Uncategorized – Page 8 – From the outside

“The Great Divide” by Andrew Haldane

This speech by Andrew Haldane (Chief Economist at the Bank of England) was given in 2016 but is sill worth reading for anyone interested in the question of what role banks play in society and why their reputation is not what it once was. Some of my long term correspondents will be familiar with the paper and may have seen an earlier draft of this post.

“The Great Divide” refers to a gap between how banks perceive themselves and how they are perceived by the community. Haldane references a survey the BOE conducted in which the most common word used by banks to describe themselves was “regulated” while “corrupt” was the community choice closely followed by “manipulated”, “self-serving”, “destructive” and “greedy”. There is an interesting “word cloud” chart in the paper representing this gap in perception.

While the focus is on banks, Haldane makes the point that the gap in perceptions reflects a broader tension between the “elites” and the common people. He does not make this explicit connection but it seemed to me that the “great divide” he was referencing could also be argued to be manifesting itself in the increasing support for populist political figures purporting to represent the interests of the common people against career politicians. This broader “great divide” idea seemed to me to offer a useful framework for thinking about the challenges the banking industry is facing in rebuilding trust.

Haldane uses this “great divide” as a reference for discussing

The crucial role finance plays in society
The progress made so far in restoring trust in finance
What more needs to be done

The crucial role finance plays in society

Haldane argues that closing the trust deficit between banks and society matters for two reasons

because a well functioning financial system is an essential foundation for a growing and well functioning economy – to quote Haldane “that is not an ideological assertion from the financial elite; it is an empirical fact”
but also because the downside of a poorly functioning financial system is so large

Haldane uses the GFC to illustrate the downside in terms of the destruction of the value of financial capital and physical capital but he introduces a third form of capital, “social capital” that he argues may matter every bit as much to the wealth and well being of society. He defines social capital as the “relationships, trust and co-operation forged between different groups of people over time. It is the sociological glue that binds diverse societies into a cohesive whole”. The concept of “trust” is at the heart of Haldane’s definition of social capital.

Haldane cites evidence that trust plays an important role at both the micro and macro level in value creation and growth and concludes that “… a lack of trust jeopardises one of finance’s key societal functions – higher growth”.

In discussing these trends, Haldane distinguishes “personalised trust” and “generalised trust“. The former refers to mutual co-operation built up through repeated personal interactions (Haldane cites example like visits to the doctor or hairdresser) while the latter is attached to an identifiable but anonymous group (Haldane cites trust in the rule of law, or government or Father Christmas).

He uses this distinction to explore why banks have lost the trust of the community;

He notes that banking was for most of its history a relationship based business. The business model was not perfect but it did deliver repeated interactions with customers that imbued banking with personalised trust. At the same time its “mystique” (Haldane’s term) meant that banking maintained a high degree of generalised trust as well.

He cites the reduction in local branches, a common strategy pre GFC, as one of the changes that delivered lower costs but reduced personal connections thereby contributing to reducing personalised trust. For a while, the banking system could reap the efficiency gains while still relying on generalised trust but the GFC subsequently undermined the generalised trust in the banking system. This generalised trust has been further eroded by the continued run of banking scandals that convey the sense that banks do not care about their customers.

What can be done to restore trust in finance

He notes the role that higher capital and liquidity have played but that this is not enough in his view. He proposes three paths

Enhanced public education
Creating “Purpose” in banking
Communicating “Purpose” in banking

Regarding public education, there is a telling personal anecdote he offers on his experience with pensions. He describes himself as “moderately financially literate” but follows with “Yet I confess to not being able to make the remotest sense of pensions. Conversations with countless experts and independent financial advisors have confirmed for me only one thing – that they have no clue either”. This may be dismissed as hyperbole but it does highlight that most people will be less financially literate than Haldane and are probably poorly equipped to deal with the financial choices they are required to make in modern society. I am not sure that education is the whole solution.

