Tag: Capital Ratios

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.

 

 

Net Stable Funding Ratio Disclosure Standards – BIS

The Bank for International Settlements has released the template to be used by banks to report their Net Stable Funding Ratio (NSFR). This is a further layer of regulation designed to bolster financial stability.  Supervisors will give effect to the disclosure requirements set out in this standard by no later than 1 January 2018. Banks will be required to comply with these disclosure requirements from the date of the first reporting period after 1 January 2018. The disclosure requirements are applicable to all internationally active banks on a consolidated basis but may be used for other banks and on any subset of entities of internationally active banks to ensure greater consistency and a level playing field between domestic and cross-border banks. The disclosure of quantitative information about the NSFR should follow the common template developed by the Committee.

The fundamental role of banks in financial intermediation makes them inherently vulnerable to liquidity risk, of both an institution-specific and market nature. Financial market developments have increased the complexity of liquidity risk and its management. During the early “liquidity phase” of the financial crisis that began in 2007, many banks – despite meeting the capital requirements then in effect – experienced difficulties because they did not prudently manage their liquidity. The difficulties experienced by some banks arose from failures to observe the basic principles of liquidity risk measurement and management.

In 2008, the Basel Committee on Banking Supervision responded by publishing Principles for Sound Liquidity Risk Management and Supervision (the “Sound Principles”), which provide detailed guidance on the risk management and supervision of funding liquidity risk. The Committee has further strengthened its liquidity framework by developing two minimum standards for funding liquidity. These standards aim to achieve two separate but complementary objectives. The first objective is to promote the short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient high-quality liquid assets (HQLA) to survive a significant stress scenario lasting for 30 days. To this end, the Committee published Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools. The second objective is to reduce funding risk over a longer time horizon by requiring banks to fund their activities with sufficiently stable sources of funding in order to mitigate the risk of future funding stress. To achieve this objective, the Committee published Basel III: The Net Stable Funding Ratio. The NSFR will become a minimum standard by 1 January 2018. This ratio should be equal to at least 100% on an ongoing basis. These standards are an essential component of the set of reforms introduced by Basel III and together will increase banks’ resilience to liquidity shocks, promote a more stable funding profile and enhance overall liquidity risk management.

This disclosure framework is focused on disclosure requirements for the Net Stable Funding Ratio (NSFR). Similar to the LCR disclosure framework,4 this requirement will improve the transparency of regulatory funding requirements, reinforce the Sound Principles, enhance market discipline, and reduce uncertainty in the markets as the NSFR is implemented.

It is important that banks adopt a common public disclosure framework to help market participants consistently assess banks’ funding risk. To promote the consistency and usability of disclosures related to the NSFR, and to enhance market discipline, the Committee has agreed that internationally active banks across member jurisdictions will be required to publish their NSFRs according to a common template. There are, however, some challenges associated with disclosure of funding positions under certain circumstances, including the potential for undesirable dynamics during stress. The Committee has carefully considered this trade-off in formulating the disclosure framework contained in this document.

The disclosure requirements set out in this document are applicable to all internationally active banks on a consolidated basis but may be used for other banks and on any subset of entities of internationally active banks to ensure greater consistency and a level playing field between domestic and cross-border banks.

Banks must publish this disclosure with the same frequency as, and concurrently with, the publication of their financial statements (ie typically quarterly or semi-annually), irrespective of whether the financial statements are audited.

Banks must either include the disclosures required by this document in their published financial reports or, at a minimum, provide a direct and prominent link to the completed disclosure on their websites or in publicly available regulatory reports. Banks must also make available on their websites, or through publicly available regulatory reports, an archive (for a suitable retention period as determined by the relevant supervisors) of all templates relating to prior reporting periods. Irrespective of the location of the disclosure, the minimum disclosure requirements must be in the format required by this document (ie according to the requirements in Section 2).

Westpac To Reduce BT Holding

Westpac today announced the intention to sell part of its shareholding in BT Investment Management (BTIM). DFA comments this is in part a move ahead of the tighter capital requirements which are in train and it is likely we will see other divestments across the industry as the screws are tightened.

The Westpac Group’s holding will reduce from its current 59% of BTIM’s issued capital to between 31% and 40%.

The sell-down will generate a post-tax accounting gain on sale of between $0.6 and $0.7 billion for Westpac. Westpac’s common equity Tier one capital ratio is also estimated to increase by between 10 and 15 basis points. The accounting gain will be treated as a cash earnings adjustment in Westpac’s full year 2015 accounts.

Westpac Group Chief Financial Officer, Peter King, said the transaction delivers benefits to both Westpac and BTIM.

