From the Outside

Loss absorption under bail-in

I recently did a post on a Discussion Paper setting out how APRA proposes to increase the Loss Absorption Capital (LAC) of Australian authorised deposit-taking institutions (ADIs). I came down on the side of this being a desirable (arguably necessary) enhancement of the Australian financial system but noted that the devil was in the detail. One of the issues discussed was the potential impact of the proposal on the statutory and contractual loss hierarchy that defines the sequence in which losses are absorbed by the capital of the bank in the first instance, and by more senior sources of funding in need.

This post attempts to dig a bit deeper into this question to better understand how losses would be assigned under a bail-in scenario. It is a pretty technical point and possibly of limited interest but I wanted to make sure I had a good handle on how loss absorption plays out in the future. Read on or stop here.

Key points

The bail-in of selected, pre-positioned liabilities modifies the traditional loss hierarchy that applies in a liquidation scenario
- As a general rule, the absorption of losses is accelerated across all tiers of LAC
- CET1 investors bear the loss via the dilution of their shareholdings as AT1 and Tier 2 are converted to common equity
- AT1 investors risk not receiving distributions but otherwise the loss hierarchy between them and T2 investors seems to collapse once their holdings are converted into CET1
- The only potential advantage to Tier 2 in these scenarios is that these instruments may only face partial conversion but how beneficial depends on the extent to which conversion to common equity offers a better chance to liquidate their holding versus selling the Tier 2 instrument itself into what is likely to be a very illiquid market
This has been increasingly true since APRA introduced Point of Non-Viability (PONV) conversion triggers in 2013, and the instruments without this contractual feature progressively matured, but the proposed expansion of the pool of LAC takes us further down this path:
- partly by virtue of making it easier for APRA to restructure bank capital structures without recourse to taxpayer support (i.e. the odds of bail-in being used in a future crisis are increased if the tool itself is more effective); and
- partly by increasing the quantum of CET1 dilution that is the mechanism by which losses are allocated to the various tiers of LAC
Investors in the various capital tiers will obviously adjust the return they require for the risks they are asked to bear but we should ensure we all have a clear and consistent understanding of how the loss hierarchy is modified, and whether the resulting loss hierarchy is desirable (or indeed equitable)
The answer to this question turns in part on whether the outcomes for AT1 and T2 investors are better or worse than the market value they could achieve if they sold their investments prior to bail-in

Loss Hierarchy – the simple version

Prudential Standard APS 111 (Capital Adequacy: Measurement of Capital) defines the order of seniority amongst the three tiers of prudential capital:

CET1 Capital “… rank behind the claims of depositors and other more senior creditors in the event of a winding up of the issuer ” (Para 19 (d))
AT1 Capital “… rank behind the claims of depositors and other more senior creditors in the event of a winding up of the issuer” (Para 28 (c))
Tier 2 Capital “represents, prior to any conversion to Common Equity Tier 1 … the most subordinated claim in liquidation of the issuer after Common Equity Tier 1 Capital instruments and Additional Tier 1 Capital instruments (Attachment H, Para 1 (b))

APS 111 (Attachment F, Para 10) also explicitly allows AT1 instruments to 1) differentiate as to whether the instrument is required to convert or be written-off in the first instance, and 2) provide for a ranking under which individual AT1 instruments will be converted or written-off. The guidance on Tier 2 is less explicit on this point but there does not seem to be any fundamental reason why a bank could not introduce a similar ranking within the overall level of subordination. I am not aware of any issuer using this feature for either AT1 or T2.

If we ignore for a moment the impact of bail-in (either by conversion or write-off), the order in which losses are applied to the various sources of funding employed by a company follows this loss hierarchy:

Going Concern:
- Common Equity Tier 1 (CET1)
- Additional Tier 1 (AT1)
Insolvency – Liquidation or restructuring:
- Tier 2 (T2)
- Senior unsecured
- Super senior
  - Covered bonds
  - Deposits
  - Insured deposits

CET1 is clearly on the front line of loss absorption (a perpetual commitment of funding with any returns subject to the issuer having profits to distribute and the Capital Conservation Ratio (CCR) not being a constraint). AT1 is subject to similar restrictions, though its relative seniority does offer some protection regarding the payment of regular distributions.

Traditionally, the claims the other forms of funding have on the issuer are only at risk in the event of the liquidation or restructuring of the company but bail-in modifies this traditional loss hierarchy.

What happens to the loss hierarchy under bail in?

First up, let’s define bail-in …

“A bail-in is the rescue of a financial institution that is on the brink of failure whereby creditors and depositors take a loss on their holdings. A bail-in is the opposite of a bailout, which involves the rescue of a financial institution by external parties, typically governments that use taxpayers money.” (Investopedia)

Investopedia’s definition above is useful, albeit somewhat generic. Never say never, but the loss hierarchy employed in Australia, combined with the fact that there are substantial layers of more junior creditors for big banks in particular, means that most Australian depositors (even the ones that do not have the benefit of deposit insurance) are pretty well insulated from bail-in risk. Not everyone would share my sanguine view on this question (i.e. the limited extent to which deposits might be bailed in) and some countries (NZ for example) quite explicitly choose to forego deposit insurance and move deposits up the loss hierarchy by ranking them equally with senior unsecured creditors.

The main point of bail-in is that existing funding is used to recapitalise the bank, as opposed to relying on an injection of new capital from outside which may or may not be forthcoming. It follows that pre-positioning sufficient layers of loss absorption, and making sure that investors understand what they have signed up for, is critical.

AT1 has always been exposed to the risk of its distributions being cut. This sounds good in theory for loss absorption but the size of these potential capital outflows is relatively immaterial in any real stress scenario. It could be argued that every dollar helps but my view is that the complexity and uncertainty introduced by making these distributions subject to the Capital Conservation Ratio (CCR) outweigh any contribution they might make to recapitalising the bank. The people who best understand this point are those who have had to calculate the CCR in a stress scenario (you have to get into the detail to understand it). The CCR issue could be addressed by simplifying the way it is calculated and I would argue that simplicity is always a desirable feature of any calculation that has to be employed under conditions of stress and uncertainty. The main point however is that it does very little to help recapitalise the bank because the heavy lifting in any really severe stress scenario depends on the capacity to convert a pool of pre-positioned, contingent capital into CET1.

APRA has had explicit power to bail-in AT1 and T2 since the January 2013 version of APS 111 introduced Point of Non-Viability (PONV) conversion triggers – these enhanced powers do a few things:

The impact of losses is brought forward relative what would apply in a conventional liquidation or restructuring process
For CET1 investors, this accelerated impact is delivered via the dilution of their shareholdings (and associated share price losses)
In theory, conversion shields the AT1 investors from loss absorption because they receive common equity equivalent in value to the book value of their claim on the issuer
In practice, it is less clear that the AT1 investors will be able to sell the shares at the conversion price or better, especially if market liquidity is adversely impacted by the events that called the viability of the issuer into question
The conversion challenge will be even greater to the extent that T2 investors are also bailed-in and seek to sell the shares they receive

Tier 2 will only be bailed-in after AT1 bail-in has been exhausted, as would be expected given its seniority in the loss hierarchy, but it is hard to see a bail-in scenario playing out where the conversion of AT1 alone is sufficient to restore the viability of the bank. AT1 is likely to represent not much more than the 1.5 percentage points of RWA required to meet minimum requirements but any crisis sufficient to threaten the viability of a bank is likely to require a much larger recapitalisation so full or partial conversion of T2 should be expected.

Partial conversion

Attachment J – Para 6 provides that “Conversion or write-off need only occur to the extent necessary to enable APRA to conclude that the ADI is viable without further conversion or write-off”. Para 8 of the same attachment also specifies that “An ADI may provide for Additional Tier 1 Capital instruments to be converted or written off prior to any conversion or write-off of Tier 2 Capital instruments”.

This makes it reasonably clear that APRA will not automatically require all AT1 and Tier 2 to be converted or written-off but the basis on which partial conversion would be applied is not covered in the discussion paper. A pro-rata approach (i.e. work out how much of the aggregate Tier 2 is required to be converted and then apply this ratio to each individual instrument) seems the simplest option and least open to legal challenge but it may be worth considering alternatives.