Regarding “purpose” Haldane’s main point seems to be that there is too much emphasis on shareholder value maximisation and not enough balance. This seems to be an issue that is amplified by the UK Companies Act that requires that directors place shareholder interests as their primary objective. To the best of my knowledge, the Australian law does not have an equivalent explicit requirement to put shareholders first but we do grapple with the same underlying problem. Two of my recent posts (“The World’s Dumbest Idea” and “The Moral Economy” touch on this issue.

Regarding communicating purpose, Haldane cites some interesting evidence that the volume of information provided by companies is working at cross purposes with actual communication with stakeholders. Haldane does not make the explicit link but Pillar 3 clearly increases the volume of information provided by banks. The points raised by Haldane imply (to me at least) that Pillar 3 might actually be getting in the way of communicating clearly with stakeholders.

This is a longish post but I think there is quite a lot of useful content in the speech so I would recommend it.

“Between Debt and the Devil: Money, Credit and Fixing Global Finance” by Adair Turner (2015)

This book is worth reading, if only because it challenges a number of preconceptions that bankers may have about the value of what they do. The book also benefits from the fact that author was the head of the UK Financial Services Authority during the GFC and thus had a unique inside perspective from which to observe what was wrong with the system. Since leaving the FSA, Turner has reflected deeply on the relationship between money, credit and the real economy and argues that, notwithstanding the scale of change flowing from Basel III, more fundamental change is required to avoid a repeat of the cycle of financial crises.

Overview of the book’s main arguments and conclusions

Turner’s core argument is that increasing financial intensity, represented by credit growing faster than nominal GDP, is a recipe for recurring bouts of financial instability.

Turner builds his argument by first considering the conventional wisdom guiding much of bank prudential regulation prior to GFC, which he summarises as follows:

Increasing financial activity, innovation and “financial deepening” were beneficial forces to be encouraged
More compete and liquid markets were believed to ensure more efficient allocation of capital thereby fostering higher productivity
Financial innovations made it easier to provide credit to households and companies thereby enabling more rapid economic growth
More sophisticated risk measurement and control meanwhile ensured that the increased complexity of the financial system was not achieved at the expense of stability
New systems of originating and distributing credit, rather than holding it on bank balance sheets, were believed to disperse risks into the hands of those best placed to price and manage it

Some elements of Turner’s account of why this conventional wisdom was wrong do not add much to previous analysis of the GFC. He notes, for example, the conflation of the concepts of risk and uncertainty that weakened the risk measurement models the system relied on and concludes that risk based capital requirements should be foregone in favour of a very high leverage ratio requirement. However, in contrast to other commentators who attribute much of the blame to the moral failings of bankers, Turner argues that this is a distraction. While problems with the way that bankers are paid need to be addressed, Turner argues that the fundamental problem is that:

modern financial systems left to themselves inevitably create debt in excessive quantities,
in particular, the system tends to create debt that does not fund new capital investment but rather the purchase of already existing assets, above all real estate.

Turner argues that the expansion of debt funding the purchase or trading of existing assets drives financial booms and busts, while the debt overhang left over by the boom explains why financial recovery from a financial crisis is typically anaemic and protracted. Much of this analysis seems to be similar to ideas developed by Hyman Minsky while the slow pace of recovery in the aftermath of the GFC reflects a theme that Reinhart and Rogoff have observed in their book titled “This time is different” which analyses financial crises over many centuries.

The answer, Turner argues, is to build a less credit intensive growth model. In pursuing this goal, Turner argues that we also need to understand and respond to the implications of three underlying drivers of increasing credit intensity;

the increasing importance of real estate in modern economies,
increasing inequality, and
global current account imbalances.

Turner covers a lot of ground, and I do not necessarily agree with everything in his book, but I do believe his analysis of what is wrong with the system is worth reading.

