“One thing is for certain, Italy continues to be a place that proves the axiom that banking is inherently a political business, regardless of whether it wants to be.”
— Read on ftalphaville.ft.com/2020/03/10/1583837452000/Italian-mortgages–in-one-pocket–out-the-other/
I have touched on residential mortgage risk weights a couple of times in this blog, most recently in a post on the Dutch proposal to increase residential mortgage RW. This post explores the question of why residential mortgage RW under the Internal Rating Based (IRB) approach can be so low. More importantly, can we trust these very low risk weights (and the banks generating them) or is this yet more evidence that the IRB approach is an unreliable foundation for measuring bank capital requirements? It also touches on some of the issues we encounter in cross border comparisons of capital strength.
It has to be said at this point that IRB modelling is not an area where I claim deep expertise and I would welcome comments and input from people who do have this subject matter expertise. However, it is an important issue given the role that residential mortgage lending plays both in the economy as a whole. If nothing else, the post will at least help me get my thoughts on these questions into some kind of order and potentially invite comments that set me straight if I have got anything wrong. Notwithstanding the importance of the issue, this post is pretty technical so likely only of interest if you want to dig into the detailed mechanics of the IRB approach.
First a recap on what the Dutch bank supervisor proposes to do. Residential mortgage RW in the Netherlands are amongst the lowest observed in Europe
The Dutch banks can of course cite reasons why this is justified but, in order to improve the resilience of the banking system, the Dutch banking supervisor proposes to introduce a floor set at 12% on how low the RW can be. The 12% floor applies to loans with a dynamic Loan to Value (LTV) of 55% or lower. The RW floor increases progressively as the LTV increases reaching a maximum of 45% for loans with a LTV of 100% or more. DNB expects the application of the measure to increase the average risk weights of Dutch IRB banks by 3-4 percentage points (from 11% to 14%-15%).
None of the discussion set out below is in any way intended to challenge bank supervisors seeking to apply limits to the low mortgage risk weights we observe being generated by the internal models developed by IRB banks. That is a whole separate discussion but the move to higher RW on these exposures broadly makes sense to me, not only for reasons of systemic resilience, but also with regard to the way that it reduces the disparity between IRB RW and those the standardised banks are required to operate against. It is however useful to understand what is driving the model outcomes before citing them as evidence of banks gaming the system.
This extract from Westpac’s September 2019 Pillar 3 Report shows a weighted average RW of 24% with individual segments ranging from 6% to 137%. The CBA Pillar 3 shows a similar pattern (RW range from 4.4% to 173.5%). I won’t get too much into the technical detail here but the effective IRB RW is higher when you factor in Regulatory Expected Loss. The impact on the RW in the table below is roughly 16% on average (I divide REL by .08 to translate it to an RWA equivalent and then divide by RWA) but this effect only becomes material for the 26% and higher RW bands).
I am very happy to stand corrected on the facts but my understanding is that the 6% and 14% RW bands in the table above capture “seasoned” portions of the loan portfolio where the Loan to Valuation (LVR) ratio has declined substantially from the circa 80% plus typically observed in newly originated loans. The declining LVR is of course a natural outcome for Principal and Interest loans which is the kind traditional prudent banking prefers.
What at face value looks like an incredibly thin capital requirement starts to make more sense when you consider the fact that the borrowers in these segments have demonstrated their capacity to service their loans and, perhaps more importantly, have built up a substantial pool of their own equity in the property that will absorb very substantial declines in property prices before the bank is likely to face a loss.
Australian owner occupied borrowers have an incentive to repay as fast as possible because their interest is not tax deductible (making the mortgage repayment one of the best applications of surplus cash) and they typically borrow on a floating rate basis. The natural amortisation of loan principal is also likely to have been accelerated by the progressive decline in interest rates in recent years which has seen a large share of borrowers apply the interest saving to higher principal repayments.
Looking at the Dutch RW provides some perspective on the mortgage RW of the Australian IRB banks and the initiatives APRA has implemented to increase them. I will only scratch the surface of this topic but it is interesting none the less to compare the 14-15% average RW the Dutch IRB banks will be required to hold with the 25% average RW that Australian IRB banks must hold.