“The sale allows the Group to realise a part of the investment in BTIM, increasing our capital ratios, while still maintaining a significant interest in BTIM.

“The strength and importance of the relationship remains unchanged. Wealth remains a strategically important focus for the Westpac Group and our continued investment in BTIM sees us maintain a stake in asset management which is a key factor in having a strong and diversified wealth business.”

Mr King said the sale is also important for BTIM shareholders.

“The transaction increases the proportion of BTIM’s shares that are readily tradable, improving liquidity and helping facilitate inclusion in key equity indices,” he said.

Westpac currently intends to retain a shareholding between 31% and 40%, with the CEO of BT Financial Group, Brad Cooper, remaining as a Non-Executive Director on the BTIM Board.

Basel Committee Consults on Interest Rate Risk in the Banking Book

The Basel Committee on Banking Supervision has issued a consultative document on the risk management, capital treatment and supervision of interest rate risk in the banking book (IRRBB). This consultative document expands upon and is intended to ultimately replace the Basel Committee’s 2004 Principles for the management and supervision of interest rate risk.

The Committee’s review of the regulatory treatment of interest rate risk in the banking book is motivated by two objectives: First, to help ensure that banks have appropriate capital to cover potential losses from exposures to changes in interest rates. This is particularly important in the light of the current exceptionally low interest rate environment in many jurisdictions. Second, to limit capital arbitrage between the trading book and the banking book, as well as between banking book portfolios that are subject to different accounting treatments.

The proposal published presents two options for the capital treatment of interest rate risk in the banking book:

(i) a Pillar 1 (Minimum Capital Requirements) approach: the adoption of a uniformly applied Pillar 1 measure for calculating minimum capital requirements for this risk would have the benefit of promoting greater consistency, transparency and comparability, thereby promoting market confidence in banks’ capital adequacy and a level playing field internationally; alternatively,

(ii) an enhanced Pillar 2 approach: a Pillar 2 option, which includes quantitative disclosure of interest rate risk in the banking book based upon the proposed Pillar 1 approach, would better accommodate differing market conditions and risk management practices across jurisdictions.

The Committee is seeking comments on the proposed approaches, which share a number of common features. Comments are sought by 11 September 2015.

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.

Bank Profits Were $35.2 billion to March 2015

APRA released their quarterly ADI performance statistics to end March 2015 today. Over the year ending 31 March 2015, ADIs recorded net profit after tax of $35.2 billion. This is an increase of $3.0 billion (9.4 per cent) on the year ending 31 March 2014.

The most telling data relates to the relationship between loans and capital. We look at the big four,  who dominate the market. Home loans continue to grow as a proportion of total assets. The major banks have $1.42 trillion of housing, out of total assets of $2.27 trillion – 62.4% of all loans are housing related. Now, because of the generous “risk weighted” calculation, whilst the tier 1 capital ratio has moved higher for the 4 big banks, to 10.8%, if you look at shareholder funds (not risk weight adjusted) we see that the ratio of shareholder funds to total loans is lower now than its been for some time, and is continuing to fall. So the banks are using less of their own funds to grow their balance sheet and hold less in reserve for a rainy day. This is why there is a discussion about the right increases in capital weightings.

APRAMarch2015
More generally, at 31 March 2015, the total assets of ADIs were $4.5 trillion, an increase of $519.9 billion (13.1 per cent) over the year. The total capital base of ADIs was $228.1 billion at 31 March 2015 and risk-weighted assets were $1.8 trillion at that date. The capital adequacy ratio for all ADIs was 12.7 per cent.

  • major banks had total assets of $3.50 trillion as at 31 March 2015, 78.0 per cent of the industry total;
  • other domestic banks had total assets of $397.7 billion, 8.9 per cent of the industry total;
  • foreign subsidiary banks had total assets of $115.1 billion, 2.6 per cent of the industry total; and
  • foreign branch banks had total assets of $404.1 billion, 9.0 per cent of the industry total.

The remainder of the industry total assets were held by building societies, credit unions and other ADIs, with $68.0 billion, 1.5 per cent of the industry total.

For all ADIs*, as at 31 March 2015:

  • Gross loans and advances were $2.80 trillion. This is an increase of $71.6 billion (2.6 per cent) on 31 December 2014 and an increase of $227.2 billion (8.8 per cent) on 31 March 2014.
  • Total liabilities were $4.22 trillion. This is an increase of $137.8 billion (3.4 per cent) on 31 December 2014 and an increase $504.3 billion (13.6 per cent) on 31 March 2014.
  • Total deposits were $2.46 trillion. This is an increase of $50.9 billion (2.1 per cent) on 31 December 2014 and an increase $196.1 billion (8.7 per cent) on 31 March 2014.
  • The net loans to deposits ratio was 112.6 per cent for the year ending 31 March 2015, an increase from 111.7 per cent for the year ending 31 March 2014.

