Capital adequacy is not always intuitive

I did a short post yesterday scratching the surface of the issues associated with Westpac’s announcement that it is reviewing its options in New Zealand. In this post I will offer a little more background and comment focussed on the impact of Australian capital adequacy requirements.

The backstory thus far is that:

These combined changes obviously impact the economics of an Australian ADI owning a NZ regulated banks but to have any hope of understanding what is going on I believe we first need to define two pieces of Australian ADI capital jargon, Level 1 and Level 2

Level 1 is the ADI itself on a stand alone basis (note that is a simplification but close enough to the truth for the purposes of this post).

Level 2 is defined in APRA’s consultation paper as “The consolidation of the ADI and all its subsidiaries other than non-consolidated subsidiaries; or if the ADI is a subsidiary of a non-operating holding company (NOHC), the consolidation of the immediate parent NOHC and all the immediate parent NOHC’s subsidiaries (including any ADIs and their subsidiaries) other than non-consolidated subsidiaries.”

For completeness I should probably also define “ADI” which is an Authorised Deposit Taking Institution (more colloquially referred to as a bank).

You can be forgiven for not being familiar with the Level 1 – Level 2 distinction but the capital ratios typically quoted in any discussion of Australian ADI capital strength are the Level 2 measures. The Unquestionably Strong benchmark that dominates the discussion is a Level 2 measure. 

Part of the problem with the RBNZ initiative is that the increase in capital required to be held in the NZ part of the Group has no impact on the Level 2 capital ratio that is used to define the “Unquestionably Strong” benchmark the Australian ADI are expected to meet. The RBNZ is of course within its rights to set what ever capital requirement it deems appropriate but APRA then has to ensure that the increase in NZ based capital does not come at the expense of Australian stakeholders.

The Level 2 capital measure tells us nothing about this question. In theory this is where the Level 1 capital adequacy measure comes into play but I have always found the Level 1 measure a bit counter-intuitive.

  • My intuitive expectation is that the Level 1 measure for an Australian ADI should include the capital actually available in Australia and the risk exposures that capital has to underwrite.
  • What actually happens is that the dollar value of the Level 1 capital can be virtually the same as the Level 2 measure even though capital has been deployed in an offshore banking subsidiary (retained earnings in the subsidiary do not count but that can be addressed by paying a divided to the parent and then investing an equivalent amount of capital back in the subsidiary).
  • Level 1 risk weighted assets of the parent only incorporate an allowance for the risk weighted value of the equity invested in the banking subsidiary
  • This adjustment to the Level 1 risk weighted assets will of course be substantially less than the risk weighted assets the subsidiary is supporting with that equity that are excluded from the Level 1 parent capital ratio.
  • As a result, it is mathematically possible for the Level 1 CET1 ratio of the parent entity to be higher than the Level 2 Group ratio even though capital has been deployed outside the parent entity – that seems counter intuitive to me.

The changes that APRA has proposed to introduce will force the Australian banks to hold more capital to offset the impact of the CET1 deduction created when the investment in the banking subsidiary exceeds the (10%) threshold. As I understand it, this deduction only applies to the Level 1 measure so Level 2 capital will, all other things being equal, be higher as a result of responding to the combined impact of the RBNZ and APRA requirements. At face value that looks like stronger capital, which it is for the Group on average (i.e. Level 2), but the Australian parts of the banking Group do not benefit from the increase and it is important to understand that when evaluating the extent to which the Australian part of the banking group continues to be Unquestionably Strong.

APRA’s proposed change addresses the immediate issue created by the RBNZ requirement but I must confess that I still find the Level 1 capital adequacy measure a touch confusing. Level 1 capital ratios calculated on the basis I have set out above do not appear (to me at least) to offer an intuitively logical view of the relative capital strength of the various parts of the banking group.

As always, it is entirely possible that I am missing something here but understanding the technical issues outlined above is I think useful when making sense of the issues that Westpac (and other Australian ADIs) will be considering as they weigh their options in New Zealand. Relying on your intuition expectations of how the two requirements interact may be an unreliable guide if you are not familiar with the technical detail.