The Dutch banks cite a favourable legal system that supports low LGD by allowing them to quickly realise their security on defaulted loans. That is a sound argument when you are comparing to a jurisdiction where it can take up to 3 years for a bank to gain access to the security underpinning a defaulted loan. That said, the Australian banks can make a similar argument so that does not look like a definitive factor in favour of lower Dutch RW.
The Australian LTV is based on the amortised value of the loan compared to the value of the property at the time the loan was originated. The Dutch LTV as I understand it seem to includes the updated value of the property as the loan ages. Again I don’t see anything in the Dutch system that renders their residential mortgage lending fundamentally less risky than the Australian residential mortgage.
The other positive factor cited by the Dutch banks is the tax deductibility of mortgage interest which applies even where the property is owner occupied. In Australia, interest on loans for owner occupied property is not tax deductible. The Dutch banks argue that the tax deduction on interest enhances the capacity of the borrower to service a loan but my guess is that this advantage is highly likely to be translated into higher borrowing capacity and hence higher property prices so it is not clear that there is a net improvement in the capacity to repay the loan.
I obviously only have a very rudimentary understanding of Dutch tax rules but my understanding is that tax deductibility of interest expense in some European jurisdictions is quid pro quo for including the implied value of rental on the property in the owner’s taxable income. If that is the case then it looks like tax deductibility of interest is a zero sum game from the lending bank perspective. Qualified by the caveats above, I will provisionally take the side of the Australian mortgage in this comparison. It seems equally likely to me that the the absence of a tax deduction creates an incentive for Australian borrowers to repay their loan as quickly as possible and hence for a greater proportion of loans outstanding to move into the low LVR bands that insulate the bank from the risk of loss. There does not seem to be the same incentive in the Dutch system, especially where the loans are fixed rate.
The purpose of this post was mostly to help me think through the questions posed in the introduction. If you are still reading at this point then I fear you (like I) take bank capital questions way too seriously.
There are two main points I have attempted to explore and stake out a position on:
If you have some evidence that contradicts what I have outlined above then by all means please let me know what I am missing.
Tony
Nice quote from Matt Levine’s opinion piece on the change in US bank capital requirements
“Everything in bank capital is controversial so this is controversial. Usually the controversy is that some people want higher capital requirements and other people want lower capital requirements. Here, pleasantly, part of the controversy is about whether this is a higher or lower capital requirement.“
https://www.bloomberg.com/opinion/articles/2020-03-05/capital-rules-get-less-stressful
We have already seen signs that the Australian banks recognise that they need to absorb some of the fallout from the economic impact of the Coronavirus. This commentator writing out of the UK makes an interesting argument on how much extra cost banks and landlords should volunteer to absorb.
Richard Murphy on tax, accounting and political economy
— Read on www.taxresearch.org.uk/Blog/2020/03/04/banks-and-landlords-have-to-pick-up-the-costs-of-the-epidemic-to-come-if-the-the-economy-is-to-have-a-chance-of-surviving/
I am not saying banks should not do this but two themes to reflect on:
1) This can be seen as part of the price of rebuilding trust with the community
2) it reinforces the cyclicality of the risk that bank shareholders are required to absorb which then speaks to what is a fair “Through the Cycle” ROE for that risk
I have long struggled with the “banks are a simple utility ” argument and this reinforces my belief that you need a higher ROE to compensate for this risk
Tony
I have been planning to write something on the relationship between capital and liquidity for a while. I have postponed however because the topic is complex and not especially well understood and I did not want to contribute to the body of misconceptions surrounding the topic. An article in the APRA Insight publications (2020 Issue One) has prompted me to have a go.
The article published in APRA’s Insight publication under the title “Capital explained” offers a simple introduction to the question what capital is starting with the observation that …
“Capital is an abstract concept and has different meanings in different contexts.
Capital being abstract and meaning different things in different contexts is a good start but the next sentence troubles me.
“In non-technical contexts, capital is often described as an amount of cash or assets held by a company, or an amount available to invest.”
I am not sure that the author intended to endorse this non-technical description but it was not clear and I don’t think it should be left unchallenged, especially when the casual reader might be inclined to take it at face value. The fact that non-technical descriptions frequently state this is arguably a true statement but the article does not clarify that this description is a source of much confusion and seems to be conflating capital and liquid assets.