Capital adequacy

The Common Equity Tier 1 capital ratio for all ADIs (excluding foreign branch banks and ‘other ADIs’) was 9.2 per cent as at 31 March 2015. This is an increase on 31 December 2014 (9.1 per cent) and 31 March 2014 (9.1 per cent).

The Common Equity Tier 1 capital ratio as at 31 March 2015 for each segment was:

  • 8.8 per cent for major banks (an increase from 8.7 per cent at 31 December 2014);
  • 9.6 per cent for other domestic banks (an increase from 9.3 per cent);
  • 15.1 per cent for foreign subsidiary banks (unchanged 31 December 2014);
  • 16.9 per cent for building societies (a decrease from 17.1 per cent); and
  • 15.7 per cent for credit unions (unchanged 31 December 2014).

The Tier 1 capital ratio for all ADIs (excluding foreign branch banks and ‘other ADIs’) was 11.0 per cent as at 31 March 2015. This is an increase on 31 December 2014 (10.8 per cent) and 31 March 2014 (10.8 per cent).  The Tier 1 capital ratio as at 31 March 2015 for each segment was:

  • 10.8 per cent for major banks (an increase from 10.6 per cent at 31 December 2014);
  • 10.9 per cent for other domestic banks (an increase from 10.6 per cent);
  • 15.1 per cent for foreign subsidiary banks (a decrease from 15.1 per cent);
  • 16.9 per cent for building societies (a decrease from 17.1 per cent); and
  • 15.9 per cent for credit unions (an increase from 15.8 per cent).

Impaired assets and past due items were $27.8 billion, a decrease of $5.9 billion (17.5 per cent) over the year. Total provisions were $14.4 billion, a decrease of $5.8 billion (28.9 per cent) over the year.

Impaired facilities were $15.2 billion as at 31 March 2015. This is a decrease of $0.7 billion (4.2 per cent) on 31 December 2014 and a decrease of $6.4 billion (29.7 per cent) on 31 March 2014. Impaired facilities as a proportion of total loans and advances was 0.5 per cent as at 31 March 2015. This is a decrease from 31 December 2014 (0.6 per cent) and a decrease from 31 March 2014 (0.8 per cent).

Past due items were $12.5 billion as at 31 March 2015. This is an increase of $1.1 billion (9.6 per cent) on 31 December 2014 and an increase of $534 million (4.4 per cent) on 31 March 2014. Total provisions held were $14.4 billion as at 31 March 2015. This is a decrease of $0.6 billion (4.0 per cent) on 31 December 2014 and a decrease of $5.8 billion (28.9 per cent) on 31 March 2014.

 

RBNZ Moves Closer To Changing Capital Rules For Investment Loans

The Reserve Bank of New Zealand published the results of its consultation on the proposal to vary the capital risk weighting of investment versus owner occupied loans. Stakeholders are invited to provide feedback on the proposed wording changes to the Reserve Bank’s capital adequacy requirements by 19 June 2015, with a view to implemention by October.

They cite considerable evidence that investment loans are inherently more risky:

  1. the fact that investment risks are pro-cyclical
  2. that for a given LVR defaults are higher on investment loans
  3. investors were an obvious driver of downturn defaults if they were identified as investors on the basis of being owners of multiple properties
  4. a substantial fall in house prices would leave the investor much more heavily underwater relative to their labour income so diminishing their incentive to continue to service the mortgage (relative to alternatives such as entering bankruptcy)
  5. some investors are likely to not own their own home directly (it may be in a trust and not used as security, or they may rent the home they live in), thus is likely to increase the incentive to stop servicing debt if it exceeds the value of their investment property portfolio
  6. as property investor loans are disproportionately interest-only borrowers, they tend to remain nearer to the origination LVR, whereas owner-occupiers will tend to reduce their LVR through principal repayments. Evidence suggests that delinquency on mortgage loans is highest in the years immediately after the loan is signed. As equity in a property increases through principal repayments, the risk of a particular loan falls. However, this does not occur to the same extent with interest-only loans.
  7. investors may face additional income volatility related to the possibility that the rental market they are operating in weakens in a severe recession (if tenants are in arrears or are hard to replace when they leave, for example). Furthermore, this income volatility is more closely correlated with the valuation of the underlying asset, since it is harder to sell an investment property that can’t find a tenant.

