Tag: Capital Ratios

A series of separate but connected events will see capital requirements of banks continue to steadily increase from 2015 onwards.  You can read about the capital issues in the earlier post. This is consistent with the outcomes from the G20. The international environment is driving capital requirements higher (on the back of the northern hemisphere government bailouts post the GFC). Locally the regulators are also making moves, and the recommendations from the Murray Financial Systems Inquiry (FSI) are also in play. Overall, some of the most significant elements are:

1. Globally Significantly Banks (GSIBs) likely to need to hold more capital, and this will likely flow down to other banks also.
2. Latest BIS recommendations on floors and ratios
3. APRA changing the liquidity coverage ratio
4. FIS on capital ratios
5. FIS on advanced IRB banks

There are other steps in the works also. The net effect is that capital requirements will be lifting in 2015, irrespective of the FSI (and the capital changes recommended do not need parliamentary approvals).

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 – and they will access the now 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, they have been falling already despite RBA rate being static, this has not received enough commentary, there are millions of households reliant on income from deposits
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.

The BIS also released a consultative paper which outlines the Basel Committee’s proposals to design a capital floor based on standardised, non-internal modelled approaches. The proposed floor would replace the existing transitional capital floor based on the Basel I framework. The floor will be based on revised standardised approaches for credit, market and operational risk, which are currently under consultation.

The floor is meant to mitigate model risk and measurement error stemming from internally-modelled approaches. It would enhance the comparability of capital outcomes across banks, and also ensure that the level of capital across the banking system does not fall below a certain level.

As noted in the Committee’s November 2014 report to the G20 Leaders, the Committee is taking steps to reduce variation in capital ratios between banks. The proposed capital floor is part of a range of policy and supervisory measures that aim to enhance the reliability and comparability of risk-weighted capital ratios. The Committee will consider the calibration of the floor alongside its work on finalising the revised standardised approaches.

BIS has just released a proposal to strengthen the existing regulatory capital standards for discussion. This is one of a number of initiatives which are all driving capital requirements higher.

The proposed Revisions to the Standardised Approach for credit risk seek to strengthen the existing regulatory capital standard in several ways. These include:

• reduced reliance on external credit ratings;
• enhanced granularity and risk sensitivity;
• updated risk weight calibrations, which for purposes of this consultation are indicative risk weights and will be further informed by the results of a quantitative impact study;
• more comparability with the internal ratings-based (IRB) approach with respect to the definition and treatment of similar exposures; and
• better clarity on the application of the standards.

The Committee is considering replacing references to external ratings, as used in the current standardised approach, with a limited number of risk drivers. These alternative risk drivers vary based on the particular type of exposure and have been selected on the basis that they are simple, intuitive, readily available and capable of explaining risk across jurisdictions.

Given the challenges associated with identifying risk drivers that can be applied globally but which also reflect the local nature of some exposures – such as retail credit and mortgages – the Committee recognises that the proposals are still at an early stage of development. Thus, the Committee seeks respondents’ comments and analysis with a view to enhancing the proposals set out in this consultative document.

The key aspects of the proposals are:

• Bank exposures: would no longer be risk-weighted by reference to the bank’s external credit rating or that of its sovereign of incorporation, but would instead be based on two risk drivers: the bank’s capital adequacy and its asset quality.
• Corporate exposures: would no longer be risk-weighted by reference to the borrowing firm’s external credit rating, but would instead be based on the firm’s revenue and leverage.
• Further, risk sensitivity and comparability with the IRB approach would be increased by introducing a specific treatment for specialised lending.
• Retail category: would be enhanced by tightening the criteria to qualify for a preferential risk weight, and by introducing an alternative treatment for exposures that do not meet the criteria.
• Residential real estate: would no longer receive a 35% risk weight. Instead, risk weights would be based on two commonly used loan underwriting ratios: the amount of the loan relative to the value of the real estate securing the loan (ie the loan-to-value ratio) and the borrower’s indebtedness (ie a debt-service coverage ratio).
• Commercial real estate: two options are currently under consideration: (a) treating the exposures as unsecured with national discretion for a preferential risk weight under certain conditions; or (b) determining the risk weight based on the loan-to-value ratio.
• Credit risk mitigation: the framework would be amended by reducing the number of approaches, recalibrating supervisory haircuts and updating the corporate guarantor eligibility criteria.

The G20 Brisbane communique included a paragraph on financial stability reform, and refers specifically to the Financial Stability Review proposals to strengthen capital requirements for globally significantly banks.