Converting the Tier 2 instruments closest to maturity in particular seems to offer some advantages over the pro rata approach

It generates more CET1 capital than the Tier 2 foregone (because the Tier 2 capital value of an instrument is amortised in its final 5 years to maturity whereas the CET1 capital created by bail-in is the full face value off the instrument)
It defers the need to replace maturing Tier 2 capital and maximises the residual pool of LAC post bail-in.

What is the reason for the 20% floor that APS 111 imposes on the conversion price?

The transition to a bail-in regime may be an opportune time to revisit the rationale for placing a floor on the conversion price used to convert AT1 and Tier 2 into common equity. Attachments E and F contain an identically worded paragraph 8 that requires that the share price used to calculate the shares received on conversion cannot be less than 20% of the ordinary share price at the the time the LAC instrument was issued. This floor arguably requires the share price to fall a long way before it has any effect but it is not clear what purpose is served by placing any limit on the extent to which common equity shareholders might see their holdings diluted in a non-viability scenario.

Bail-in via write-off of AT1 or T2

I am concentrating on bail-in via conversion because that seems to be the default loss absorption contemplated by APS 111 and the one that is most consistent with the traditional loss hierarchy. LAC instruments can be designed with write-off as the primary loss absorption mechanism but it is not clear that any issuer would ever choose to go down that path as it would likely be more expensive versus bail-in via conversion. The write-off option seems to have been included as a failsafe in the event that conversion is not possible for whatever reason.

Conclusion

The loss absorption hierarchy under a bail-in based capital regime is a bit more complicated than the simple, progressive three tier hierarchy that would apply in a traditional liquidation scenario. I believe however that this added complexity is justified both by the enhanced level of financial safety and by the extent to which it addresses the advantage big banks have previously enjoyed by virtue of being Too Big To Fail.

The main concern is that AT1 and Tier 2 investors who underwrite the pre-positioning of this contingent source of new CET1 capital properly understand the risks. I must confess that I had to think it through and remain open to the possibility that I have missed something … if so tell me what I am missing.

Tony

Does more loss absorption and “orderly resolution” eliminate the TBTF subsidy?

The Australian Government’s 2014 Financial System Inquiry (FSI) recommended that APRA implement a framework for minimum loss-absorbing and recapitalisation capacity in line with emerging international practice, sufficient to facilitate the orderly resolution of Australian authorised deposit-taking institutions (ADIs) and minimise taxpayer support (Recommendation 3).

In early November, APRA released a discussion paper titled “Increasing the loss absorption capacity of ADIs to support orderly resolution” setting out its response to this recommendation. The paper proposes that selected Australian banks be required to hold more loss absorbing capital. Domestic Systemically Important Banks (DSIBs) are the primary target but, depending partially on how their Recovery and Resolution Planning addresses the concerns APRA has flagged, some other banks will be captured as well.

The primary objectives are to improve financial safety and stability but APRA’s assessment is that competition would also be “Marginally improved” on the basis that “requiring larger ADIs to maintain additional loss absorbency may help mitigate potential funding advantages that flow to larger ADIs“. This assessment may be shaped by the relatively modest impact (5bp) on aggregate funding costs that APRA has estimated or simple regulatory conservatism. I suspect however that APRA is under selling the extent to which the TBTF advantage would be mitigated if not completely eliminated by the added layer of loss absorption proposed. If I am correct, then this proposal would in fact, not only minimise the risk to taxpayers of future banking crises, but also represent an important step forward in placing Australian ADIs on a more level playing field.

Why does the banking system need more loss absorption capacity?

APRA offers two reasons:

The critical role financial institutions play in the economy means that they cannot be allowed to fail in a disorderly manner that would have adverse systemic consequences for the economy as a whole.
The government should not be placed in a position where it believes it has no option but to bail out one or more banks

The need for extra capital might seem counter-intuitive, given that ADI’s are already “unquestionably strong”, but being unquestionably strong is not just about capital, the unstated assumption is that the balance sheet and business model are also sound. The examples that APRA has used to calibrate the degree of total loss absorption capacity could be argued to reflect scenarios in which failures of management and/or regulation have resulted in losses much higher than would be expected in a well-managed banking system dealing with the normal ups and downs of the business cycle.

At the risk of over simplifying, we might think of the first layers of the capital stack (primarily CET1 capital but also Additional Tier 1) being calibrated to the needs of a “good bank” (i.e. well-managed, well-regulated) while the more senior components (Tier 2 capital) represent a reserve to absorb the risk that the good bank turns out to be a “bad bank”.

What form will this extra capital take?

APRA concludes that ADI’s should be required to hold “private resources” to cope with this contingency. I doubt that conclusion would be contentious but the issue is the form this self-insurance should take. APRA proposes that the additional loss absorption requirement be implemented via an increase in the minimum Prudential Capital Requirement (PCR) applied to the Total Capital Ratio (TCR) that Authorised Deposit-Taking Institutions (ADIs) are required to maintain under Para 23 of APS 110.

“The minimum PCRs that an ADI must maintain at all times are:
(a) a Common Equity Tier 1 Capital ratio of 4.5 per cent;
(b) a Tier 1 Capital ratio of 6.0 per cent; and
(c) a Total Capital ratio of 8.0 per cent.
APRA may determine higher PCRs for an ADI and may change an ADI’s PCRs at any time.”

APS 110 Paragraph 23

This means that banks have discretion over what form of capital they use, but APRA expect that banks will use Tier 2 capital that counts towards the Total Capital Ratio as the lowest cost way to meet the requirement. Advocates of the capital structure irrelevance thesis would likely take issue with this part of the proposal. I believe APRA is making the right call (broadly speaking) in supporting more Tier 2 rather than more CET1 capital, but the pros and cons of this debate are a whole post in themselves. The views of both sides are also pretty entrenched so I doubt I will contribute much to that 50 year old debate in this post.

How much extra loss absorbing capital is required?

APRA looked at three things when calibrating the size of the additional capital requirement

Losses experienced in past failures of systemically important banks
What formal requirements other jurisdictions have applied to their banks
The levels of total loss absorption observed being held in an international peer group (i.e. what banks choose to hold independent of prudential minimums)

Based on these inputs, APRA concluded that requiring DSIBs to maintain additional loss absorbing capital of between 4-5 percentage points of RWA would be an appropriate baseline setting to support orderly resolution outcomes. The calibration will be finalised following the conclusion of the consultation on the discussion paper but this baseline requirement looks sufficient to me based on what I learned from being involved in stress testing (for a large Australian bank).

Is more loss absorption a good idea?

The short answer, I think, is yes. The government needs a robust way to recapitalise banks which does not involve risk to the taxpayer and the only real alternative is to require banks to hold more common equity.

The devil, however, is in the detail. There are a number of practical hurdles to consider in making it operational and these really need to be figured out (to the best of out ability) before the fact rather than being made up on the fly under crisis conditions. The proposal also indirectly raises some conceptual issues with capital structure that are worth understanding.

How would it work in practice?

The discussion paper sets out “A hypothetical outcome from resolution action” to explain how an orderly resolution could play out.

“The approximate capital levels the D-SIBs would be expected to maintain following an increase to Total Capital requirements, and a potential outcome following the use of the additional loss absorbency in resolution, are presented in Figure 6. Ultimately, the outcome would depend on the extent of losses.

If the stress event involved losses consistent with the largest of the FSB study (see Figure 2), AT1 and Tier 2 capital instruments would be converted to ordinary shares or written off. After losses have been considered, the remaining capital position would be wholly comprised of CET1 capital. This conversion mechanism is designed to allow for the ADI to be stabilised in resolution and provide scope to continue to operate, and particularly to continue to provide critical functions.”

Source – APRA Discussion Paper (page 24)

What I have set out below draws from APRA’s example while adding detail that hopefully adds some clarity on what should be expected if these scenarios ever play out.