Although the Basel guidelines for IRB banks envisage that loans to residential property investors be treated as non-retail lending, the same is not the case for banks operating on the standardised approach. The Basel guidelines consider all mortgage lending within the standardised approach as retail lending within the same sub-asset class. However, the guidelines also provide regulators with ample flexibility to implement them according to the needs of their respective jurisdictions. There are three reasons why any consideration as to whether to group loans to residential property investors in New Zealand should also include standardised banks.

  1. the different risk profile of property investors applies irrespective of whether the lending bank is a bank operating on the standardised approach or on the internal models approach.
  2. macro-prudential considerations include standardised banks as well as internal models banks. Prepositioning banks for a potential macro-prudential restriction on lending to residential property investors has to involve all locally incorporated banks.
  3. risk weights on housing loans are comparatively high in New Zealand and, more crucially, the gap in mortgage lending risk weights between standardised and IRB banks is not as high as it might be in many other jurisdictions. In order to maintain the relativities between the two groups of banks for residential investment property lending, it would be useful to also include standardised banks in the policy considerations.

So the bank is proposing to impose different risk weightings on investment and owner occupied loans, for both IRB and standard capital models.

The Reserve Bank would expect banks to continue to use their current PD models until such time that new models have been developed or banks have been able to verify that the current models can also be applied to property investment loans. Through the cycle PD rates appear broadly similar to those of owner-occupiers if the evidence from overseas also holds for New Zealand, although it is not clear whether the risk drivers are the same between the two groups of mortgage borrowers. The Reserve Bank would therefore expect banks to assess in due course whether their current PD mortgage models can be used for the new asset class or whether new or amended versions of the current models should be used.

RBNZCapital1May2015For standardized banks, the Reserve Bank has to prescribe the risk weights as per the relevant capital adequacy requirements. Those requirements currently link a loan’s risk weight to its LVR at origination. Maintaining that link, the Reserve Bank proposed higher risk weights per LVR band

RBNZCapital2May2015These calibrations would lead to a higher capital outcome for residential property investment mortgages compared to owner-occupier loans. However, the capital outcome would be below that of using the income producing real estate asset class and, in the Reserve Bank’s opinion, reflect the mix of property investment borrowers that the new asset class would entail.

Stakeholders are invited to provide feedback on the proposed wording changes to the Reserve Bank’s capital adequacy requirements by 19 June 2015.

This further tilts the playing field away from property investment loans.

Post Crisis Reform – APRA

APRA’s Wayne Byres, spoke in Singapore  “The post-crisis reform agenda – a stocktake“. He discusses progress in Prudential Regulation, across banking, too-big-to-fail, shadow banking and derivatives; and also calls out areas for future attention, including the regulation of financial firms, and the broader issues of culture and behaviourial change within financial service players.

The international reform agenda has focussed on four broad objectives:

  • building resilient financial firms (particularly banks);
  • ending too-big-to-fail;
  • transforming shadow banking into transparent and resilient market-based financing; and
  • making derivative markets safer.

When we look at each of these areas, I am confident that most people in this room would agree with the broad conclusion that a great deal of work has been done, and that in all cases we are better off today than we were pre-2007. But I suspect many of you would also hold to the view that there is more to do before we can genuinely sit back and say the job is done.

Let’s start with bank capital and liquidity. Basel III substantially increased the quality and quantity of bank capital and, just as importantly, introduced new standards for liquidity and funding where there had previously been an international void. Even though many of these new standards are not required to be fully in place for a few years yet, we can look at the banking industry today and say that, by and large, the industry is meeting the new standards with:

  • substantial amounts of new equity having been raised;
  • capital instruments that did not act as a loss absorber being replaced;
  • greater levels of liquidity, and (more importantly) better liquidity management evident; and
  • excessive structural maturity mismatches being contained to more prudent levels.

All of this has been achieved without, as was predicted by some when the reforms were announced, the sky falling in. Indeed, resilience has become a virtue for financial firms, and critical to being a strong competitor in financial markets. Long may that continue.

Critical to making sure this is not a temporary phenomenon has been consistent implementation of the Basel III standards into national regulations. One of the more important post-crisis reforms that does not always get the credit it deserves is the decision by member jurisdictions to open themselves up to a much greater level of peer review. The Basel Committee’s Regulatory Consistency Assessment Programme (RCAP) has been instrumental in demonstrating to the world that the G20’s commitment to the full, timely and consistent implementation of Basel III was serious – and it has placed the spotlight on areas where it has not yet been delivered. Having been intimately involved in the first dozen or so of these reviews, I can confidently say they have had an unambiguously positive impact. Similar peer review programmes by the FSB and other standard-setters have provided additional scrutiny and transparency to national implementation in a range of other areas.