Tony – From the Outside

Westpac considers its options in NZ

Westpac today (24 March 2021) announced that it is “… assessing the appropriate structure for its New Zealand business and whether a demerger would be in the best interests of shareholders. Westpac is in the very early stage of this assessment and no decisions have been made.”

There are obviously a lot of moving parts here but one important consideration is the interaction between the substantial increase in capital requirements mandated by the RBNZ and APRA’s proposed change in the way that these investments must be funded by the Australian parent.

The rest of this post offers a short summary of how these investments are currently treated under the Australian capital adequacy standard (APS 111) and APRA’s proposed changes.

As a rule, APRA’s general capital treatment of equity exposures requires that they be fully 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 was comfortable with that outcome based on exposure levels that preceded the RBNZ change in policy.

The RBNZ’s move towards higher CET1 requirements however undermines this status quo and potentially sees 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 has proposed to amend APS 111 to limit the extent to which an ADI may use debt to fund investments in banking and insurance subsidiaries.

  • ADIs, at Level 1, will be required to deduct these equity investments from CET1 Capital, but only to the extent the investment in the subsidiary is in excess of 10 per cent of CET1 Capital.
  • An ADI may risk weight the investment, after deduction of any intangibles component, at 250 per cent to the extent the investment is below this 10 per cent threshold.
  • The amount of the exposure that is risk weighted would be included as part of the related party limits detailed in the recently finalised APS 222.

As APRA is more concerned about large concentrated exposures, it proposed 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.

You can find my original post here which offers more background and may be useful if you are not familiar with the technicalities of Level 1 and Level 2 capital adequacy. At the time the change was proposed, APRA indicated that it would release more detail during 2020 with the aim of implementing the change on 1 January 2021. Covid 19 obviously derailed that original timeline but I assume APRA will provide an update sometime soon.

Tony – From the Outside

Marc Rubinstein on “The story of clearing”

Marc Roubinstein published an interesting post on his “Net Interest” newsletter delving into the history of clearing houses. His account is set against the background of the $3bn call the National Securities and Clearing Commission made on Robinhood Securities at the height of the recent peak in trading in GameStop. The post is short and worth reading in full but the following extract will give you a flavour …

Power comes in many forms. Last week’s events surrounding GameStop show how power can coalesce in the hands of individual investors when they pool their intellectual and financial resources. But the events also reveal a different manifestation of power: the power to call a high-profile tech company in the middle of the night and demand $3 billion. That’s quite some power!

The entity wielding that power is the NSCC, which – as Vlad Tenev, the CEO of Robinhood spelled out to Elon Musk – stands for the National Securities and Clearing Corporation. The NSCC in turn is a part of the DTCC, which stands for the Depository Trust and Clearing Corporation. And the DTCC is perhaps the most powerful entity you’ve never heard of. It’s the engine of the US securities markets; in 2019 alone, it processed over $2.15 quadrillion worth of securities (yes, quadrillion!) It’s big and ugly enough to be included among a very short list of entities designated by people in Washington as “systemically important financial market utilities”.  

To understand what (and who) the DTCC is, we need to delve a little into market structure, and the best way to do that is with some historical perspective.

WTF is DTCC? The Story of Clearing – net – Marc Rubinstein

If that appeals then read on here ….

Tony – From the Outside

First-time buyers: how do they finance their purchases and what’s changed? – Bank Underground

Some interesting research out of the UK examining the impact of a variety of factors associated with first time house purchases.

Our results support claim that average FTBs are increasingly higher up the income distribution for their age. And slower than average income growth for younger workers have worked against FTBs. But our results challenge the view that average FTB ages have got much higher. And while FTBs on average are borrowing more in nominal terms, they aren’t spending more of their income on mortgage repayments than before: cheaper credit has roughly cancelled out the effect of bigger mortgages.