In a stress event, losses first impact any surplus CET1 held in excess of the Capital Conservation Buffer (CCB) requirement, and then the CCB itself (the first two layers of loss absorption in Figure 6 above)
As the CCB is used up, the ADI is subject to progressive constraints on discretionary distributions on CET1 and AT1 capital instruments
In the normal course of events, the CCB should be sufficient to cope with most stresses and the buffer is progressively rebuilt through profit retention and through new issuance, if the ADI wants to accelerate the pace of the recapitalisation process
The Unquestionably Strong capital established to date is designed to be sufficient to allow ADIs to withstand quite severe expected cyclical losses (as evidenced by the kinds of severe recession stress scenarios typically used to calibrate capital buffers)
In more extreme scenarios, however, the CCB is overwhelmed by the scale of losses and APRA starts to think about whether the ADI has reached a Point of Non-Viability (PONV) where ADI’s find themselves unable to fund themselves or to raise new equity; this is where the proposals in the Discussion Paper come into play
The discussion paper does not consider why such extreme events might occur but I have suggested above that one reason is that the scale of losses reflects endogenous weakness in the ADI (i.e. failures of risk management, financial control, business strategy) which compound the losses that would be a normal consequence of downturns in the business cycle
APRA requires that AT1 capital instruments, classified as liabilities under Australian Accounting Standards, must include a provision for conversion into ordinary shares or write off when the CET1 capital ratio falls to, or below 5.125 per cent
In addition, AT1 and Tier 2 capital instruments must contain a provision, triggered on the occurrence of a non-viability trigger event, to immediately convert to ordinary shares or be written off
APRA’s simple example show both AT1 and Tier 2 being converted to CET1 (or write-off) such that the Post Resolution capital structure is composed entirely of CET1 capital

Note that conversion of the AT1 and Tier 2 instruments does not in itself allocate losses to these instruments. The holders receive common equity equivalent to the book value of their instrument which they can sell or hold. The ordinary shareholders effectively bear the loss via the forced dilution of their shareholdings. The main risk to the ATI and Tier 2 holders is that, when they sell the ordinary shares received on conversion, they may not get the same price that which was used to convert their instrument. APRA also imposes a floor on the share price that is used for conversion which may mean that the value of ordinary shares received is less than the face value of the instrument being converted. The reason why ordinary shareholders should be protected in this way under a resolution scenario is not clear.

The devil is in the detail – A short (probably incomplete) list of issues I see with the proposal:

Market capacity to supply the required quantum of additional Tier 2 capital required
Conversion versus write-off
The impact of conversion on the “loss hierarchy”
Why not just issue more common equity?
To what extent would the public sector continue to stand behind the banking system once the proposed level of self insurance is in place?

Market capacity to supply the required level of additional loss absorption

APRA has requested industry feedback on whether market appetite for Tier 2 capital will be a problem but its preliminary assessment is that:

” … individual ADIs and the industry will have the capacity to implement the changes necessary to comply with the proposals without resulting in unnecessary cost for ADIs or the broader financial system.

Preliminary estimates suggest the total funding cost impact from increasing the D-SIBs’Total Capital requirements would not be greater than five basis points in aggregate based on current spreads. Assuming the D-SIBs meet the increased requirement by increasing the issuance of Tier 2 capital instruments and reducing the issuance of senior unsecured debt, the impact is estimated by observing the relative pricing of the different instruments. The spread difference between senior unsecured debt and Tier 2 capital instruments issued by D- SIBs is around 90 to 140 basis points.”

I have no expert insights on this question beyond a gut feel that the required level of Tier 2 capital cannot be raised without impacting the current spread between Tier 2 capital and senior debt, if at all. The best (only?) commentary I have seen to date is by Chris Joye writing in the AFR (see here and here). The key points I took from his opinion pieces are:

The extra capital requirement translates to $60-$80 billion of extra bonds over the next four years (on top of rolling over existing maturities)
There is no way the major banks can achieve this volume
Issuing a new class of higher ranking (Tier 3) bonds is one option, though APRA also retains the option of scaling back the additional Tier 2 requirement and relying on its existing ability to bail-in senior debt

Chris Joye know a lot more about the debt markets than I do, but I don’t think relying on the ability to bail-in senior debt really works. The Discussion Paper refers to APRA’s intention that the “… proposed approach is … designed with the distinctive features of the Australian financial system in mind, recognising the role of the banking system in channelling foreign savings into the economy “ (Page 4). I may be reading too much into the tea leaves, but this could be interpreted as a reference to the desirability of designing a loss absorbing solution which does not adversely impact the senior debt rating that helps anchor the ability of the large banks to borrow foreign savings. My rationale is that the senior debt rating impacts, not only the cost of borrowing, but also the volume of money that foreign savers are willing to entrust with the Australian banking system and APRA specifically cites this factor as shaping their thinking. Although not explicitly stated, it seems to me that APRA is trying to engineer a solution in which the D-SIBs retain the capacity to raise senior funding with a “double A” rating.

Equally importantly, the creation of a new class of Tier 3 instruments seems like a very workable alternative to senior bail-in that would allow the increased loss absorption target to be achieved without impacting the senior debt rating. This will be a key issue to monitor when ADI’s lodge their response to the discussion paper. It also seems likely that the incremental cost of the proposal on overall ADI borrowing costs will be higher than the 5bp that APRA included in the discussion paper. That is not a problem in itself to the extent this reflects the true cost of self insurance against the risk of failure, just something to note when considering the proposal.

Conversion versus write-off

APRA has the power to effect increased loss absorption in two ways. One is to convert the more senior elements of the capital stack into common equity but APRA also has the power to write these instruments off. Writing off AT1 and/or T2 capital, effectively represents a transfer of value from the holders of these instruments to ordinary shareholders. That is hard to reconcile with the traditional loss hierarchy that sees common equity take all first losses, with each of the more senior tranches progressively stepping up as the capacity of more junior tranches is exhausted.

Consequently I assume that the default option would always favour conversion over write-off. The only place that I can find any guidance on this question is Attachment J to APS 111 (Capital Adequacy) which states

Para 11. “Where, following a trigger event, conversion of a capital instrument:

(a) is not capable of being undertaken;

(b) is not irrevocable; or

(c) will not result in an immediate and unequivocal increase in Common Equity Tier 1 Capital of the ADI,

the amount of the instrument must immediately and irrevocably be written off in the accounts of the ADI and result in an unequivocal addition to Common Equity Tier 1 Capital.”

That seems to offer AT1 and Tier 2 holders comfort that they won’t be asked to take losses ahead of common shareholders but the drafting of the prudential standard could be clearer if there are other reasons why APRA believe a write-off might be the better resolution strategy. The holders need to understand the risks they are underwriting but ambiguity and uncertainty are to helpful when the banking system is in, or a risk of, a crisis.

The impact of conversion on the “loss hierarchy”

The concept of a loss hierarchy describes the sequence under which losses are first absorbed by common equity and then by Additional Tier 1 and Tier 2 capital, if the more junior elements prove insufficient. Understanding the loss hierarchy is I think fundamental to understanding capital structure in general and this proposal in particular:

In a traditional liquidation process, the more senior elements should only absorb loss when the junior components of the capital stack are exhausted
In practice, post Basel III, the more senior elements will be required to participate in recapitalising the bank even though there is still some book equity and the ADI technically solvent (though not necessarily liquid)
This is partly because the distributions on AT1 instruments are subject to progressively higher capital conservation restrictions as the CCB shrinks but mostly because of the potential for conversion to common equity (I will ignore the write-off option to keep things simple)

I recognise that APRA probably tried to simplify this explanation but the graphic example they used (see Figure 6 above) to explain the process shows the Capital Surplus and the CCB (both CET1 capital) sitting on top of the capital stack followed by Tier 2, Additional Tier 1 and finally the minimum CET1 capital. The figure below sets out what I think is a more logical illustration of the capital stack and loss .

Losses initially impact CET1 directly by reducing net tangible assets per share. At the point of a non-viability based conversion event, the losses impact ordinary shareholders via the dilution of their shareholding. AT1 and Tier 2 holders only share in these losses to the extent that they sell the ordinary shares they receive for less than the conversion price (or if the conversion price floor results in them receiving less than the book value of their holding).

Why not just issue more common equity?

Capital irrelevancy M&M purists will no doubt roll their eyes and say surely APRA knows that the overall cost of equity is not impacted by capital structure tricks. The theory being that any saving in the cost of using lower cost instruments, will be offset by increases in the costs (or required return) of more subordinated capital instruments (including equity).