The important point to note is that, when we think about post-crisis reforms, it is not just financial firms that have needed to lift their game; regulatory agencies have needed to do likewise.

There is still more to do, and the Basel Committee’s upcoming meeting has a busy agenda. If I have a reservation when it comes to the remaining policy work programme of the Committee, it is that the finish line still looks a little too far away in some key areas. We may be better off if we narrow our focus and devote our resources to a few key issues – which I would argue centre on the IRB approach and the reliability of models in the regulatory framework – and make sure we deal with them as quickly as possible. That doesn’t mean we should not address the full range of remaining issues on the agenda, but the need for immediate action is much less.

Too-big-to-fail has been a long-standing problem; almost by definition, long-standing problems don’t have an easy answer. Nevertheless, measures that reduce implicit subsidies and price risk correctly should substantially improve the resilience, efficiency and competitiveness of the financial system, so our efforts are undoubtedly adding value. And we have made good headway.  Regimes for identifying and applying higher capital requirements for G- and D-SIBs (and soon G-SIIs), more robust resolution arrangements, the development of meaningful recovery plans that do not rely on public sector support, and current efforts to establish greater loss-absorbing capacity in the world’s G-SIBs will not necessarily rid the world completely of the too-big-to-fail problem, but will lessen the difficulties that authorities face in times of stress. It is certainly a worthwhile investment to make.

When it comes to shadow banking and derivative reforms, we have made important progress in key areas, but the task is far from complete. In the case of shadow banking, we continue to grapple with understanding what exists in the shadows. The good news is that our knowledge is better than it was, and we are all alert to the risks, but we cannot yet feel confident that a concentration of risk could not be lurking undetected. The increased use of trade repositories and CCPs for derivatives markets has created a more transparent and orderly trading environment. But again, we have not yet done all we need to to get a good global picture of the risks in these markets.

That brings me to an important general observation. We have done better in implementing reforms where we have set international minimum standards, but allowed national regulators a degree of discretion to tailor the nature and timing of local requirements to local circumstances. A corollary of this is that we have tended to do better in implementing reforms that relate to financial firms than we have for reforms that relate to financial markets.

Some countries have gone faster and some slower on Basel III, some have introduced the minimum requirements and some have seen fit to do more, some have had to tailor the new requirements to fit with domestic legislative requirements, but generally speaking the new set of minimum standards have been implemented fairly uniformly around the globe (including by countries that are not members of the Basel Committee). The community of national regulators has been able to do this largely because there is scope, given their status as minimum international standards applying to individual firms, for a degree of domestic discretion. There are, if you like, safety values that mean domestic needs can be accommodated while at the same time preserving a common internationally‑agreed minimum. And, because they are applied to individual firms, the externalities that are imposed on other jurisdictions by any variations in implementation are fairly limited – provided, of course, the minimum standards are met.

Progress has been more difficult in areas where a much higher degree of cooperation or consistency is needed. International aspects of recovery and resolution planning, for example, are far less advanced than domestic aspects. It is even more evident when we look at many of the market-based standards. Today’s financial markets are global (or at very least highly inter-connected), and cannot work efficiently if they are subject to regulations that vary widely from jurisdiction to jurisdiction. In other words, the externalities from inconsistent implementation are much greater. A coherent and consistent regulatory regime – critical to limiting opportunities for arbitrage and the tendency for activity to flow to the weakest regulatory environment – requires us all to look beyond our domestic bases, but this has at times proven difficult.

There is no simple solution to this, beyond a recognition that we need to redouble our efforts towards cooperation for the global good. We cannot get away from the fact we are national regulators, with domestic mandates. Where taxpayer funds are ultimately at risk, it is difficult to expect otherwise. But all is not lost because, in an increasingly inter-connected world, domestic interests and the global common good are often quite well aligned. And we have to remember that we all lose if sound economic activity is significantly impeded.

Before I conclude, I would like to highlight two areas where I think we have not yet done anywhere near enough to address the shortcomings that the financial crisis highlighted.

The first is in the supervision of financial firms. We have done a great deal to strengthen the regulatory framework within which financial firms operate. We cannot, however, hope to achieve financial stability, and resilience in individual firms, with just a rulebook.

Whatever type of football you follow, you would not ask two professional football teams to adjudicate a match by themselves. Even though all the players may know the rulebook very well, their competitive instincts mean that without on-field officials, the temptation to break the rules would likely be too great. Any such a game is likely to quickly degenerate into chaos.

Good match officials are critical to an attractive match. They keep the game flowing, their presence acts as reminder to players to play within the rules, and they will sometimes be able to head off infringements before they occur. When needed, they will ensure transgressions are detected and penalised. Good supervisors play a similar role in the financial system – the game is better for the participants and the spectators when high quality officials are monitoring the play.