— Read on

Separating deposit-taking from investment banking: new evidence on an old question

The BOE has released a paper exploring the question of how ring fencing deposit taking from investment banking impacts the banking market. I have included the abstract of the paper below and you can find a summary of the paper here on the “Bank Underground” blog. I don’t see this as the final word on these questions but it does offer a perspective worth noting.


The idea of separating retail and investment banking remains controversial. Exploiting the introduction of UK ring-fencing requirements in 2019, we document novel implications of such separation for credit and liquidity supply, competition, and risk-taking via a funding structure channel.

By preventing conglomerates from using retail deposits to fund investment banking activities, this separation leads conglomerates to rebalance their activities towards domestic mortgage lending and away from supplying credit lines and underwriting services to large corporates.

By redirecting the benefits of deposit funding towards the retail market, this rebalancing reduces the cost of credit for households, without eroding lending standards. However the rebalancing also increases mortgage market concentration and risk-taking by smaller banks via indirect competition effects.

Tony – From the Outside

Financing the American home

Marc Rubinstein has written a short piece on his “Net Interest blog” outlining some of the mysteries of the the 30-year fixed-rate fully prepayable mortgage that finances the majority of home purchases in America. Rubinstein draws on Bethany McLean (Shaky Ground: The Strange Saga of the US Mortgage Giants) and Sarah Quinn (Government Policy, Housing, and the Origins of Securitization, 1780 – 1968) as well as his own experience as an investor in Fannie Mae and Freddie Mac junior preferreds (2011 – 2019).

This short extract will give you a flavour of of the piece but I recommend reading it in full

From the consumer’s perspective, it’s an amazing product. It’s a simple loan that offers stable repayments, kept low because they are spread out over such a long period of time. Its kicker is a free option to prepay, which shields the borrower from interest rate risk. If rates go up, borrowers can commend themselves on a great bargain; if they go down, stay calm—the loan can be refinanced without penalty. Win/win.

All the characteristics that make it terrific for the consumer make it terrible for a traditional lender. Thirty years is a long time to have something sitting on your balance sheet, watching the credit risk compound. Especially something that’s loaded with as much interest rate risk as this. If it’s win/win for the consumer, somebody has to be on the other side of that trade.

Sustaining such a one-sided design clearly requires work. An entire ecosystem of complex financial instruments provides one layer of support. But underneath that sits another: the US government, which now controls two-thirds of the market. By removing the credit risk and dispersing the interest rate risk inherent in long-term fixed-rate mortgages, the US government gives them life. As Bethany McLean says, they “accomplished something that Rumpelstiltskin would envy. They took the worst possible investment – a 30-year fixed-rate fully prepayable mortgage – and turned it into the second most liquid instrument in the world, just behind Treasuries.”

To many, the idea that the US, a beacon of the free market, should support its mortgage market so directly seems odd. The former Governor of the Bank of England, Mervyn King, once remarked: “You Americans are so strange. Most countries have socialised healthcare and a private market in mortgages. You have socialised mortgages and a private market in healthcare.”

Tony – From the Outside

The cleansing effect of banking crises …

… is the title of an interesting post on the Voxeu website summarising some research conducted by a group of European academics.

I have only skimmed the research at this point but the conclusion that realising losses and restructuring banks sets the economy up for stronger growth seem intuitively logical. It is also a timely area of research at a time when there seems to be widespread concern that many so called “zombie” companies are only continuing to operate by virtue of extraordinary levels of liquidity and other financial support being injected into the financial system via central banks.

The post summarises their findings as follows …

Our findings show that restructuring of distressed banks during a crisis has positive long-term effects on productivity. We emphasise the importance of long-term productivity considerations in the design of optimal bank resolution mechanisms. Our results indicate that the challenge is the inherent trade-off between the short- and the long-term effects, which can complicate the political economy of the problem. For instance, in the short term, bailouts can look appealing to government officials, especially if the long-term costs bear less weight in their decision-making processes.