Strengthening the resilience of the global economy and stability of the financial system are crucial to sustaining growth and development. We have delivered key aspects of the core commitments we made in response to the financial crisis. Our reforms to improve banks’ capital and liquidity positions and to make derivatives markets safer will reduce risks in the financial system. We welcome the Financial Stability Board (FSB) proposal as set out in the Annex requiring global systemically important banks to hold additional loss absorbing capacity that would further protect taxpayers if these banks fail. Progress has been made in delivering the shadow banking framework and we endorse an updated roadmap for further work. We have agreed to measures to dampen risk channels between banks and non – banks. But critical work remains to build a stronger, more resilient financial system. The task now is to finalise remaining elements of our policy framework and fully implement agreed financial regulatory reforms, while remaining alert to new risks. We call on regulatory authorities to make further concrete progress in swiftly implementing the agreed G20 derivatives reforms. We encourage jurisdictions to defer to each other when it is justified, in line with the St Petersburg Declaration. We welcome the FSB’s plans to report on the  implementation and effects of these reforms, and the FSB’s future priorities. We welcome the progress made to strengthen the orderliness and predictability of the sovereign debt restructuring process.

It is sometimes hard to read the meaning behind the words, but Mark Carney, Governor of the Bank of England made some important comments in a speech in Singapore on his way home from Brisbane.

Banks are now much more resilient. They have more capital, more liquidity and are less susceptible to procyclical spirals. Capital requirements for banks are much higher, as are risk weights and the quality of bank capital. In all, new capital requirements are at least seven times the pre-crisis standards for most banks. For globally systemic banks, they are more than ten times. Large internationally active banks are on course to meet the new requirements 4 years ahead of the 2019 deadline. Despite the scale of the changes, the aggregate shortfall of those banks that still have shortfalls was €15bn at end 2013, having been €115bn two years ago.

It is just as clear that banks’ liquidity positions before the crisis were precarious. Now, for the first time, global standards have been agreed to place requirements on the liquid asset buffers banks must hold and on the extent of maturity transformation in which they can engage. The rapid contagion during the crisis showed how the system magnified shocks. Two particular fault lines made the system procyclical.

First, banks were heavily exposed to movements in market prices and volatility around them, creating a cycle in which falls in prices caused banks to retrench and reduce their positions, leading to further falls in asset prices. That issue has been addressed through strengthening regulatory requirements on trading books – a move that has contributed to the share of banks’ assets accounted for by trading assets almost halving.

Second, banks and shadow banks were entwined in a dangerous funding spiral. Incredibly low initial margins on repo transactions facilitated the build-up of excessive leverage and maturity mismatches in shadow banks. The first wave of losses led banks to tighten margin requirements, effectively reducing financing available to the non-bank financial system, causing those institutions to deleverage through asset sales, driving a death spiral of falling asset prices and rising margin requirements.

As the memory of the crisis fades, it will be ever more important to explain the benefits of reform to counter the fatalism. So let me take this opportunity to take stock of the benefits of reforms, both of those already agreed and of the next phase of reform I have outlined. While we all recognise that future crises can never be ruled out, the steps taken to make banks safer and simpler have certainly reduced the likely frequency and severity of future financial crises. In doing so, they have reduced the exorbitant costs of instability. The Basel Committee assessed in 2010 that the economic cost of the median financial crisis amounted, over time, to 60% of national income. With a 5% probability of a crisis each year, that is equivalent to annual costs of 3% of GDP. For the G20 as a whole that is $2trn. By eroding these costs, financial reform alone can therefore more than deliver the G20 commitment to raise GDP by more than 2%. The Basel Committee found these costs to be minimised only if risk-weighted bank capital ratios were raised above 15%. The Basel III requirements did not go this far, in part because they anticipated the additional requirements for loss absorbing capacity that G20 Leaders have just endorsed.

Once implemented, the combined effects of the reforms will take the system much closer to the degree of safety needed to minimise the costs of financial crises. That authorities have reached this point in a measured way – allowing both equity and forms of debt to qualify as loss absorbing capacity – shows our sensitivity to the potential costs of greater safety. What are those costs? Three points are worth emphasising.

First, the Basel Committee study judged that each 1% increase in capital ratios could reduce output by just 0.1% as higher bank funding costs were passed through to borrowers. However, even that small number seems an upper bound. It fails to take account of the fact that monetary policy can offset the impact of higher lending spreads on effective borrowing rates.In fact, the need to offset the impact of higher lending spreads is one reason why some advanced economy central banks, such as the Bank of England, are so clear now that interest rate increases, when they come,will be gradual and limited.