I do not think we have yet invested enough in promoting good supervision. Indeed, the immediate post-crisis period seemed to start with a philosophy that we should have less supervision and more rules. The strengthened rules were absolutely essential, but they will not be effective in the long run without being supplemented by strong and robust supervision. Our approach is Australia is not to consider supervisors as a means of enforcing regulation, but rather regulation as a means of empowering good supervision. But this philosophy is not universally held, and I think the system is weaker for it.

The second area that we still have room to make serious improvement is in the inter-related areas of governance, culture and remuneration. Building up capital and liquidity, and ensuring loss absorbing capacity in the event of failure, will undoubtedly make for a more resilient financial system. But they will only offer a partial remedy to the problems that were experienced unless there are behavioural changes within financial firms as well.

Culture is a nebulous concept, much more difficult to define and observe than capital adequacy. But strengthening culture, like strengthening capital, is critical to long-run stability. We regularly see instances where participants in financial markets, when faced with an ethical dilemma, fail to ask themselves ‘is this right?’  Instead, the question has often been ‘can I get away with this?’ – or, more ominously, in some cases it appears no question was asked because the attitude was ‘if you ain’t cheating, you ain’t trying’.  For an industry that is ultimately founded on trust, something serious is amiss, and strong and ethical leadership within financial firms is needed to set this right.

Both the industry, and the community of supervisors, is still grappling with how best to make assessments of organisational culture, and how to respond when a culture is shown to be in need of improvement. Much has to do with the incentives that individuals face and how they signal what an organisation truly values (and what it does not). It is clear that, in many cases, aspirational statements of organisational culture have been no match for the personal incentives that are created for individuals. Much of the post-crisis reform agenda has been aimed at getting the organisational interests of financial firms more aligned with those of the wider community. Getting personal incentives correspondingly aligned with organisational interests needs to be seen as equally important. On this, we all have more to do.

Banking: Australian Banks’ Moves to Curb Residential Investment Lending Are Credit-Positive – Moody’s

In a  brief note, Moody’s acknowledged that the bank’s recent moves to adjust their residential loan criteria could be positive for their credit ratings, but also underscored a number of potential risks in the Australian housing sector including elevated and rising house prices, declining mortgage affordability, and record levels of household indebtedness. As a result, they believe more will need to be done to tackle the risks in the portfolio.

Moody’s says the recent initiatives are credit positive since they reduce the banks’ exposure to a higher-risk loan segment. At the same time, it is likely that further additional steps will be required because the growing imbalances in the Australian housing market pose a longer-term challenge to the Australian banks’ credit profiles, over and above the immediate concerns relating to investment lending.

Therefore they expect the banks first to curtail their exposure to high LTV loans and investment lending further over the coming months; and second, they will gradually improve the quantity and quality of their capital through a combination of upward revisions to mortgage risk weights and capital increases. This is likely to happen over the next 18 months or so.

The Impact of Evolving Financial Regulation

The BIS published an interesting report on how financial regulation is evolving. In short, significantly more capital will be required as the screws are tightened, or in other words capital rules have been too lax. These changes will have an impact on monetary policy; sometimes limiting credit availability; it will impact asset prices; weaken the relationship between policy rates and real-life interest rates; and make the banks reliance on the central bank stronger. It also provided a good summary of changes proposed under Basel III.

Financial regulation is evolving, as policymakers seek to strengthen the financial system in order to make it more robust and resilient. Changes in the regulatory environment are likely to have an impact on financial system structure and on the behaviour of financial intermediaries that central banks will need to take into account in how they implement monetary policy. Against this background, in February 2014, the Committee on the Global Financial System (CGFS) and Markets Committee (MC) jointly established a Working Group – co-chaired by Ulrich Bindseil (European Central Bank) and William Nelson (Federal Reserve Board) – to assess the combined impact of key new regulations on monetary policy.

The BIS has now released their report which presents the Group’s findings. It is based on information from a range of sources, including central bank case studies as well as structured interviews with private sector market participants. It argues that the likely impacts of the new financial regulations on financial institutions and markets should have only limited and manageable effects on monetary policy operations and transmission. Hence, as necessary, central banks should be able to make adjustments within their existing policy frameworks and in ways that preserve policy effectiveness. These adjustments will tend to differ across jurisdictions according to the financial systems and policy frameworks in place. Specific implications, and examples of potential policy responses, are set out and elaborated in the report.