“The cleansing effect of banking crises”- Reint Gropp, Steven Ongena, Jörg Rocholl, Vahid Saadi; Voxeu – 7 August 200

The power of ideas

This post was inspired by a paper by Dani Rodrik titled “When Ideas Trump Interests: Preferences, Worldviews, and Policy Innovations”. I have set out some more detailed notes here for the policy wonks but the paper is not light reading. The short version here attempts to highlight a couple of ideas I found especially interesting.

Rodrik starts by noting a tendency to interpret economic and social outcomes through the lens of “vested interests” while paying less attention to the ideas that underpin these outcomes. The vested interest approach looks for who benefits and how much power they have to explain outcomes. Rodrik does not dispute the relevance of understanding whose interests are in play when economic choices are being made but argues that “ideas” are an equally powerful motivating force.

Rodrik expresses his point this way:

“Ideas are strangely absent from modern models of political economy. In most prevailing theories of policy choice, the dominant role is instead played by “vested interests”—elites, lobbies, and rent-seeking groups which get their way at the expense of the general public. Economists, political scientists, and other social scientists appeal to the power of special interests to explain key puzzles in regulation, international trade, economic growth and development, puzzles in regulation, international trade, economic growth and development, and many other fields.”

“When Ideas Trump Interests: Preferences, Worldviews, and Policy Innovations” Dani Rodrik, Journal of Economic Perspectives—Volume 28, Number 1—Winter 2014—Pages 189–208

Applying this lens offers a broader and more nuanced perspective of how self and vested interest operates (emphasis added).

“… a focus on ideas provides us with a new perspective on vested interests too. As social constructivists like to put it, “interests are an idea.” Even if economic actors are driven purely by interests, they often have only a limited and preconceived idea of where their interests lie. This may be true in general, of course, but it is especially true in politics, where preferences are tightly linked to people’s sense of identity and new strategies can always be invented. What the economist typically treats as immutable self-interest is too often an artifact of ideas about who we are, how the world works, and what actions are available.”


The importance of understanding how ideas drive public policy and personal choices resonates with me. One of the examples Rodrik used to illustrate his argument was bank regulation pre the GFC. Rodrik does not dispute that self and vested interests play a significant role but he explores the equally important role of ideas in shaping how interests are defined and pursued and the ways in which the models people use to understand the world shape their actions.

Applying this lens to bank regulation

Many observers … have argued that the policies that produced the crisis were the result of powerful banking and financial interests getting their way, which seems like a straightforward application of the theory of special interests.

But this begs the question why were banking vested interests allowed to get their way. The “vested interest” argument is “regulatory capture” but Rodrik offers an alternative explanation …

Still, without the wave of ideas “in the air” that favored financial liberalization and self-regulation and emphasized the impossibility (or undesirability) of government regulation, these vested interests would not have gotten nearly as much traction as they did. After all, powerful interests rarely get their way in a democracy by nakedly arguing for their own self-interest. Instead, they seek legitimacy for their arguments by saying these policies are in the public interest. The argument in favor of financial deregulation was not that it was good for Wall Street, but that it was good for Main Street.

Other observers have argued that the financial crisis was a result of excessive government intervention to support housing markets, especially for lower-income borrowers. These arguments were also grounded on certain ideas—about the social value of homeownership and the inattentiveness of the financial sector to those with lower incomes. Again, ideas apparently shaped politicians’ views of how the world works— and therefore their interest in acting in ways that precipitated the crisis.

I want to come back to this topic in another post. I have touched on the issue of self interest in an earlier post looking at a book by Samuel Bowles titled “The Moral Economy”. Rodrik’s paper offers another perspective on the issue as does his book “Economics Rules: Why Economics Works, When It Fails, and How To Tell The Difference”. I have some notes on a couple of other books including “The Economists’ Hour” by Binyamin Applebaum and The Value of Everything” by Mariana Mazzucato. All of these have something interesting to say but I want to think some more before attempting to say something.

Let me conclude for the moment with John Maynard Keynes (emphasis added …

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.”

The General Theory of Employment, Interest and Money, 1936

Tony (From the Outside)