So this school argues you should just hold more CET1 and the cost of the more senior instruments will decline. The practical problem I think is that, the cost of senior debt already reflects the value of the implied support of being too big, or otherwise systemically important, to be allowed to fail. The risk that deposits might be exposed to loss is even more remote partly due to deposit insurance but, possibly more importantly, because they are deeply insulated from risk by the substantial layers of equity and junior ranking liabilities that must be exhausted before assets are insufficient to cover deposit liabilities.

To what extent would the public sector continue to stand behind the banking system once the proposed level of self insurance is in place?

Assuming the market capacity constraint question could be addressed (which I think it can), the solution that APRA has proposed seems to me to give the official family much greater options for dealing with future banking crises without having to call on the taxpayer to underwrite the risk of recapitalising failed or otherwise non-viable banks.

It does not, however, eliminate the need for liquidity support. I know some people argue that this is a distinction without a difference but I disagree. The reality is that banking systems built on mostly illiquid assets will likely face future crises of confidence where the support of the central bank will be necessary to keep the financial wheels of the economy turning.

There are alternative ways to construct a banking system. Mervyn King, for example, has advocated a version of the Chicago Plan under which all bank deposits must be 100% backed by liquid reserves that would be limited to safe assets such as government securities or reserves held with the central bank. Until we decide to go down that path, or something similar, the current system requires the central bank to be the lender of last resort. That support is extremely valuable and is another design feature that sets banks apart from other companies. It is not the same however, as bailing out a bank via a recapitalisation.

Conclusion

I have been sitting on this post for a few weeks while trying to consider the pros and cons. As always, the risk remains that I am missing something. That said, this looks to me like a necessary (and I would argue desirable) enhancement to the Australian financial system that not only underpins its safety and stability but also takes us much closer to a level playing field. Big banks will always have the advantage of sophistication, scale and efficiency that comes with size but any funding cost advantage associated with being too big to fail now looks to be priced into the cost of the additional layers of loss absorption this proposal would require them to put in place.

Tony

Will Expected Loss loan provisioning reduce pro cyclicality?

I may not always agree with everything they have to say, but there are a few people who reliably produce content and ideas worth reading, Andy Haldane is one and Claudio Borio is another (see previous posts on Haldane here and Borio here for examples of their work). So I was interested to read what Borio had to say about the introduction of Expected Credit Loss (ECL) provisioning. ECL is one of those topic that only interests the die-hard bank capital and credit tragics but I believe it has the potential to create some problems in the real world some way down the track.

Borio’s position is that:

Relative to the “incurred loss” approach to credit risk that precedes it, the new standard is likely to mitigate pro cyclicality to some extent;
But it will not be sufficient on its own to eliminate the risk of adverse pro cyclical impacts on the real economy;
So there is a need to develop what he calls “capital filters” (a generic term encompassing capital buffers and other tools that help mitigate the risk of pro cyclicality) that will work in conjunction with, and complement, the operation of the loan loss provisions in managing credit risk.

There are two ways to respond to Claudio Borio’s observations on this topic:

One is to take issue with his view that Expected Credit Loss provisioning will do anything at all to mitigate pro cyclicality;
The second is to focus on his conclusion that ECL provisioning by itself is not enough and that a truly resilient financial system requires an approach that complements loan provisions

Will ECL reduce the risk of pro cyclicality?

It is true that, relative to the incurred loss model, the ECL approach will allow loan loss provisions to be put in place sooner (all other things being equal). In scenarios where banks have a good handle on deteriorating economic conditions, then it does gives more freedom to increase provisions without the constraint of this being seen to be a cynical device to “smooth” profits.

The problem I see in this assessment is that the real problems with the adequacy of loan provisioning occur when banks (and markets) are surprised by the speed, severity and duration of an economic downturn. In these scenarios, the banks may well have more ECL provisions than they would otherwise have had, but they will probably still be under provisioned.

This will be accentuated to the extent that the severity of the downturn is compounded by any systematic weakness in the quality of loans originated by the banks (or other risk management failures) because bank management will probably be blind to these failures and hence slow to respond. I don’t think any form of Expected Loss can deal with this because we have moved from expected loss to the domain of uncertainty.

The solution to pro cyclicality lies in capital not expected loss

So the real issue is what to do about that. Borio argues that, ECL helps, but you really need to address the problem via what he refers to as “capital filters” (what we might label as counter cyclical capital buffers though that term is tainted by the failure of the existing system to do much of practical value thus far). On this part of his assessment, I find myself in violent agreement with him:

let accounting standards do what they do, don’t try to make them solve prudential problems;
construct a capital adequacy solution that complements the accounting based measurement of capital and profits.

Borio does not offer any detail on exactly what these capital solutions might look like, but the Bank of England and the OFSI are working on two options that I think are definitely worth considering.

In the interim, the main takeaway for me is that ECL alone is not enough on its own to address the problem of pro cyclicality and, more importantly, it is dangerous to think it can.

Tony

Modelling bank capital requirements – The Zone of Validity

Even casual students of bank capital will be familiar with the view that advanced modelling of capital requirements is a waste of time – offering no useful insights at all and indeed dangerous to the extent these “advanced” or “sophisticated” approaches create a false sense of safety that results in excessive leverage and or credit growth.

The more technical critiques of modelling focus on the fact that a capital requirement, by definition, seeks to measure the unexpected. Mervyn King (“The End of Alchemy“), for example, argues that there is a core element of what he labels “radical uncertainty” (aka Knightian uncertainty) that cannot be modelled in the probabilistic sense that underpins the advanced approaches to capital risk measurements.

“… no amount of sophisticated statistical analysis is a match for the historical experience that “stuff happens”. At the heart of modern macroeconomics is the same illusion that uncertainty can be confined to the mathematical manipulation of known probabilities.”

There are I think substantial elements of truth in this view. The high confidence level employed in the regulatory capital requirement was intended to bring a healthy margin of safety to the measure but the idea that a model derived answer made bank insolvency a 1: 1000 year event was never very robust once you started to look at the detail.

To be fair, the architects of Basel II were well aware of the restrictive assumptions they had made (e.g. well diversified risk, portfolio invariant) expecting that both banks and regulators would make suitable allowances for the extent to which real banks did not conform to the ideal model assumptions. In practice though, these caveats tended to get lost in the enthusiasm for a seemingly precise and robust number. Disclosure and market discipline also proved much less robust controls on bank leverage than seemed logical in the 1980’s when the Efficient Market Hypothesis reigned supreme.

There is however a “zone of validity” in which I believe that models do offer useful insight and guidance. I want to focus here on the models employed in the Internal Ratings Based (IRB) approach to credit risk; the dominant risk class for many banking systems.

I encountered the term “zone of validity” in Wilmott and Orrell’s book (The Money Formula) but I am sure the idea is not new; it is also fairly intuitive

“The key then is to keep with simple models, but make sure that the model is capturing the key dynamics of the system, and only use it within its zone of validity. Models should be seen as imperfect patches, rather than as accurate representations of the complete system. Instead of attempting … a better, more complete “theory of everything”, the aim is to find models that are useful for a particular purpose, and know when they break down”.

“The Money Formula”, Wilmott and Orrell, Chapter 8

Applying the “zone of validity” filter to IRB models

The first thing to do is distinguish the different types of models employed in the IRB framework (Yes Virginia, there is not just one monolithic IRB model). One of the people I go to when I want to understand credit risk has proposed the following taxonomy of IRB models which can be ranked in terms of robustness and empirical evidence for their effectiveness.

Relative Risk (Rank Ordering) Models – that measure relative risk (aka rank ordering) at an obligor level – e.g. Probability of Default (PD) rating models, Exposure at Default (EAD) segmentation models, Loss Given Default (LGD) segmentation models.
Point in Time (Econometric) Models – that capture the relationship between external systemic (economic) drivers and point in time default rates or loss rates – e.g. point in time PD
Highly Extrapolated, Point in Time, Models – Essentially the same form of model as above but applied to highly stressed or rare scenarios – e.g. stress testing models targeting a 1 in 25 year or higher scenario consistent with a severe recession
VAR models – which attempt to describe the entirety of the credit loss distribution and correlation effects, usually with the goal to quantify the size of low probability tail loss events such as a 1 in 100 or 1 in 1000 year loss – e.g. capital models

Relative Risk models arguably have the widest zone of validity. We may not be able to predict precisely when individual exposures will default but models tend to do a pretty reasonable job of rank ordering the risk of default. We also have a pretty good handle on the kinds of factors that increase the severity of loss in the event of default, at least in relative terms.