The report’s findings can be characterised in terms of five distinct sets of implications. In addition, more general effects of the emerging regulatory environment that are independent of specific macroeconomic conditions can be differentiated from those that pertain in the context of the current environment of low policy rates. All of these, and examples of potential policy responses. In brief, they are as follows:

Safer financial systems and their implications for policymaking. The emerging regulatory environment will contribute to enhanced bank resilience, reducing the risk of spillovers from the banking sector to the real economy, and is expected to limit the extent of liquidity and maturity transformation undertaken at banks. Therefore, if the regulations are effective, bank credit will be more stable on average, because credit cycles will be less severe and less frequent. At the same time, at some points of the credit cycle, the supply of bank credit for the non-financial sector will tend to be lower than it would be in the absence of the new regulations (and with everything else unchanged). Thus, to achieve the same economic outcomes, central banks may end up adopting a policy stance that is somewhat more accommodating during some parts of the cycle than would otherwise be the case.

Shifting asset price relationships and their implications for policy targets. As markets adjust to the new regulatory requirements, the equilibrium relationships between financial asset prices and central bank policy rates will shift, adding to the existing uncertainty around these relationships – at least during the transition period. As a result, central banks may need to adjust the settings of their policy instruments to achieve the same stance of monetary policy. A complicating factor is that different regulations, considered in isolation, can have consequences that go in opposite directions. Moreover, the interaction of these regulations could add to the difficulties in predicting their overall impact. As a result, central banks will need to monitor these changes and respond to them as they manifest themselves.

Reduced arbitrage activity and its impact on policy implementation. New regulations, such as the leverage ratio, may disincentivise certain low-margin arbitrage activities, such as banks’ matched repo book business. This reduction would tend to weaken, and make more uncertain, the links between policy rates and other interest rates, weakening the transmission of monetary policy impulses along the yield curve as well as to other asset prices relevant for economic activity. More difficult reserve demand forecasting. For central banks with an operational target of steering a short-term interest rate within a corridor system, if the rate paid on reserve balances is close to the interest rate on other types of high quality liquid assets (HQLA Level 1), small changes in interest rates could result in relatively large swings in reserve demand as banks substitute freely between reserves and these other assets. Additionally, new limits on counterparty concentration may mean that forecasts of the level of reserve balances will depend more strongly than in the past on the distribution of those reserves across counterparties. Similarly, with periodic calculation of regulatory ratios (such as at year- or quarter-ends), window dressing behaviour and associated movements in short-term interest rates are likely to intensify.

More central bank intermediation. Many of the new regulations will increase the tendency of banks to take recourse to the central bank as an intermediary in financial markets – a trend that the central bank can either accommodate or resist. Weakened incentives for arbitrage and greater difficulty of forecasting the level of reserve balances, for example, may lead central banks to decide to interact with a wider set of counterparties or in a wider set of markets. In addition, in a number of instances, the regulations treat transactions with the central bank more favourably than those with private counterparties. For example, Liquidity Coverage Ratio rollover rates on a maturing loan from a central bank, depending on the collateral provided, can be much higher than those for loans from private counterparties.

Effects specific to the current low interest rate environment. In addition to these more general implications, there are a number of effects for monetary policy that are specific to the current environment of low policy rates in the major advanced economies. For example, effects that tend to lower market interest rates relative to policy rates will support monetary policy in jurisdictions at the zero lower bound, but may hinder efforts to normalise the stance of policy. Effects that tend to raise market rates relative to policy rates will have the opposite consequence. Moreover, any temporary reduction of credit supply resulting from the new regulations and their phasing-in may imply the need for additional unconventional measures for central banks operating at the zero lower bound, with the added complication that some unconventional measures may make the new regulations more binding.

The four key regulations identified by the Working Group as being the most likely ones to significantly affect monetary policy implementation:

Liquidity Coverage Ratio. The stated objective of the LCR is to ensure that banks maintain an adequate level of unencumbered, high-quality liquid assets (HQLA) that can be converted into cash to meet their liquidity needs under a 30-day scenario of severe funding stress. It is defined as the ratio of the stock of HQLA (numerator) to net cash outflows expected over the stress period (denominator). The initial minimum requirement of 60%, effective January 2015, will be increased in a stepwise fashion to 100% by 2019. The HQLA definition groups eligible assets into two discrete categories (Level 1 and Level 2). Level 1 assets, which can be included without limit, are those with 0% risk weights for Basel II capital calculations, such as cash, central bank reserves and sovereign debt (which may be subject to haircuts). Level 2 assets, which can make up no more than 40% of the buffer, include assets with low capital risk weights as well as highly rated non-financial corporate and covered bonds, subject to a 15% haircut. (Under certain conditions, supervisors may choose to include additional asset types, termed Level 2B, up to a limit of 15% of the total HQLA stock and carrying haircuts of 25% or higher.) Net cash outflows, in turn, are calculated on the basis of agreed run-off and inflow rates that are applied to different sources of cash out- and inflows (with an aggregate cap of 75% of total cash outflows).