Let me start with an argument I do not find compelling; i.e. that risk based capital requirements are unreliable because they are based on a fundamental misunderstanding of the difference between risk (which can be measured) and uncertainty (which cannot):

Distinguishing between risk and uncertainty is clearly a fundamental part of understanding risk and Turner is not alone in emphasising its importance
I believe that means that we should treat risk based capital requirements with a healthy degree of scepticism and a clear sense of their limitations but that does not render them entirely unreliable especially when we are using them to understand relative differences in risk and to calibrate capital buffers
The obvious problem with non-risk based capital requirements is that they create incentives for banks to take higher risk that may eventually offset the supposed increase in soundness attached to the higher capital
It may be that Turner discounts this concern because he envisages a lower credit growth/intensity economy delivering less overall systemic risk or because he envisages a more active role for the public sector in what kinds of assets banks lend against; i.e. his support for higher capital may stem mostly from the fact that this reduces the capacity of private banks to generate credit growth

While advocating much higher capital, Turner does seem to part company with M&M purists by expressing doubt that equity investors will be willing to accept deleveraged returns. His reasoning is that returns to equity investments need a certain threshold return to be “equity like” while massively deleveraged ROE still contains downside risks that are unacceptable to debt investors.

Turning to the arguments which I think raise very valid concerns and deserve serious attention.

Notwithstanding my skepticism regarding a leverage ratio as the solution, the arguments he makes about the dangers of excessive credit growth resonate very strongly with what I learned during my banking career. Turner is particularly focussed on the downsides of applying excessive debt to the financing of existing assets, real estate in particular. The argument seems to be similar to (if not based on) the work of Hyman Minsky.

Turner’s description of the amount of money that banks can create as being “infinitely elastic” seems an overstatement to me (especially in the Australian context with the Net Stable Funding Ratio (NSFR) weighing on the capacity to grow the balance sheet) but the general point he is making about the way that credit fuelled demand for a relatively inelastic supply of desirable residential property tends to result in inflated property values with no real social value rings true.

What banks can do about this remains an open question given that resolving the problem with inelastic supply of property is outside their direct control but it is obviously important to understand the dynamics of the market underpinning their largest asset class and it may help them engage more constructively with public policy debates that seek to address the problem.

Turner’s analysis of the downsides of easy monetary policy (the standard response to economic instability) also rings true. He identifies the fact that lower interest rates tend to result in inflated asset values (residential property in particular given its perceived value as a safe asset) which do not address the fundamental problem of over-indebtedness and may serve to increase economic inequality. His discussion of the impact of monetary policy and easy credit on economic inequality is also interesting. The banks providing the credit in the easy money environment may not necessarily be taking undue risk and prudential supervisors have tools to ensure sound lending standards are maintained if they do believe there is a problem with asset quality. What may happen however is that the wealthier segments of society benefit the most under easy money because they have the surplus cash flow to buy property at inflated values while first homebuyers become squeezed out of the market. Again their capacity to address the problem may be limited but Turner’s analysis prompted me to reflect on what increasing economic inequality might mean for bank business models.

In addition to much higher bank capital requirements, Turner’s specific recommendations for moving towards a less credit intensive economy include:

Government policies related to urban development and the taxation of real estate
Changing tax regimes to reduce the current bias in favour of debt over equity financing (note that Australia is one of the few countries with a dividend imputation system that does reduce the bias to debt over equity)
Broader macro prudential powers for central banks, including the power to impose much larger countercyclical capital requirements
Tough constraints on the ability of the shadow banking system to create credit and money equivalents
Using public policy to produce different allocations of capital than would result from purely market based decisions; in particular, deliberately leaning against the market signal based bias towards real estate and instead favouring other “potentially more socially valuable forms of credit allocation”
Recognising that the traditional easy monetary policy response to an economic downturn (or ultra-easy in the case of a financial crisis such as the GFC) is better than doing nothing but comes at a cost of reigniting the growth in private credit that generated the initial problem, creating incentives for risky financial engineering and exacerbating economic inequality via inflating asset prices.