From there on, the zone of validity progressively shrinks along with the degree of precision that the models are capable of offering. That said, the models can still offer useful insights so long as we understand the limitations of what they are saying.

Point in time models will help anchor loan loss provisioning; like any model, there will be a degree of error, but the structured approach makes it much easier to deconstruct the overall loan loss estimate and figure out where you agree or disagree with the output.
Highly extrapolated models such as you might see in a stress testing model clearly expand the range of error but again they offer a way of peering under the hood and seeing what part of the output looks wrong;
- Will the PD increase by a factor of 5 in a severe recession or is a 10 fold increase closer to the mark? – what happened in the last severe recession and why? – if house prices decline by 25% then what kind of LGD should I expect and how does the increase in PD impact the decline in prices? if I just decided to increase my PD should I also increase LGD? is the increase in loss being projected a function of some external shock impacting a sound credit portfolio or does a decline in the quality of the portfolio contribute to the severity of the losses?
- There are no precise answers to these questions but you can get a lot closer to a coherent answer if you have a decent model.
- These kinds of models also offer a much better way of calibrating capital buffers than the traditional solution of copying what the other banks are holding (who are most likely copying you) or just doing what the prudential rules prescribe (now that they define minimum capital buffers).
VAR models arguably do operate outside their zone of validity (at a minimum they are not a reliable measure of the 1 in 1000 year risk the bank’s capital will be sufficient) so the answers they provide need to be used with that weakness in mind.

The fixes and the potential unintended consequences

A very common response to the modelling problems discussed above is to apply more conservative values to the risk parameters (i.e PD, LGD, EAD and Correlation) employed in the IRB capital calculation. This is relatively easy to do, feels intuitively right and gives a higher capital requirement but this approach also has costs. The cost may be justified but should be recognised.

One of the issues with arbitrarily increasing risk estimates is that you start to distort the model outputs that do lie within their zone of validity. Modelling (estimating) Regulatory Expected Loss (REL), in particular, should be quite simple – just multiply PD by LGD by EAD and “voila”, we have a 1 year measure of what we expect the credit portfolio to lose at this point in the credit cycle. In principle, we can also be reasonably confident that our stressed loss estimate is useful provided we are honest about the quality of our credit portfolio and don’t get too ambitious on the level of severity. It seems to me that these applications are mostly within the zone of validity of the models we use to measure these things; and we hold capital to cover the risk that something unexpected happens.

However, in practice, we start the REL estimate by using a “downturn” measure of LGD that reflects what we expect to lose during a part of the credit cycle that may or may not coincide with where we actually are at this point in time. Next we increase PD to be conservative; again that choice of a conservative measure may or may not reflect were we actually are in the credit cycle at this point in time. The same goes for EAD. Exactly what we are measuring starts to become unclear and it is hard to see how deliberately introducing reduced clarity can ever be desirable.

My purpose here is not oppose the idea of bank capital needing to be a conservative measure (and I know that there are reasons deeply embedded in the IRB model’s history for why we use a downturn measure of LGD). My point is simply that the way that you pursue that conservatism has consequences and I have used Regulatory Expected Loss as an example. If the aim is simply to require a bank to hold more capital then there are alternatives (increase the correlation assumptions or increase the capital buffer ratio requirements) that achieve that outcome without distorting the REL measure.

Tell me what I am missing …

Tony

Responsible lending

The conventional wisdom is that banks are bastards and the discussion of responsible lending in the Royal Commission’s Interim Report seems to offer further evidence to confirm this self-evident truth.

This assessment troubles me. Not so much the banks are bastards bit, that has been a truth of the Australian perception of their banks for as long as I can remember (which is quite a long time). What troubles me is that the Responsible Lending obligation is open to the interpretation that borrowers may be relieved of any responsibility for their own decisions and indeed for telling the truth when applying for a loan.

Christopher Joye wrote an interesting opinion piece on his topic. Joye argues that the Royal Commission has adopted an “inexplicably one-eyed” interpretation of the laws that “projects the impression they are devoid of doubt” when in fact these laws are yet to be clarified by the courts. I have no particular legal insights here on where the truth lies; i.e. is the law as black and white as portrayed in the Commission’s Interim Report or more open to interpretation and clarification as Joye asserts. That I think is something to pay close attention to as the Commission plays out.

I do however share Joye’s concern with the extent to which the Royal Commission interpretation seems to create moral hazard which potentially increases risks and cost for lenders.

I think he possibly overstates the potential impact of the risk transfer on depositors. Australian bank depositors in my view are pretty well insulated from the risk transfer, partly by virtue of the Australian government guarantee of small deposits, but mostly because of the deeply senior position deposits hold in the Australian bank loss hierarchy. Joye’s comments on the extent to which this shifting of the onus of responsibility impacts the cost of bank funding are more concerning.

I am not suggesting that there is anything wrong with laws that help bank customers make more informed choices and otherwise tip the balance of power back in their favour in the interests of a fairer, more competitive market for financial services. I just don’t see that home loan borrowers are as badly done by as is often suggested. Borrowers clearly do struggle with very high house prices in the major cities but that is not the banks’ fault. The process of getting a loan and comparing offers however seems as easy, open and competitive as it has been in my memory.

I think we can probably agree that banks should not take advantage of customers were there is a power imbalance. It is less clear that banks should be held responsible for policing borrower risk appetites, including their willingness to make sacrifices to own a home, by imposing limits that are more strict than what would be required to ensure that the credit risk is sound.

It is entirely possible that I am missing something here, but I can only call it the way I see it. Banks may be bastards but that does not mean that everything they do is wrong.

Tony

“The Origin of Financial Crises” by George Cooper

There are a lot of books on the topic of financial crises but this one, written in 2008, stand the test of time. At the very least, it offers a useful introduction to Minsky’s Financial Instability Hypothesis. There is also an interesting discussion of the alternative approaches adopted by central banks to the problem of financial stability.

George Cooper argues that our financial system is inherently unstable and that this tendency is accentuated by a combination of factors

The belief that market forces will tend to produce optimal allocations of capital, and
Monetary policy that seeks to smooth (and ideally eliminate) business cycle fluctuations in economic activity

Cooper draws heavily on Hyman Minsky’s Financial Instability Hypothesis (FIH) which he argues offers much better insight into the operation of the financial system than the the Efficient Market Hypothesis (EMH) which tended to be the more influential driver of economic policy in the years preceding the Global Financial Crisis.

Cooper uses these competing theories to explore what makes prices within financial markets move. The EMH maintains that the forces of supply and demand will cause markets to move towards equilibrium and hence that we must look to external forces to understand unexpected shocks and crises. Minsky’s FIH, in contrast, argues that financial markets can be driven by internal forces into cycles of credit expansion and asset inflation followed by credit contraction and asset deflation.

Cooper identifies the following ways in which financial systems can become unstable

Markets characterised by supply constraints tend to experience price inflation which for a period of time can drive further increases in demand
Monetary policy which is oriented towards mitigating (and in some cases pre-empting) economic downturns can also amplify market instability (i.e. the Greenspan put makes the market less resilient in the long run)
Credit creation by private sector banks contributes to money supply growth; this in turn can facilitate growth in demand but there is no mechanism that automatically makes this growth consistent with the economy’s sustainable growth path

The point about some asset markets being prone to instability is particularly pertinent for banks that focus on residential property lending. Classical economic theory holds that increased prices should lead to increased supply and reduced demand but this simple equilibrium model does not necessarily work for property markets. Property buyers more often reason that they need to meet the market because it will only get more expensive if they wait. Many of them will have already seen this happen and regret not meeting the market price previously as they contemplate paying more to get a property that is not as nice as ones they underbid on. The capacity of home builders to respond to the price signal is frequently constrained by a myriad of factors and there is a long lead time when they do respond.

The argument Cooper makes rings very true for Australia and is very similar to the one that Adair Turner made in his book titled ”Between debt and the devil”. Cooper’s (and Minsky’s) argument that the pursuit of stability is not a desirable objective and that the system benefits from a modest amount of stress is similar to the argument made by Nassim Taleb in “Antifragility”.