Net Stable Funding Ratio. The aim of the NSFR, which will be introduced as of January 2018, is to (i) limit overreliance on short-term wholesale funding, (ii) encourage better assessment of funding risk across all on-and offbalance sheet items, and (iii) promote funding from stable sources on a structural basis. The NSFR is defined as the ratio of available stable funding (ASF) to required stable funding (RSF), which needs to be equal to at least 100% on an ongoing basis. The numerator is determined by applying ASF factors to a bank’s liability positions, with higher factors assigned for longer maturities (according to pre-defined buckets: less than six months, between six and 12 months, and higher), and more stable funding sources. The denominator reflects the product of RSF factors and the bank’s assets, differentiated according to HQLA/non-HQLA definitions and by counterparty (financial/non-financial). Asset encumbrance generally results in higher RSF factors, especially for longer encumbrance periods (eg assets encumbered for a period of one year or more receive the maximum RSF factor of 100%, while central bank reserves have a factor of 0% (with discretion to apply a higher rate) and other Level 1 assets a factor of 5%). Differentiated RSF factors also apply according to whether assets are secured against Level 1 assets or not.

Leverage ratio. The Basel III minimum leverage ratio is intended to restrict the build-up of leverage in the banking sector, and to backstop the risk-based capital requirements with a simple, non-risk-based measure. Public disclosure of the regulatory LR by banks commenced on 1 January 2015. The final calibration and any further adjustments to the definition will be completed by 2017 with a view to migrating to a binding Pillar 1 requirement on 1 January 2018. The LR is defined as the ratio of Tier 1 capital to total exposures. The denominator consists of the sum of all onbalance sheet exposures, derivative positions, securities financing transactions and off-balance sheet items. As such, the total exposure measure includes central bank reserves and repo positions. Netting of cash legs (ie of receivables and payables) of repo exposures (with the same counterparty) is permitted under certain conditions, but netting across counterparties or of cash positions against collateral is not.

Large exposure limits. The large exposures (LE) framework of the Basel Committee on Banking Supervision (BCBS) is a set of rules for internationally active banks aimed at reducing system-wide contagion risk. It imposes limits on banks’ exposures to single counterparties in order to constrain the maximum loss a bank could face in the event of sudden counterparty failure. The framework is due to be fully implemented on 1 January 2019. Under the LE framework, a bank’s exposure to any single counterparty or group of connected counterparties cannot exceed 25% of the bank’s Tier 1 capital. A tighter limit of 15% is set for exposures between banks that have been designated as globally systemically important. While exposure measurement is aligned with the standardised approach under risk-based capital rules, exposures to sovereigns and central banks, as well as intraday interbankexposures, are exempt from the limit.

Basel III capital regulation includes a number of new elements to boost banks’ capital base. First, it incorporates a significant expansion in risk coverage, which increases risk-weighted assets. Specifically, it targets the instruments and markets that were deemed most problematic during the crisis – that is, trading book exposures, counterparty credit risk and securitised assets. This builds on the earlier approach under Basel II, which introduced differentiated risk weights (which are either internal model-based or set by regulation). A key differentiation from the perspective of monetary policy is that central bank reserves carry a zero risk weight under the risk-weighted standard, whereas the leverage ratio introduces an implied capital charge that is equal for all assets. Riskweighted capital charges also differ according to whether a transaction is secured or unsecured. Second, and critically, Basel III tightens the definition of eligible capital, with a strong focus on common equity. This represents a
move away from complex hybrid capital instruments that proved incapable of absorbing losses in periods of stress. A unique feature of Basel III is the introduction of capital buffers that banks can use without compromising their solvency, and surcharges, which counter individual banks’ contribution to systemic risk.

BaselIIIChartBISMay2015First, a conservation buffer is designed to help preserve a bank as a going concern by restricting discretionary distributions (such as dividends and bonus payments) when the bank’s capital ratio deteriorates. Second, a countercyclical buffer – capital that accumulates in good times and that can be drawn down in periods of stress – will help protect banks against risks that evolve over the financial cycle. Finally, a capital surcharge will be applied to global systemically important banks (G-SIBs), or banks with large, highly interconnected and complex operations, in order to discourage the concentration of risk. These international standards impose lower bounds on regulators: countries may choose to implement higher standards to address particular risks in their national contexts. Combining these elements will significantly increase banks’ capital requirements.