Second, the transitional costs of moving to higher capital requirements were found to be a little higher than the long-run costs. But that result depends on the starting position. Outside of financial booms, under capitalised banking systems do not provide the credit needed for economic growth, regardless of capital requirements.Where banking systems have raised capital and restored trust in their creditworthiness, access to credit has returned. This central lesson from the US and the UK recoveries could not be clearer. The evidence internationally suggests much the same. With the possible exception of parts of the euro area, lending spreads have fallen and credit volumes have increased at the same time as capital has gone up. In other words, if anything, regulators may have significantly overestimated the transitional costs, or even possibly got the sign wrong.

According to Fitch Ratings, the Australian Banks will be able to handle any potential increase in capital requirements, and would be credit positive for the banks.

Australia’s Financial System Inquiry (FSI), due to report by end-2014, is likely to recommend higher capital requirements for the large banks, says Fitch Ratings. A higher capital charge and/or a rise to the mortgage risk-weighting floor for the four domestic systemically important banks (D-SIBs) are the most likely ways in which this will be implemented. In either case, Fitch maintains that Australia’s banks are well positioned to meet the additional buffers though internal capital generation.

Australia’s bank capital profiles have strengthened since 2008, though they are about average relative to their international peers. Fitch maintains that additional capital requirements for the four D-SIBs – ANZ, CBA, NAB and Westpac – would be credit positive.

The FSI, led by Chairman David Murray, is expected to push for regulatory changes that would reinforce the improvements in recent years. The gap between Australia’s banks and global peers in terms of capital strength has closed, though an objective of the FSI is to bring the largest banks back into the upper quartile. Increasing the D-SIB capital buffer requirement from the current 1ppt, as well as implementing a mortgage risk-weight floor for banks using advanced models to calculate regulatory capital, are likely to be two areas of focus for the Murray report.

A number of global initiatives are addressing the wide discrepancy in risk weights based on banks’ internal models, including a Basel Committee project. Risk-weights for residential mortgages have been a particular focus because they can be very low. In Sweden, the risk-weight floor for residential mortgages was raised to 25% from 15% this year, while Norway is raising its floor to 20%-25% from 10%-20%. In Switzerland, the authorities are reviewing the differences between risk-weights based on banks’ internal models and those based on the standard approach used by domestic and regional banks.

Taking the global context into account, there is the potential for the FSI to recommend raising Australia’s mortgage risk-weight floor to 25%, which would result in capital shortfalls for each of the four major banks – AUD2.9bn for ANZ (the lowest) to in excess of AUD4.6bn for Westpac, based on FY14 numbers and assuming the banks maintain an internal buffer of 1ppt over the fully loaded regulatory requirements. Under a more aggressive scenario, where the risk-weight floor is increased to 30%, the D-SIB charge also raised 2ppt to 3ppt, and a 1ppt internal buffer maintained, the capital shortfalls would be between AUD12bn-15bn for each of the Big 4, and total around AUD53bn. With combined profits for the four banks of around AUD29bn in FY14, the capital shortfall under this scenario would be just less than twice annual profit before dividend.

The Basel Committee’s framework for D-SIBs is more flexible and less prescriptive than the G-SIB framework that applies to the world’s largest banks, but the phase-in for both starts in 2016. Few jurisdictions have yet finalised their D-SIB implementation, but the current 1ppt requirement in Australia appears low compared with Sweden, where a systemic risk buffer of 3ppt is required from 1 January 2015, with a further 2ppt within Pillar 2. Hong Kong, Singapore and India are considering D-SIB buffers of up to 2.5ppt, 2.0ppt and 0.8ppt, respectively, although these have not necessarily been finalised.

Fitch expects that the Australian authorities would set implementation timetables so that the banks would be able to generate the bulk of capital internally, even under the latter scenario.

Increasing the capital of the Big 4 would continue the trend for credit profile strengthening that has occurred since 2008 at a time when there are concerns about risks from rising property prices and exposure to a slowing China and commodity cycle. However, competitively, the higher D-SIB charges and risk-weight floors for the Big 4 could erode some of their substantial scale advantages relative to smaller competitors.

It is important to note that if the measures to address the problems of ‘too big to fail’ banks went beyond higher capital requirements and included measures such as ‘bail-in’ of senior creditors, this would be likely to result in downgrades of Fitch’s Support Ratings and Support Rating Floors – the agency currently factors in a very high likelihood of government support for the major banks, given their strong market position in the domestic banking system. The Issuer Default Ratings, however, would be unaffected, as no Australian bank is currently at its Support Rating Floor.