For those who want to dig deeper, I have gone into a bit more detail here on what Turner has to say about the following topics:

The way in which inefficient and irrational markets leave the financial system prone to booms and busts
The dangers of debt contracts sets out how certain features of these contracts increase the risk of instability and hamper the recovery
Too much of the wrong sort of debt describes features of the real estate market that make it different from other asset classes
Liberalisation, innovation and the credit cycle on steroids recaps on the philosophy that drove the deregulation of financial markets and what Turner believes to be the fundamental flaws with that approach. In particular his conclusion that the amount of credit created and its allocation is “… too important to be left to bankers…”
Private credit and money creation offers an outline of how bank deposits evolved to play an increasing role (the key point being that it was a process of evolution rather than overt public policy design choices)
Credit financed speculation discusses the ways in which credit in modern economies tends to be used to finance the purchase of existing assets, in particular real estate, and the issues that flow from this.
Inequality, credit and more inequality sets out some ways in which the extension of credit can contribute to increasing economic inequality
Capital requirements sets out why Turner believes capital requirements should be significantly increased and why capital requirements (i.e. risk weights) for some asset classes (e.g. real estate) should be be calibrated to reflect the social risk of the activity and not just private risks captured by bank risk models
Turner defence against the argument that his proposals are anti-markets and anti-growth.

“The World’s Dumbest Idea” by James Montier of GMO.

Anyone interested in the question of shareholder value will I think find this paper by James Montier interesting.

The focus of the paper is to explore problems with elevating Shareholder Value to be the primary objective of a firm. Many companies are trying to achieve a more balanced approach but the paper is still useful background given that some investors appear to believe that shareholder value maximisation is the only valid objective a company should pursue. The paper also touches on the question of how increasing inequality is impacting the environment in which we operate.

While conceding that the right incentives can prompt better performance, JM argues that there is a point where increasing the size of the reward actually leads to worse performance;

“From the collected evidence on the psychology of incentives, it appears that when incentives get too high people tend to obsess about them directly, rather than on the task in hand that leads to the payout. Effectively, high incentives divert attention away from where it should be”

The following extracts will give you a sense of the key points and whether you want to read the paper itself.

“Let’s now turn to the broader implications and damage done by the single-minded focus on SVM. In many ways the essence of the economic backdrop we find ourselves facing today can be characterized by three stylized facts: 1) declining and low rates of business investment; 2) rising inequality; and 3) a low labour share of GDP (evidenced by Exhibits 7 through 9).” — Page 7 —
“This preference for low investment tragically “makes sense” given the “alignment” of executives and shareholders. We should expect SVM to lead to increased payouts as both the shareholders have increased power (inherent within SVM) and the managers will acquiesce as they are paid in a similar fashion. As Lazonick and Sullivan note, this led to a switch in modus operandi from “retain and reinvest” during the era of managerialism to “downsize and distribute” under SVM.” — Page 9 —
“This diversion of cash flows to shareholders has played a role in reducing investment. A little known fact is that almost all investment carried out by firms is financed by internal sources (i.e., retained earnings). Exhibit 13 shows the breakdown of the financing of gross investment by source in five-year blocks since the 1960s. The dominance of internal financing is clear to see (a fact first noted by Corbett and Jenkinson in 1997”— Page 10 —
“The obsession with returning cash to shareholders under the rubric of SVM has led to a squeeze on investment (and hence lower growth), and a potentially dangerous leveraging of the corporate sector” — Page 11 —
“The problem with this (apart from being an affront to any sense of fairness) is that the 90% have a much higher propensity to consume than the top 10%. Thus as income (and wealth) is concentrated in the hands of fewer and fewer, growth is likely to slow significantly. A new study by Saez and Zucman (2014) … shows that 90% have a savings rate of effectively 0%, whilst the top 1% have a savings rate of 40%…. ultimately creating a fallacy of composition where they are undermining demand for their own products by destroying income).” —Page 13 —
“Only by focusing on being a good business are you likely to end up delivering decent returns to shareholders. Focusing on the latter as an objective can easily undermine the former. Concentrate on the former, and the latter will take care of itself.” — Page 14 —
“… management guru Peter Drucker was right back in 1973 when he suggested “The only valid purpose of a firm is to create a customer.”” — Page 14 —