The source of the confusion possibly lies in double entry bookkeeping based explanations in which a capital raising will be associated with an influx of cash onto a company balance sheet. What happens next though is that the company has to decide what to do with the cash, it is extremely unlikely that the cash just sits in the company bank account. This is especially true in the case of a bank which has cash flowing into, and out of, the balance sheet every day. The influx of one source of funding (in this case equity) for the bank means that it will most likely choose to not raise some alternate form of funding (debt) on that day. The amount of cash it holds will be primarily driven by the liquidity targets it has set which are related to but in no way the same thing as its capital targets.
How should we think about the relationship between capital and liquidity including the extent to which holding more liquid assets might, as is sometimes claimed, justify holding less capital.
It is entirely possible that I am missing something here – I hope not but let me know if you see an error in my logic
Interesting post on the Bank Underground blog by Bank of England staff Joel Suss and Henry Treitel.
This extract summarises their findings
“Our paper makes important contributions, not least of which is practical: bank supervisors can utilise our findings to anticipate firm weaknesses and take appropriate mitigating action ahead of time.
However, the job is not done. For one, we are missing important data which is relevant for anticipating distress. For example, we haven’t included anything that speaks directly to the quality of a firm’s management and governance, nor have we included any information on organisational culture.
Moreover, our period of study only covers 2006 to 2012 – a notoriously rocky time in the banking sector. A wider swathe of data, including both good times and bad, would help us be more confident that our models will perform well in the future.
So while prediction, especially about the future, remains tough, our research demonstrates the ability and improved clarity of machine learning methodologies. Bank supervisors, armed with high-performing and transparent predictive models, are likely to be better prepared to step-in and take action to ensure the safety and soundness of the financial system.”
The European Banking Authority (EBA) published today an Opinion endorsing the decision by Central Bank of the Netherlands (De Nederlandsche Bank – DNB) to modify capital requirements in order to address an increase in macroprudential risk.
These extracts from the EBA press release give you the main facts
This new measure aims at enhancing the resilience of the Dutch banking sector to a potential severe downturn in the residential real estate market against the background of sustained price increases in real estate over the past few years.
In particular, the DNB notified the EBA of its intention to introduce a new macroprudential measure, which consists of a minimum average risk weight floor at the portfolio level based on the loan-to-value (LTV) ratio of the individual loans. More specially, a 12% risk weight is assigned to the portion of the loan not exceeding 55% of the market value of the property that serves to secure the loan, and a 45% risk weight is assigned to the remaining portion of the loan. If the LTV ratio is lower or equal to 55, then a fixed 12% risk weight is assigned to the loan.
In its Opinion, addressed to the Council, the European Commission and the DNB, the EBA acknowledges, in line with the ESRB recommendation on medium-term vulnerabilities in the residential real estate sector in the Netherlands, the concerns on the build-up of risk in this sector, the large proportion of high-LTV loans, high level of indebtedness in Dutch households and the low risk weights for real estate exposures by Dutch IRB banks. In light of this conclusion, the EBA does not object to the deployment, by the DNB, of its proposed macroprudential measure
This post is possibly (ok probably) a bit technical but touches on what I think is an important issue in understanding how the financial system operates. The conventional wisdom as I understand it is that markets thrive on information. I think that is true in some cases but it may not be necessarily true for all markets. If the conventional wisdom is wrong then there are important areas of market and bank regulation that probably need to be reconsidered.
I have written on this topic before in relation to papers by Gary Gorton and Bengt Holmstrom. These papers developed an analytical argument in favour of certain assets (or markets) being “information insensitive”. That argument makes intuitive sense to me and I have used these arguments in a couple of previous posts; one titled “Why banks are different” and another titled “Deposit insurance and moral hazard“.
I hope to eventually do a longer piece where I can bring all these ideas together but the purpose today is simply to flag an interesting post (and associated paper) I came across that offers some empirical evidence in favour of the thesis. The post is titled “(When) Does Transparency Reduce Liquidity” and you can find the paper of the same name here.
This extract from the blog post I think captures the key ideas:
“To sum up, our findings can be grouped under two headings. The first is that more information in financial markets is not always beneficial. It can reduce rather than increase trading and liquidity.
The second is that one size does not fit all in terms of gauging the impact of transparency on liquidity. For the safest of the MBS securities, the impact of transparency is negligible, while for the riskiest, transparency enhances liquidity. It is in the broad middle of the risk spectrum that liquidity is negatively impacted.
