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:

  1. 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.
  2. 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.”

IMG_5866.JPG

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:

  1. Market capacity to supply the required quantum of additional Tier 2 capital required
  2. Conversion versus write-off
  3. The impact of conversion on the “loss hierarchy”
  4. Why not just issue more common equity?
  5. 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 .

IMG_2739

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:

  1. One is to take issue with his view that Expected Credit Loss provisioning will do anything at all to mitigate pro cyclicality;
  2. 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

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:

  1. The risk weights applied to its assets
  2. The target capital ratio applied to those risk weighted assets
  3. 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 …

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:

  1. 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
  2. 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
  3. 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.

Canada innovates in the capital buffer space

The Canadian prudential regulator (OFSI) has made an interesting contribution to the capital buffer space via its introduction of a Domestic Stability Buffer (DSB).

Key features of the Domestic Stability Buffer:

  • Applies only to Domestic Systemically Important Banks (D-SIB) and intended to cover a range of systemic vulnerabilities not captured by the Pillar 1 requirement
  • Vulnerabilities currently included in the buffer include (i) Canadian consumer indebtedness; (ii) asset imbalances in the Canadian market and (iii) Canadian institutional indebtedness
  • Replaces a previously undisclosed Pillar 2 loading associated with this class of risks (individual banks may still be required to hold a Pillar 2 buffer for idiosyncratic risks)
  • Initially set at 1.5% of Total RWA and will be in the range of 0 to 2.5%
  • Reviewed semi annually (June and December); with the option to change more frequently in exceptional circumstances
  • Increases phased in while decreases take effect immediately

Implications for capital planning:

  • DSB supplements the Pillar 1 buffers (Capital Conservation Buffer, D-SIB surcharge and the Countercyclical Buffer)
  • Consequently, the DSB will not result in banks being subject to the automatic constraints on capital distributions that are applied by the Pillar 1 buffers
  • Banks will be required to disclose that the buffer has been breached and the OFSI will require a remediation plan to restore the buffer

What is interesting:

  • The OFSI argues that translating the existing Pillar 2 requirement into an explicit buffer offers greater transparency which in turn “… will support banks’ ability to use this capital buffer in times of stress by increasing the market’s understanding of the purpose of the buffer and how it should be used”
  • I buy the OFSI rationale for why an explicit buffer with a clear narrative is a more usable capital tool than an undisclosed Pillar 2 requirement with the same underlying rationale
  • The OFSI retains a separate Countercyclical Buffer but this Domestic Stability Buffer seems similar but not identical in its over-riding purpose (to me at least) to the approach that the Bank of England (BoE) has adopted for managing the Countercyclical Buffer.
  • A distinguishing feature of both the BoE and OFSI approaches is linking the buffer to a simple, coherent narrative that makes the buffer more usable by virtue of creating clear expectations of the conditions under which the buffer can be used.

Bottom line is that I see useful features in both the BoE and OFSI approach to dealing with the inherent cyclicality of banking.  I don’t see  either of the proposals doing much to mitigate the cyclicality of banking but I do see them offering more potential for managing the consequences of that cyclicality. Both approaches seem to me to offer material improvements over the Countercyclical Buffer as originally conceived by the BCBS.

It will be interesting to see if APRA chooses to adapt elements of this counter cyclical approach to bank capital requirements.

If I am missing something, please let me know …

From the Outside

The answer is more loan loss provisions, what was the question?

I had been intending to write a post on the potential time bomb for bank capital embedded in IFSR9 but Adrian Docherty has saved me the trouble. He recently released an update on IFRS9 and CECL titled Much Ado About Nothing or Après Moi. Le Deluge?

This post is fairly technical so feel free to stop here if you are not a bank capital nerd. However, if you happen to read someone saying that IFRS 9 solves one of the big problems encountered by banks during the GFC then be very sceptical. Adrian (and I) believe that is very far from the truth. For those not discouraged by the technical warning, please read on.