People want money

This post draws on a FT article titled “People want money” which led me to an interesting paper by Gary Gorton and George Pen na cchi titled “Financial Intermediaries and Liquidity Creation”. I took the following points away from the Gorton/Pennacchi paper:

The modern financial markets based economy relies on “money” to facilitate the bulk of its economic activity and bank deposits are the dominant form of money
There is however a continuous search for ways to expand the domain of what matches the liquidity of “money” while offering a better return
History has seen a variety of instruments and commodities operate as money but a critical issue is whether they retain their “moneyness” during adverse economic conditions (I think this is something that the crypto currency advocates don’t seem to fully grasp)
Gorton/Pennacchi argue that the liquidity of an instrument and hence its capacity to be accepted and used as money depends on the ability of uninformed agents to trade it without fear of loss; i.e. the extent to which the value of the instrument is insulated from any adverse information about the counterparty – This I think is their big idea
The role of a bank has traditionally been characterised as one of credit intermediation between savers and borrowers but Gorton/Pennacchi argue that the really critical role of banks is to provide a liquid asset in the form of bank deposits that serves as a form of money
Note that other functions offered by banks can be replicated by non-banks (e.g. non-banks are increasingly providing payment functions for customers and offering loans) but the capacity to issue liabilities that serve as money is unique to banks
The challenge is that banks tend to hold risky assets and to be opaque which undermines the liquidity of bank deposits/money (as an aside, Gorton/Pennacchi offer some interesting historical context in which opacity was useful because people trusted banks and the opacity helped shield them from any information which might undermine this trust)
There are a variety of ways to make bank deposits liquid in the sense that Gorton/Pennacchi define it (i.e. insensitive to adverse information about the bank) but they argue for solutions where depositors have a sufficiently deep and senior claim on the assets of the bank that any volatility in their value is of no concern to them
This of course is what deposit insurance and giving deposits a preferred claim in the bank loss hierarchy does (note that the insured deposit a preferred claim on a bank’s assets also means the government can underwrite deposit insurance with very little risk of loss)
A lot of the regulatory change we have seen to date (more equity, less short term funding) contribute to that outcome without necessarily being expressed in terms of improving the liquidity of bank deposits in the way Gorton/Pennacchi frame the desired outcome

A lot of the above is not necessarily new but I do see some interesting connections with the role of banks in the money creation process and how this influences the debate about what is the optimum capital structure for a bank

It has been argued that more (and more) equity is a costless solution to the problem of how much is enough because the cost of equity will decline as the percentage of equity in the balance sheet increases
This conclusion depends in turn on the Modigliani and Miller (M&M) thesis that the value of a firm is independent of its financing structure
The Money Creation analysis however shows that banks are in fact unique (amongst private companies) in that one of the things they produce is money (or bank deposits to be more precise) – Gorton/Pennacchi explicitly call this out as a factor that means that M&M does not apply to banks in the simplistic way proponents of very high capital assert (most other critiques of higher bank capital just focus on the general limitations of M&M)
If you accept Gorton/Pennacchi’s argument that bank deposits need to be risk free in the minds of the users if they are to serve as money (the argument makes sense to me) then it follows that the cost of deposits does not change incrementally with changes in the financing structure in the way that M&M assume
In practice, bank deposits are either assumed to be risk free or they lose that risk free status – the risk trade-off is binary – one or the other, but not a smooth continuum assumed by M&M
That implies that all the real risk in a bank balance sheet has to reside in other parts of the loss hierarchy (i.e. equity, other loss absorbing capital and senior instruments)
And this will be even more so under Basel III because the government is developing the capacity to impose losses on all these stakeholders without having to resort to a formal bankruptcy and liquidation process (i.e. via bail-in and TLAC)
Critics of bail-in argue that you can’t impose losses on liabilities but here I think they are conflating what you can’t do to depositors (where I would very much agree) with what can and does happen to bondholders relatively frequently
Bondholders have faced losses of principal lending to a range of counterparties (including sovereigns) so I don’t see why banks should be special in this regard – what matters is that bondholders understand the risk and price it appropriately (including not lending as much as they might otherwise have done)
I would also argue that imposing the risk of bail in onto bondholders is likely to be a much more effective risk discipline than requiring banks to hold arbitrarily large equity holdings that mean they struggle to earn an adequate equity like return