Our findings ought to be of interest to regulators on both sides of the Atlantic. In order to promote transparency and to bolster market discipline, supervisors have imposed various loan-level requirements in both Europe and the United States. The assumption seems to be that more transparency is always a good thing.
In such a climate, there has been insufficient investigation or understanding of the effects, including the negative effects, of such requirements on MBS market liquidity. Our work, we believe, begins to put this right.
“(When) Does Transparency Reduce Liquidity?” by Professors Karthik Balakrishnan at Rice University, Aytekin Ertan at London Business School, and Yun Lee at Singapore Management University and London Business School. Posted on “The CLS Blue Sky Blog” October 30 2019
If this thesis is correct (i.e. that there are certain types of funding that should be “information insensitive” by design and that it is a mistake to apply to money markets the lessons and logic of stock markets) then this has implications for:
I have not as yet managed to integrate all of these ideas into something worth sharing but the post referenced above and the associated paper are definitely worth reading if you are engaged with the same questions. If you think I am missing something then please let me know.
Tony
Students of the dark art of bank capital adequacy measurement were excited this week by the release of some proposed revisions to APRA’s “Prudential Standard APS 111 Capital Adequacy” (APS 111); i.e. the one which sets out the detailed criteria for measuring an ADI’s Regulatory Capital.
Is anyone still reading? Possibly not, but there is something I think worth noting here if you want to understand what may be happening with Australian bank capital. This is of course only a consultation at this stage but I would be very surprised if the key proposal discussed below is not adopted.
The consultation paper has a number of changes but the one that I want to focus on is the proposal to apply stricter constraints on the amount of equity an ADI invests in banking and insurance subsidiaries.
In order to understand how this impacts the banks, I have to throw in two more pieces of Australian bank capital jargon, specifically Level 1 and Level 2 capital.
You can be forgiven for not being familiar with this distinction but the capital ratios typically quoted in any discussion of Australian bank capital strength are the Level 2 measures. The Unquestionably Strong benchmark that dominates the discussion is a Level 2 measure. The changes proposed in this consultation however operate at the Level 1 measurement (the ones that virtually no one currently pays any attention to) and not the Level 2 headline rate.
This has the potential to impact the “Unquestionably Strong” benchmark and I don’t recollect seeing this covered in the consultation paper or any public commentary on the proposal that I have seen to date.
APRA has been quite open about the extent to which these changes are a response to the RBNZ proposal to substantially increase equity requirements for NZ banks.
“This review was prompted in part by recent proposals by the Reserve Bank of New Zealand (RBNZ) to materially increase capital requirements in New Zealand. The RBNZ’s proposals and APRA’s processes are a natural by-product of both regulators working to protect their respective communities from the costs of financial instability and the regulators continue to support each other as these reforms are developed.”
The changes have however been calibrated to maintain the status quo based on the amounts of capital the Australian majors currently have invested in their NZ subsidiaries.
“APRA has calibrated the proposed capital requirements so they are broadly consistent with … the current capital position of the four major Australian banks, in respect of these exposures (i.e. preserving most of the existing capital uplift).”
It follows that any material increase in the capital the majors are required to invest in their NZ subsidiaries (in response to the RBNZ’s proposed requirement) will in turn require that they have to hold commensurately more common equity on a 1:1 basis in the Level 1 ADI to maintain the existing Level 1 capital ratios.
So far as I can see, the Level 2 measure does not require that this extra capital invested in banking subsidiaries be subject to the increased CET1 deductions applied at Level 1. It follows that the Level 2 CET1 ratio will increase but the extent to which a creditor benefits from that added strength will depend on which part of the banking group they sit.
I am not saying this a problem in itself. The RBNZ has the authority to set the capital requirements it deems necessary, Australian bank shareholders can make their own commercial decisions on whether the diluted return on equity meets their requirements and APRA has to respond to protect the interests of the Australian banking system.
I am saying that measuring relative capital adequacy is getting more complicated so you need to pay attention to the detail if this matters to you. In particular, I am drawing attention to the potential for the Level 2 CET1 ratios of the Australian majors to increase in ways that the existing “Unquestionably Strong” benchmark is not calibrated to. I don’t think this matters much for Australian bank depositors who have a very safe super senior position in the Australian loss hierarchy. It probably does matter for creditors who are closer to the sharp end of the loss hierarchy including senior and subordinated bondholders.