Cooper also discusses the different philosophies that central banks bring to the challenge of managing financial stability. The dominant view is one that focuses on the risk that sees the management of inflation risk as a dominant concern while placing greater trust in the capacity of the market to self correct any instability. The European Central Bank, in contrast, seems to have placed less faith in the market and perhaps been closer to Minsky.

Some quotes from the book will give a sense of the ideas being discussed:

“Through its role in asset price cycles and profit generation, credit formation (borrowing money for either consumption or investment) lies at the heart of the financial market’s fundamental instability”.

“Hyman Minsky said that “stability creates instability” referring to our tendency to build up an unsustainable stock of debt in times of plenty only for that debt to then destroy the times of plenty”

“For a system as inherently unstable as the financial markets, we should not seek to achieve perfect stability; arguably it is this objective that has led to today’s problems. A more sustainable strategy would involve permitting, and at times encouraging, greater short-term cyclicality, using smaller, more-frequent downturns to purge the system of excesses”

“Credit creation is the foundation of the wealth-generation process; it is also the cause of financial instability. We should not let the merits of the former blind us to the risks of the latter.”

I have made some more detailed notes on the book here.

Tony

Mortgage risk weights – fact check

It is frequently asserted that the major Australian banks have been “gifted” a substantially lower mortgage risk weight than the smaller banks. To be precise, the assertion is that the major banks are only required to hold capital based on a 25% risk weight versus 39% for smaller banks.

If you are not familiar with the arcane detail of bank capital adequacy, then you could be forgiven for concluding that this differential (small banks apparently required to hold 56% more capital for the same risk) is outrageous and unfair. While the risk weights for big banks are certainly lower on average than those required of small banks, I believe the difference in capital requirements is not as large as the simple comparison of risk weights suggests.

Bank capital requirements involve more than risk weights

To understand why this comparison of risk weights is misleading, it will be helpful to start with a quick primer on bank capital requirements. The topic can be hugely complex but, reduced to its essence, there are three elements that drive the amount of capital a bank holds:

The risk weights applied to its assets
The target capital ratio applied to those risk weighted assets
Any capital deductions required when calculating the capital ratio

Problem 1 – Capital adequacy ratios differ

The comparison of capital requirements based on risk weights implicitly assumes that the regulator applies the same capital ratio requirement to all banks, but this is not the case. Big banks are targeting CET1 ratios based on the 10.5% Unquestionably Strong benchmark set by APRA while there is a greater range of practice amongst the smaller banks. Bendigo and Suncorp appear to be targeting a CET1 ratio in the range of 8.5 to 9.0% while the smaller of the small banks appear to be targeting CET1 ratios materially higher (say 15% or more).

If we confine the comparison to the alleged disadvantage suffered by Bendigo and Suncorp, then the higher risk weights they are required to apply to residential mortgages is substantially offset by the lower CET1 target ratios that they target (the 56% difference in capital required shrinks to something in the order of 30% if you adjust for the difference in target CET1 ratios).

Broadening the comparison to the smaller banks gets even more interesting. At face value the much higher CET1 ratios they appear to target suggest that they are doubly penalised in the required capital comparison but you have to ask why are they targeting such high CET1 ratios. One possible explanation is that the small less diversified mortgage exposures are in fact more risky than the more diversified exposures maintained by their larger competitors.

Problem 2 – You have to include capital deductions

This is quite technical I recognise but, in addition to the capital tied to the risk weight, the big banks are also required to hold capital for a capital deduction linked to the difference between their loan loss provisions and a regulatory capital value called “Regulatory Expected Loss”. This capital deduction increases the effective risk weight. The exact amount varies from bank to bank but I believe it increases the effective capital requirement by 10-12% (I.e. an effective RW closer to 28%). My understanding is that small banks are not required to make the same capital deduction.

Problem 3 – The Standardised risk weights for residential mortgages seem set to change

A complete discussion of the RW difference should also take account of the fact that APRA has proposed to introduce lower RW Categories for the smaller banks such their average RW may be lower than 39% in the future. I don’t know what the average RW for small banks would be under these new RW but that is a question you could put to the banks who use the 39% figure without acknowledging this fact.

Problem 4 – The risk of a mortgage depends on the portfolio not the individual loan

The statement that a loan is the same risk irrespective of whether it is written by a big bank or small bank sounds intuitively logical but is not correct. The risk of a loan can only be understood when it is considered as part of the portfolio the bank holds. Small banks will typically be less diversified than a big bank.

Problem 5 – What about the capital required for Interest Rate Risk in the Banking Book (IRRBB)?

I don’t have sufficient data to assess how significant this is, but intuitively I would expect that the capital that the major banks are required to hold for IRRBB will further narrow the effective difference between the risk weights applied to residential mortgages.

Summing up

My aim in this post was not to defend the big banks but rather to try to contribute some of the knowledge I have acquired working in this area to what I think is an important but misunderstood question. In the interests of full disclosure, I have worked for one of the large Australian banks and may continue to do work for them in the future.

On a pure risk basis, it seems to me that the loan portfolio of a large bank will tend to be more diversified, and hence lower risk, than that of a smaller bank. It is not a “gift” for risk weights to reflect this.

There is a legitimate debate to be had regarding whether small banks should be given (gifted?) an advantage that helps them compete against the big banks. That debate however should start with a proper understanding of the facts about how much advantage the large banks really have and the extent to which their lower risk weights reflect lower risk.

If you disagree tell me what I am missing …

The secret to growth may be how your economy deals with downside risk

Andrew Haldane’s work is always worth reading and a recent speech he made titled “Ideas and Institutions – A Growth Story” is no exception.

Haldane’s revised story of growth

Haldane starts with the observation that GDP growth matters and not just for narrow materialistic reasons.

“It is now pretty well-established that growth is a vital ingredient, indeed pre-requisite, for meeting many of the broader societal objectives many would view as important to our longer-term health, wealth and happiness. While not an end in itself, economic growth appears to be a vitally important means of achieving those societal ends.”

If you accept this premise then understanding how to foster growth matters. One of the clues has been to look at what drove the step change in the pattern of cumulative long term GDP growth that started around 1750. Haldane notes that the traditional explanation was that there had been a happy confluence of ideas and innovation starting with the Industrial Revolution that resulted in growth taking off.

Haldane recounts that he subscribed to this story of growth but two facts prompted him to reconsider.

“I thought I understood the story of economic growth, its drivers and determinants. But recently I have changed my mind. I have a new story of growth.”

Fact number one is that innovation did not just start in 1750 …

”… waves of innovation, big and small, have been lapping the shores of society for the entirety of human civilisation… while ideas and innovation may well be a necessary condition for economic growth, the historical record suggests they may not themselves have been sufficient. Other forces appear to have been at play, translating these ideas into sustained growth in living standards.”

Fact number two was analysis of long term growth provided by economic historians, Steve Broadberry and John Wallis.

Indeed, Haldane states it was probably this new perspective, above all others, that led him to change his own story about growth. This “fact” must be treated with caution given the challenge of seeking to collate a picture of GDP growth over the past 1000 years. However, it does offer an intriguing and plausible (to me at least) new perspective on one of the keys to sustaining the kinds of growth that underpin modern standards of living.

Broadberry and Wallis found that, even prior to the Industrial Revolution, economies experienced notable periods of strongly positive growth. This has continued post the Industrial Revolution (albeit a bit less than growth during expansion periods prior to the Industrial Revolution). What changed post the Industrial Revolution was a dramatic fall in both the probability and cost of GDP contractions.

“Since 1750, recessions have become far less frequent and less painful. It is the avoidance of deep recessions that differentiates the Golden Era from its Malthusian predecessor.”

The alternative story Haldane finds persuasive is that the real game changer altering the long term cumulative growth trajectory was just as much an “Institutional Revolution” as an Industrial Revolution. Innovation in the institutional structures of the economy reduced the incidence and severity of recessions but also helped to mitigate the social impact of the disruption associated with the technological change that was driving increases in productivity.

“… the story that better fits the facts appears to be one in which the conveyor belt of ideas and innovation has been continuous over the centuries, causing lengthy if lumpy ideas-fuelled expansions. But whereas prior to the Industrial Revolution this conveyor belt was regularly halted by recessions, more recently these interruptions have been far fewer and less costly.

