxpayers. The complexity of capital rules, interaction with national accounting standards, and differences in application resulted in inconsistencies in the definition of regulatory capital across jurisdictions. Further, insufficient capital was held in respect of certain risks. This made it difficult for the market to assess the true quality of banks’ regulatory capital and led some market participants to turn to simpler solvency assessment methods.

The BCBS responded with new requirements for bank capital, collectively known as Basel III, which built on the existing frameworks of Basel I and Basel II. Basel III strengthens the minimum standards for the quality and quantity of banks’ capital, and aims to reduce bank leverage and improve the risk coverage of the Basel Capital Accords. One of the purposes of Basel III is to make it more likely that banks have sufficient capital to absorb the losses they might incur, thus reducing the likelihood that a bank will fail, or that a government will be called on to use taxpayer funds to bail out a bank. Basel III also introduced an international standard on bank liquidity. Overall, these requirements increase resilience in the financial sector and reduce the probability of future systemic collapses of the financial sector.

The RBNZ Bulletin article explains the rationale behind the Basel III capital requirements, identifies and discusses their significant features, explains how the Reserve Bank has applied the requirements in New Zealand, and examines the development of the New Zealand market for instruments meeting the Basel III definition of capital.

The changes to the Capital Accord brought into effect by Basel III included: enhancing the requirements for the quality of the capital base;increasing the minimum amount of capital required to be held against risk exposures; requiring capital buffers to be built up in good times that can be drawn down in times of economic stress; introducing a leverage ratio requirement; and enhancing the risk coverage of the capital framework. Draft international minimum standards for liquidity were also proposed for the first time as part of the Basel III package. The liquidity requirements are not discussed in this article. The Basel III capital standards have been widely adopted worldwide. The Reserve Bank has largely adopted the Basel III capital requirements. As New Zealand banks were well capitalised at the time Basel III was issued, the Reserve Bank was able to put the Basel III capital requirements in place in New Zealand ahead of the timetable set by the BCBS for Basel III implementation.

 

 

Restoring Trust in Basel IRB Models Will Take Time – Fitch

Greater comparability in capital requirements across EU banks is likely to take time, Fitch Ratings says. Meanwhile, doubts surrounding internal ratings-based (IRB) models are likely to continue to undermine trust in regulatory capital ratios.

The European Banking Authority’s (EBA) consultation on the future of the IRB approach, which closed last month, included proposals for detailed changes to IRB models. Fostering supervisory convergence lies within the EBA’s remit, but to address some of the consistency and comparability issues, legislative changes, particularly to the EU’s Capital Requirements Regulation, will be required. This is likely to take considerable time.

Greater consistency in the way capital ratios are calculated is especially important because almost all the world’s 30 global systemically important banks use IRB models, as do most of the EU’s systemically important banks. Market participants mistrust capital ratios generated using IRB models to calculate risk-weighted assets (RWA) in part because model input variation and definition inconsistencies make meaningful comparison of ratios across banks and countries very difficult.

The Basel Committee on Banking Supervision’s Regulatory Consistency Assessment Programme (RCAP) initiative is making slow progress in reducing RWA variability and there is limited transparency on which banks’ ratios might be overstated. For example, in April 2015, the Committee announced it had agreed to remove just six of around 30 national discretions from Basel II’s capital framework.

The Committee’s reluctance or inability to name the banks whose capital ratios are overstated undermines confidence in the IRB models generally. The Committee’s EU Assessment of Basel III regulations report, published last December under the RCAP, highlighted that the exclusion of sovereigns and other public-sector exposures from the IRB framework, plus liberal risk weights for SME exposures, as permitted in the EU, positively affected the capital ratios of five EU banks. It did not name any banks. We understand that disclosure may be difficult because banks often participate in initiatives voluntarily and the Committee has no legal means to force disclosure.

Unwillingness to name names is not new. In July 2013 the Committee reported on a hypothetical portfolio benchmarking exercise across 32 major international banking groups and found material differences in IRB-calculated RWAs. The names of the outlier banks were not made public. This was also the case in the EBA’s reports, which analysed the consistency of RWA across banks, published in December 2013. A benchmarking exercise of SME and residential mortgages highlighted substantial variations. Naming the banks would be useful for market participants as it could shed some light on the banks’ estimated default probabilities and loss expectations, allowing analysts to adjust reported capital ratios if required.

The Committee’s November 2014 G20 presentation outlined five policy proposals to reduce excessive variability in the IRB approach. We think the most significant initiative is the proposal to introduce some fixed loss given default (LGD) parameters. LGDs, which measure the losses a bank would incur if a borrower defaulted, taking into account mitigating factors such as collateral, are a key input into the IRB models.

The EBA’s discussions on the IRB approach appear to be gaining momentum but its proposed timeline for defining technical standards is set at end-2016. Harmonisation of the definitions of default, LGD, conversion factors, probability of default estimates and the treatment of defaulted assets is essential as a first step towards achieving capital ratio comparability. We think delays to the EBA’s proposed timetable are likely.

APRA Extends Basel III Consultation

APRA today extended the consultation period on the changes to Basel III disclosure requirements.

On 18 September 2014, APRA released for consultation a discussion paper and draft amendments to Prudential Standard APS 110 Capital Adequacy and Prudential Standard APS 330 Public Disclosure, which outlined APRA’s proposed implementation of new disclosure requirements for authorised deposit-taking institutions (ADIs).

The disclosures are in relation to:

  • the leverage ratio;
  • the liquidity coverage ratio; and
  • the identification of potential globally systemically important banks.

This consultation package also proposed minor amendments to rectify minor deviations from APRA’s implementation of the Basel Committee’s Basel III framework.

APRA’s intention was that, subject to the outcome of the consultation, these amendments would come into effect from 1 January 2015. A number of matters remain to be addressed before APRA is able to finalise the new standards. Accordingly, given the limited period of time remaining before the scheduled implementation date, APRA is advising affected ADIs that any new requirements will not take effect until 1 April 2015 at the earliest.