To date, the Level 2 capital adequacy ratios have been sufficient to provide a measure of relative capital strength; a higher CET1 ratio equals greater capital strength and that was probably all you needed to know. Going forward, I think you will need to pay closer attention to what is happening at the Level 1 measure to gain a more complete understanding of relative capital strength. The Level 2 measure by itself may not tell you the full story.
As a rule, APRA’s general capital treatment of equity exposures is to require that they be deducted from CET1 Capital in order to avoid double counting of capital. The existing rules (APS 111) however provides a long-standing variation to this general rule when measuring Level 1 capital adequacy. This variation allows an ADI at Level 1 to risk weight (after first deducting any intangibles component) its equity investments in banking and insurance subsidiaries. The risk weight is 300 percent if the subsidiary is listed or 400 per cent if it is unlisted.
APRA recognises that this improves the L1 ratios by around 100bp versus what would be the case if a full CET1 deduction were applied but is comfortable with that outcome based on current exposure levels.
The RBNZ’s (near certain) move towards higher CET1 requirements however threatens to undermine this status quo and potentially see a greater share of the overall pool of equity in the group migrate from Australia to NZ. APRA recognises of course that the RBNZ can do whatever it deems best for NZ depositors but APRA equally has to ensure that the NZ benefits do not come at the expense of Australian depositors (and other creditors).
To address this issue, APRA is proposing to limit the extent to which an ADI may use debt to fund investments in banking and insurance subsidiaries.
As APRA is more concerned about large concentrated exposures, it is proposing to limit the amount of the exposure to an individual subsidiary that can be leveraged to 10 per cent of an ADI’s CET1 Capital. This means capital requirements are increasing for large concentrated exposures, as amounts over the 10 per cent threshold would be required to be met dollar-for-dollar by the ADI parent company.
What APRA is proposing to do makes sense to me. We can debate the necessity for the RBNZ to insist on virtually 100% CET1 capital (for the record, I continue to believe that a mix of CET1 and contingent convertible debt is likely to be a more effective source of market discipline). However, once it became clear that the RBNZ was committed to its revised capital requirements, APRA was I think left with no choice but to respond.
What will be interesting from here is to see whether investments of CET1 in NZ banking subsidiaries increase in response to the RBNZ requirement or whether the Australian majors choose to reduce the size of their NZ operations.
If the former (i.e. the majors are required to increase the capital committed to NZ subsidiaries) then we need to keep an eye on how this impacts the Level 2 capital ratios and what happens to the “Unquestionably Strong” CET1 benchmark that currently anchors the capital the Australian majors maintain.
This is a pretty technical area of bank capital so it is possible I am missing something; if so please let me know what it is. Otherwise keep an eye on how the capital adequacy targets of the Australian majors respond to these developments.
Tony (From the Outside)
I have been wanting to put something down on the question of Australian major bank ROE for a while. The issue generates a lot of heat but the public discussion I have observed has been truncated, in my opinion, by misconceptions.
I think we can agree that banks need to be profitable to be healthy and a healthy banking system underpins the health of the economy as a whole. Excessive profitability however is clearly bad for consumers, business and for the economy as a whole. The problem is determining what level of profitability is excessive. This post is unlikely to be the final word on this topic but hopefully it introduces a couple of considerations that seem to me to be largely missing from the public debate.
Most of what I read on this topic seems to treat the ROE of the Australian majors as self evidently excessive and focuses on what to do about it. Exhibit A is the reported ROE which in the 2019 half year updates varied from 10.05% to 14.10%. This is much less than it was but still substantially better than what is being achieved by most banks outside Australia and by the smaller local banks. Exhibit B is the fact that the Australian banking system is an oligopoly which almost by definition earn excess profits.
Any discussion of ROE must be anchored by the estimated Cost of Equity (COE), the minimum return that investors require to hold equity risk. There are a variety of ways of calculating this but all of them generate a number that is much less than the ROE the majors currently earn. So case closed.
There is no question that the Australian majors cover their cost of equity, but it is less clear to me that the margin of excess profitability is as excessive as claimed.