Put differently, the real revolution in living standards after 1750 came about not exclusively, or perhaps even mainly, from the surge in ideas and technologies. Rather, it resulted from societies having found some means of avoiding the subsequent recessionary bullets. Prior to the Industrial Revolution, these killed expansions dead. After it, societies appear to have found some effective means of dodging them.”

What exactly is the Institutional Revolution that Haldane sees playing a key role in having facilitating sustainable growth

Haldane offers a definition by Douglass North as a good starting point:

Institutions are “…. humanly devised constraints that structure political, economic and social interactions”. So defined, institutions are social infrastructure. They include formal or legal institutions, like Parliaments, judiciaries, central banks, social safety nets and schools. But they also include less formal associations and groups, such as universities, trade unions, guilds and charities.”

The Industrial Revolution resulted in new forms of physical capital but the Institutional Revolution is reflected in a broader set of “capitals” not just physical capital (plant and machines) but human (skills and expertise), intellectual (ideas and technologies), infrastructural (transport and legal systems), social (co-operation and trust) and institutional (national and civic, private and public) capital.

History suggests each of these capitals may have played an important supporting role in the story of growth. Ideas alone, without the support of one or more of these broader capitals, have historically run aground. For example, in the UK many of the foundations for growth after the Industrial Revolution were laid in the centuries preceding it. It was on this platform of “capitals”, plural, that ideas and innovation then built.

What flows from this revised story of growth

Haldane identified a number of institutions but this speech is addressed to a group of university students so he naturally focuses on the role universities can play in managing the downside associated with the current wave of technological innovation.

“The story of growth is a story with two “i”s – ideas and institutions. The Fourth Industrial Revolution will expand the range of ideas, perhaps more than any of its predecessors. It may also expand the range of workers who suffer its side-effects, perhaps more so than any of its predecessors. In the past, new institutions have emerged to cushion this painful transition, limiting the recessionary hit to societies.

Historically, doing so appears to have held the key to sustainable growth. If this time’s technological transition is as great as any previously, securing sustainable growth will need new institutions to manage this transition and mitigate its societal side-effects. I have speculated on one area where that next institutional wave might usefully break – universities like this one, as new centres of lifelong learning and technological diffusion. In future, institutional innovation will be every bit as important as technological innovation if that gift of growth is to keep on giving.”

“What experience since the Industrial Revolution has taught us is that this risk can be mitigated by an appropriate institutional response. To be effective in curbing recession risk, that response should have as its objectives, first, speeding-up the process of reskilling by workers (“enabling”) and, second, cushioning the impact of new technologies on displaced companies and their workers (“insuring”).

If true, this alternative explanation for why the growth trajectory changed carries important implications for understanding the future challenges of technology and for devising the future policies and institutions necessary to meet them”

Loan loss provisioning gets more procyclical

I know we are expected to believe Expected Loss Loan provisioning (IFRS9 / CECL) will make the banking system less procyclical. I very much doubt that is true and expect it will, if anything, be more rather than less procyclical.

I recently flagged a note by Adrian Docherty that set out why this is likely to be so. Now I offer Tony Hughes of Moody’s Analytics who wrote a good piece here explaining why this new approach to loan loss provisions will in fact add to procyclicality. It is a quick read but worth the effort.

Tony

Capital adequacy – an option to add transparency and flexibility into the “Unquestionably Strong” mix

Two of my earlier posts (here and here) discussed the potential to improve the capital adequacy framework by revisiting the calibration and operation of regulatory capital buffers. Some of the issues discussed in those posts are touched on in a discussion paper APRA has released titled “Improving the transparency, comparability and flexibility of the ADI capital framework“.

APRA is open to alternatives but sets out two options for discussion

In APRA’s words, the DP outlines

“… options to modify the ADI capital framework to improve transparency and comparability of reported capital ratios. The main conceptual approaches APRA is considering and seeking feedback on are:

developing more consistent disclosures without modifying the underlying capital framework; and
modifying the capital framework by adjusting the methodology for calculating capital ratios.”

The First Approach– “Consistent disclosure” – seems to be a beefed up version of the status quo in which APRA gets more directly involved in the comparability process by adding its imprimatur to the internationally harmonised ratios some Australian banks currently choose to disclose as an additional informal measure of capital strength.

“Under this approach, ADIs would continue to determine regulatory capital ratios using APRA’s definitions of capital and RWA. However, APRA would also specify a methodology for ADIs to determine certain adjustments to capital and RWA that could be used for disclosure (Pillar 3) purposes. As noted above, the methodology would focus on aspects of relative conservatism that are material in size and able to be calculated simply and objectively.”

APRA argues that “The supplementary disclosure would allow all stakeholders to better assess the capital strength of an ADI on a more comparable basis. However, it would result in two APRA-endorsed capital ratios: an APRA regulatory capital ratio to be compared against minimum requirements, and an additional disclosure-only capital ratio for, in particular, international comparison.”

A Second Approach – “Capital ratio adjustments” would involve APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and RWA.

The DP explains that this “… alternative approach would involve APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and RWA. This would involve removing certain aspects of relative conservatism from ADIs’ capital ratio calculations and lifting minimum regulatory capital ratio requirements in tandem. This increase in regulatory capital ratio requirements could be in the form of a transparent adjustment to minimum capital ratio requirements—for the purposes of this paper, such an adjustment is termed the ‘APRA Overlay Adjustment’.”

“To maintain overall capital adequacy, the APRA Overlay Adjustment would need to be calculated such that the total dollar amount of Prudential Capital Requirement (PCR) and Capital Conservation Buffer (CCB) would be the same as that required if these measures were not adopted. In other words, the risk-based capital requirements of ADIs would be unchanged in absolute dollar terms, maintaining financial safety, but adjustments to the numerator and the denominator of the capital ratio to be more internationally comparable would increase reported capital ratios.”

APRA clarify that

“These options are not mutually exclusive, and there is potential for both approaches to be adopted and applied in different areas.”

Approach 2 has some clear advantages …

It would make the “unquestionably strong” capital ratios more directly comparable with international peers, thereby reducing the potential for the perception of this strength to be obscured or misunderstood.

“Perception” is the key word here. It matters that the strength of Australian banks is simple, transparent and evident rather than being something where the perceivers must understand a sequence of relatively obscure and complex adjustments to fully appreciate the strength of a bank’s capital. More importantly perception matters most when the system is under stress and people do not have the time, or the inclination, to look beyond the reported numbers.

The adjusted capital ratio approach also provides opportunity to increase the flexibility of the ADI capital framework in times of stress but only to the extent to which the Overlay Adjustment is applied to the capital buffer, rather than increasing the minimum capital requirements. Higher minimum requirements would do nothing to enhance flexibility and may even be a backward step.

I believe a non zero baseline for the CCyB would also enhance the flexibility of the capital framework by virtue of the fact that it improves the odds that the banks (and APRA) have a flexible buffer in place before it is needed. This opportunity for enhanced flexibility is an option under both approaches so long as the Unquestionably Strong Benchmark maintains a material surplus over the Capital Conservation Buffer as it currently does.

But also some challenges …

APRA notes that the Adjusted Capital Ratio approach:

May significantly increase operational complexity for ADIs by virtue of the fact that the application of the APRA Overlay Adjustment would result in variable capital ratio requirements,

• Potentially results in variable minimum capital requirements which introduces complexity in analysing capital buffers and may undermine the desired transparency, and

• Reduces the dollar value of the 5.125 per cent (of RWA) loss absorption trigger point.

Do the advantages of the Adjusted Capital Ratio approach outweigh the challenges?

The short answer, I think, is yes … albeit with some qualifications.

So far as I can see, the added complexity only enters the discussion to the extent that some of the APRA Overlay Adjustment is applied to increase the minimum capital requirement. Most, if not all, of the operational complexity is avoided if the “Overlay Adjustment” is confined to increasing the size of the capital buffer.

Conversely, the benefits of increased responsiveness (or risk sensitivity) and flexibility lie in an increased capital buffer.

It follows then that the best way to pursue this approach is for any harmonised adjustments to the reported capital ratio to be confined to a higher CCB. This begs the question whether all the Overlay Adjustment should be applied to the capital buffer. I address that question in my responses below to some of the questions APRA has posed to solicit industry feedback.