Gorton and Pennacchi’s paper did not explicitly raise this point but I also see an interesting connection with the Basel III Net Stable Funding Ratio (NSFR) requirement that does not get much attention;

The NSFR places great value on having a high level of depositor funding but, the greater the share of deposits in the liability stack, the more exposed those deposits are to any volatility in the value of the bank’s assets
So holding too many deposits might in fact be counterproductive and less resilient than an alternative structure in which there is slightly more long term wholesale funding and less retail deposits
This line of analysis also calls into question the logic underpinning the Open Bank Resolution regime in NZ where deposits can be bailed in pro rata with senior unsecured liabilities
The NZ regime allows some de minimis value of deposits to be excluded from bail in but there is no depositor preference such as Australia has under the Banking Act
The RBNZ seems to assume that applying market discipline to deposits is desirable on Moral Hazard grounds but Gorton/Pennacchi’s thesis seems to me to imply the exact opposite

Tell me what I am missing …

The Countercyclical Capital Buffer

This post uses a recent BCBS working paper as a stepping off point for a broader examination of how the countercyclical capital buffer (CCyB) can help make the banking system more resilient.

This post uses a recent BCBS working paper as a stepping off point for a broader examination of how the countercyclical capital buffer (CCyB) can help make the banking system more resilient. The BCBS paper is titled “Towards a sectoral application of the countercyclical capital buffer: A literature review – March 2018” (BCBS Review) and its stated aim is to draw relevant insights from the existing literature and use these to shed light on whether a sectoral application of the CCyB would be a useful extension of the existing Basel III framework under which the CCyB is applied at an aggregate country level credit measure. The views expressed in Working Papers like this one are those of their authors and do not represent the official views of the Basel Committee but they do still offer some useful insights into what prudential supervisors are thinking about.

Key points

I very much agree with the observation in the BCBS Review that the standard form of the CCyB is a blunt instrument by virtue of being tied to an aggregate measure of credit growth
And that a sectoral application of the CCyB (operating in conjunction with other sector focussed macro prudential tools) would be an improvement
But the CCyB strategy that has been developed by the Bank of England looks to be a much better path to pursue
Firstly, because it directly addresses the problem of failing to detect/predict when the CCyB should be deployed and secondly because I believe that it results in a much more “usable” capital buffer
The CCyB would be 1% if APRA adopted the Bank of England strategy (the CCyB required by APRA is currently 0%) but adopting this strategy does not necessarily require Australian banks to hold more capital at this stage of the financial cycle
One option would be to align one or more elements of APRA’s approach with the internationally harmonised measure of capital adequacy and to “reinvest” the increased capital in a 1% CCyB.

First a recap on the Countercyclical Capital Buffer (aka CCyB).

The CCyB became part of the international macro prudential toolkit in 2016 and is intended to ensure that, under adverse conditions, the banking sector in aggregate has sufficient surplus capital on hand required to maintain the flow of credit in the economy without compromising its compliance with prudential requirements.