The short version of Adrian’s note is:

  • The one-off transition impact of the new standard is immaterial and the market has  largely ignored it
  • Market apathy will persist until stressed provisions are observed
  • The dangers of ECL provisioning (procyclical volatility, complexity and subjectivity) have been confirmed by the authorities …
  • … but criticism of IFRS 9 is politically incorrect since the “correct” narrative is that earlier loan loss provisioning fulfils the G20 mandate to address the problem encountered during the GFC
  • Regulatory adaption has been limited to transition rules, which are not a solution. We need a fundamentally revised Basel regime – “Basel V” – in which lifetime ECL provisions somehow offset regulatory capital requirements.

Adrian quotes at length from Bank of England (BoE) commentary on IFRS 9. He notes that their policy intention is that the loss absorbing capacity of the banking system is not impacted by the change in accounting standards but he takes issue with the way that they have chosen to implement this policy approach. He also calls out the problem with the BoE instruction that banks should assume “perfect foresight” in their stress test calculations.

Adrian also offers a very useful deconstruction of what the European Systemic Risk Board had to say in a report they published in July 2017 . He has created a table in which he sets out what the report says on one column and what they mean in another (see page 8 of Adrian’s note).

This extract from Adrian’s note calls into question whether the solution developed is actually what the G20 asked for …

“In official documents, the authorities still cling to the assertion that ECL provisioning is good for financial stability “if soundly implemented” or “if properly applied”. They claim that the new standard “means that provisions for potential credit losses will be made in a timely way”. But what they want is contrarian, anti-cyclical ECL provisioning. This is simply not possible, in part because of human psychology but, more importantly, because the standard requires justifiable projections based on objective, consensual evidence.

Surely the authorities know they are wrong? Their arguments don’t stack up.

They hide behind repeated statements that the G20 instructed them to deliver ECL provisioning, whereas a re-read of the actual instructions clearly shows that a procyclical, subjective and complex regime was not what was asked for.

It just doesn’t add up.”

There is of course no going back at this point, so Adrian (rightly I think) argues that the solution lies in a change to banking regulation to make Basel compatible with ECL provisioning. I will quote Adrian at length here

 “So the real target is to change banking regulation, to make Basel compatible with ECL provisioning. Doing this properly would constitute a genuine “Basel V”. Yes, the markets would still need to grapple with complex and misleading IFRS 9 numbers to assess performance. But if the solvency calculation could somehow adjust properly for ECL provisions, then solvency would be stronger and less volatile.

And, in an existential way, solvency is what really matters – it’s the sina qua non  of a bank. Regulatory solvency drives the ability of a bank to grow the business and distribute capital. Accounting profit matters less than the generation of genuinely surplus solvency capital resources.

Basel V should remove or resolve the double count between lifetime ECL provisions and one-year unexpected loss (UL) capital resources. There are many different ways of doing this, for example:

A. Treat “excess provisions” (the difference between one-year ECL and lifetime ECL for Stage 2 loans) as CET1

B. Incorporate expected future margin as a positive asset, offsetting the impact of expected future credit losses

C. Reduce capital requirements by the amount of “excess provisions” (again, the difference between one-year ECL and lifetime ECL for Stage 2 loans) maybe with a floor at zero

D. Reduce minimum regulatory solvency ratios for banks with ECL provisioning (say, replacing the Basel 8% minimum capital ratio requirement to 4%)

All of these seem unpalatable at first sight! To get the right answer, there is a need to conduct a fundamental rethink. Sadly, there is no evidence that this process has started. The last time that there was good thinking on the nature of capital from Basel was some 17 years ago. It’s worth re-reading old papers to remind oneself of the interaction between expected loss, unexpected loss and income.  The Basel capital construct needs to be rebuilt to take into account the drastically different meaning of the new, post-IFRS 9 accounting equity number.”

Hopefully this post will encourage you to read Adrian’s note and to recognise that IFRS 9 is not the cycle mitigating saviour of banking it is represented to be. The core problem is not so much with IFRS9 itself (though its complexity and subjectivity are issues) but more that bank capital requirements are not constructed in a way that compensates for the inherent cyclicality of the banking industry. The ideas that Adrian has listed above are potentially part of the solution as is revisiting the way that the Counter cyclical Capital Buffer is intended to operate.

From the Outside