One issue not covered in the Discussion Paper in any detail is that the capital ratios under Approach 2 will be more sensitive to any changes in the numerator. This is a simple mathematical consequence of RWA being lower if more harmonised measures are adopted. I do not see this as a problem but the heightened risk sensitivity of the framework needs to be clearly understood beforehand to minimise the potential for larger changes in capital ratios to be misunderstood. A more risk sensitive capital ratio may even be an advantage. This may not be obvious but there is a body of research which suggests a more responsive, more volatile, measure of capital adequacy can be beneficial to the extent that it prompts greater risk awareness on the part of bank management and external stakeholders. Greg Ip’s book “Foolproof” offers an introduction to some of this research but a simple example illustrating the point is the way that the benefits of improved braking in modern cars is offset to some extent by people driving faster.

APRA concludes its discussion paper with some direct questions.

There are 8 questions in all but in the context of this post I will have a go at addressing 3 of them, questions 2, 7 and 8.

Question 2: If APRA were to apply a combination of Approach 1 and Approach 2, which aspects of relative conservatism are best suited to be treated under Approach 2?

If you accept the argument that the minimum capital requirement should continue to be a set value (i.e. not subject to periodic adjustment), then the aspects of relative conservatism best suited to Approach 2 are those which can reasonably be assigned to an increase in, and regular adjustment of, one or more of the capital buffers.

Running through the list of adjustments currently applied to generate the internationally harmonised capital ratios, we can distinguish three broad categories of APRA conservatism:

The extra credit risk related losses a bank might expect to experience under a very severe recession or financial crisis style scenario but not necessarily a gone concern where losses extend into the tail of the loss distribution
Assets whose value depends on the ADI being a going concern and consequently are less certain to be realisable if the bank is in liquidation or has otherwise reached a point of non-viability
Capital deduction intended to avoid “double counting” capital invested outside the ADI include

There are very few areas of black and white in the response to this question, but the first group are the items of APRA conservatism that I think have the clearest claim to be included in the capital buffer. These reflect potential loss scenarios that are conservative but still within the domain of plausibly severe downturns in the business cycle; this would encompass the following capital ratio adjustments:

the 20 per cent loss given default (LGD) portfolio constraint required for residential mortgage exposures;

the LGD parameter for unsecured non-retail exposures;

credit conversion factors (CCFs) for undrawn non-retail commitments;

use of supervisory slotting and the scaling factor for specialised lending;

risk weights for other retail exposures covered by the standardised approach to credit risk; and

the exchange rate used to convert Euro-denominated thresholds in the Basel capital framework into Australian dollars.

The second category are assets which have a value if the bank is a going concern but cannot necessarily be relied upon in non viability scenarios; I.e.

deferred tax assets arising from timing differences;
capitalised expenses and transaction costs
the capital requirement applied by APRA for IRRBB (I am open to arguments that I am being too harsh on IRRBB)

The third category captures capital that is committed to risks where the bank is taking a first loss exposure including

investments in other financial institutions;
holdings of subordinated tranches of securitisations.
investments in commercial entities;

Another way to explore this question is to map these three categories to the traditional graphic expression of a bank loss distribution and establish whether they are expected to lie:

closer to the middle of the loss distribution (sometimes framed as a 1 in 25 year downturn or the kinds of losses we expect in a severe downturn)
Or closer to the “tail” of the loss distribution (typically expressed as a 1 in 1000 year loss in regulatory capital terms).

To be clear, I am not seeking to ascribe any level of precision to these statistical probabilities; simply to distinguish between the relative likelihood of the items of conservatism that APRA has embedded in its current measure of capital adequacy. These three items tend to be treated as equivalent under the current approach and enhanced disclosure per Approach 1 will do nothing to address this conflation of risks.

Question 7: Would increasing the size of capital buffers (either by increasing the CCB or by setting a non-zero baseline CCyB) relative to PCR appropriately balance capital strength with financial stability through the cycle?

I have advocated the benefits of a non zero baseline CCYB in previous posts. One of these posts focused on the approach adopted by the Bank of England where I identified two advantages.

Firstly, it directly addresses the problem of failing to detect/predict when systemic risk in the banking system requires prudential intervention. A lot of progress has been made in dealing with this challenge, not the least of which has been to dispense with the idea that central banks had tamed the business cycle. The financial system however retains its capacity to surprise even its most expert and informed observers so I believe it is better to have the foundations of a usable counter cyclical capital buffer in place as soon as possible after the post crisis repair phase is concluded rather than trying to predict when it might be required.

The BOE approach still monitors a range of core indicators for the CCyB grouped into three categories.

• The first category includes measures of ‘non-bank balance sheet stretch’, capturing leverage in the broader economy and in the private non-financial (ie household and corporate) sector specifically.

• The second category includes measures of ‘conditions and terms in markets’, which capture borrowing terms on new lending and investor risk appetite more broadly.

• The third category includes measures of ‘bank balance sheet stretch’, which capture leverage and maturity/liquidity transformation in the banking system.

However the BOE implicitly accepts that it can’t predict the future so it substitutes a simple, pragmatic and error resilient strategy (put the default CCyB buffer in place ASAP) for the harder problem of trying to predict when it will be needed. This strategy retains the option of increasing the CCyB, is simpler to administer and less prone to error than the standard BCBS approach. The BOE might still miss the turning point but it has a head start on the problem if it does.

The BOE also integrates its CCyB strategy with its approach to stress testing. Each year the stress tests include a scenario:

“intended to assess the risks to the banking system emanating from the financial cycle – the “annual cyclical scenario”

The severity of this scenario will increase as risks build and decrease after those risks crystallise or abate. The scenario might therefore be most severe during a period of exuberance — for example, when credit and asset prices are growing rapidly and risk premia are compressed. That might well be the point when markets and financial institutions consider risks to be lowest. And severity will be lower when exuberance has corrected — often the time at which markets assess risks to be largest. In leaning against these tendencies, the stress-testing framework will lean against the cyclicality of risk taking: it will be countercyclical.”

The Bank of England’s approach to stress testing the UK banking system – October 2015 (page 5)

I have discussed the BOE approach at length but the Canadian supervisor has also introduced some interesting innovations in the way that it uses a capital buffer to address the systemic risk of large banks that are worth considering as part of this review.

The second reason I favour a non zero baseline is because I believe it is likely to result in a more “usable” buffer once risk crystallizes (not just systemic risk) and losses start to escalate.

In theory, the standard capital conservation buffer (CCB) introduced under Basel III can absorb any unexpected increase in losses and allow banks the time to progressively rebuild the buffer when economic conditions improve

In practice, the upper boundary of the CCB acts as a de facto minimum requirement such that banks face strong market pressure to immediately rebuild the buffer potentially at material cost to shareholders

There are no guarantees for what happens to banking systems under stress, but a flexible buffer that is sensitive to the state of the credit cycle is I think far more fit for purpose.

It is important to note that a non zero CCYB is an option under both approaches. There is potentially enough surplus capital in the Unquestionably Strong calibration for a non-zero CCYB to be introduced without requiring banks to raise any more capital. This would be so under either of the approaches that APRA has outlined.

So a larger buffer would be desirable from the perspective of increased comparability and transparency but the advantages of a non zero CCYB could also be pursued under the Unquestionably Strong status quo or Approach 1.

Question 8: What may be some of the potential impacts if APRA increases the prescribed loss absorption trigger point above 5.125 per cent of RWA?

The rationale for increasing the PONV Trigger is that APRA believes it is important to preserve the value of the trigger in dollar terms.

I can see that it is important to have a PONV trigger well before a bank reaches the point of insolvency (I.e. where liabilities exceed assets).

It is less clear that the reduction in the dollar value of the trigger point is sufficiently material to matter.

What really matters is the amount of contingent capital available to be converted into common equity if the PONV conversion trigger is pulled.

In the absence of this source of new capital, the fact that a bank has X billion dollars more or less of book equity (according to the financial accounts) at the point of deemed non-viability is arguably irrelevant to whether it remains a going concern.

I am also pretty sure that we do not want the operational complexity associated with a PONV trigger that moves around over time as a result of seeking to compensate for the impact of the Overlay Adjustment on capital deductions and RWA.