Corporate finance 101 teaches us that we can derive a company’s cost of equity using the Capital Asset Pricing Model (CAPM) which holds that the required return is equal to the Risk Free Return plus the Equity Risk Premium (ERP) multiplied by the extent to which the return the individual stock is correlated with the market as a whole. The general idea of being paid a premium for taking on equity risk makes sense but there are a bunch of issues with the CAPM once you get into the detail. One of the more topical being what do you do when the risk free rate approaches zero.
I don’t want to get into the detail of those issues here but will assume for the purposes of this post that a rate of return in the order of 8-10% can be defended as a minimum acceptable return. I recognise that some of the more mechanical applications of the CAPM might generate a figure lower than this if they simply apply a fixed ERP to the current risk free rate.
It is often asserted that banking is a low risk, “utility” style business and hence that shareholders should expect commensurately low returns. The commentators making these assertions tend to focus on the fact that the GFC demonstrated that it is difficult (arguably impossible) to allow large banks to fail without imposing significant collateral damage on the rest of the economy. Banks receive public sector support to varying degrees that reduces their risk of failure and hence the risk to shareholders. A variation of this argument is that higher bank capital requirements post the GFC have reduced the risk of investing in a bank by reducing the risk of insolvency.
There is no question that banks do occupy a privileged space in the economy due to the central bank liquidity support that is not available to other companies. This privilege (sometimes referred to as a “social licence”) is I think an argument for tempering the kinds of ROE targeted by the banks but it does not necessarily make them a true utility style investment whose earnings are largely unaffected by cyclical downturns.
The reality is that bank ROE will vary materially depending on the state of the credit cycle and this inherent cyclicality is probably accentuated by accounting for loan losses and prudential capital requirements. Loan losses for Australian banks are currently (October 2019) close to their cyclical low points and can be expected to increase markedly when the economy eventually moves into a downturn or outright recession. Exactly how much downside in ROE we can expect is open to debate but history suggests that loan losses could easily be 5 times higher than what we observe under normal economic conditions.
There is also the issue of how often this can be expected to happen. Again using history as a guide for the base rate, it seems that downturns might be expected every 7-10 years on average and long periods without a downturn seem to be associated with increased risk of more severe and prolonged periods of reduced economic activity.
What kind of risk premium does an investor require for this cyclicality? The question may be academic for shareholders who seek to trade in and out of bank stocks based on their view of the state of the cycle but I will assume that banks seek to cater to the concerns and interests of long term shareholders. The answer for these shareholders obviously depends on how frequent and how severe you expect the downturns to be, but back of the envelope calculations suggest to me that you would want ROE during the benign part of the credit cycle to be at least 200bp over the COE and maybe 300bp to compensate for the cyclical risk.
Good risk management capabilities can mitigate this inherent volatility but not eliminate it; banks are inherently cyclical investments on the front line of the business cycle. Conversely, poor risk management or an aggressive growth strategy can have a disproportionately negative impact. It follows that investors will be inclined to pay a premium to book value for banks they believe have good risk management credentials. I will explore this point further in the discussion of book value versus market value.
Apart from the cyclical factors discussed above, the simple fact that ROE is higher than COE is frequently cited as “proof” that ROE is excessive. It is important however to examine the unstated assumption that the market value of a bank should be determined by the book value of its equity. To the best of my knowledge, there is no empirical or conceptual basis for this assumption. There are a number of reasons why a company’s share price might trade at a premium or a discount to its book value as prescribed by the relevant accounting standards.
The market may be ascribing value to assets that are not recognised by the accounting standards.The money spent on financial control and risk management, for example, is largely expensed and hence not reflected in the book value of equity. That value however becomes apparent when the bank is under stress. These “investments” cannot eliminate the inherent cyclicality discussed above but they do mitigate those risk.
A culture built on sound risk management and financial control capabilities is difficult to value and won’t be reflected in book value except to the extent it results in conservative valuation and provisioning outcomes. It is however worth something. Investors will pay a premium for the banks they believe have these intangible strengths while discounting or avoiding altogether the shares of banks they believe do not.
This post is in no way an exhaustive treatment of the topic. Its more modest objective was simply to offer a couple of issues to consider before jumping to the conclusion that the ROE earned by the large Australian banks is excessive based on simplistic comparisons of point in time ROE versus mechanical derivations of the theoretical COE.
As always, it is entirely possible that I am missing something – if so let me know what it is ….
Tony
From the outside 