A key feature in the original BCBS design specification is that the buffer is intended to be deployed in response to high levels of aggregate credit growth (i.e high relative to the sustainable long term trend rates) which their research has identified as an indicator of heightened systemic risk. That does not preclude bank supervisors from deploying the buffer at other times as they see fit, but responding to excess credit growth has been a core part of the rationale underpinning its development.

The BCBS Review

The BCBS Review notes that the CCyB works in theory but concedes there is, as yet, virtually no empirical evidence that it will work in practice. This is not surprising given that it has only been in place for a very short period of time but still important to remember. The BCBS Review also repeatedly emphasises the point that the CCyB may help to mitigate the credit cycle but that is a potential side benefit, not the main objective. Its primary objective is to ensure that banks have sufficient surplus capital to be able to continue lending during adverse economic conditions where losses will be consuming capital.

The Review argues that the CCyB is a useful addition to the supervisor’s tool kit but is a blunt instrument that impacts all sectors of the economy indiscriminately rather than just targeting the sectors which are the source of systemic concern. It concludes that applying the CCyB at a sectoral level might be more effective for three reasons

more direct impact on the area of concern,
stronger signalling power, and
smaller effects on the wider economy than the Basel III CCyB.

The Review also discusses the potential to combine a sectoral CCyB with other macro prudential instruments; in particular the capacity for the two approaches to complement each other;

Quote “Generally, macroprudential instruments that operate through different channels are likely to complement each other. The literature reviewed indicates that a sectoral CCyB could indeed be a useful complement to alternative sectoral macroprudential measures, including borrower-based measures such as LTV, LTI and D(S)TI limits. To the extent that a sectoral CCyB is more effective in increasing banks’ resilience and borrower-based measures are more successful in leaning against the sectoral credit cycle, both objectives could be attained more effectively and efficiently by combining the two types of instruments. Furthermore, there is some evidence that suggests that a sectoral CCyB could have important signalling effects and may therefore act as a substitute for borrower-based measures.”

A Sectoral CCyB makes sense

Notwithstanding repeated emphasis that the main point of the CCyB is to ensure banks can and will continue to support credit growth under adverse conditions, the Review notes that there is not much, if any, hard empirical evidence on how effective a release of the CCyB might be in achieving this. The policy instrument’s place in the macro prudential tool kit seems to depend on the intuition that it should help, backed by some modelling that demonstrates how it would work and a pinch of hope. The details of the modelling are not covered in the Review but I am guessing it adopts a “homo economicus” approach in which the agents act rationally. The relatively thin conceptual foundations underpinning the BCBS version of the CCyB are worth keeping in mind.

The idea of applying the CCyB at a sectoral level seems to make sense. The more targeted approach advocated in the Review should in theory allow regulators to respond to sectoral areas of concern more quickly and precisely than would be the case when the activation trigger is tied to aggregate credit growth. That said, I think the narrow focus of the Review (i.e. should we substitute a sectoral CCyB for the current approach) means that it misses the broader question of how the CCyB might be improved. One alternative approach that I believe has a lot of promise is the CCyB strategy adopted by the Bank of England’s Financial Policy Committee (FPC).

The Bank of England Approach to the CCyB (is better)

The FPC published a policy statement in April 2016 explaining that its approach to setting the countercyclical capital buffer is based on five core principles. Many of these are pretty much the same as the standard BCBS policy rationale discussed above but the distinguishing feature is that it “… intends to set the CCyB above zero before the level of risk becomes elevated. In particular, it expects to set a CCyB in the region of 1% when risks are judged to be neither subdued nor elevated.”

This contrasts with the generic CCyB, as originally designed by the BCBS, which sets the default position of the buffer at 0% and only increases it in response to evidence that aggregate credit growth is excessive. This might seem like a small point but I think it is a material improvement on the BCBS’s original concept for two reasons.

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 countercyclical 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 FPC 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 FPC 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 BCBS approach. The FPC might still miss the turning point but it has a head start on the problem if it does.

The FPC 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)

The second reason I favour the FPC strategy 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. I must admit I have struggled to clearly articulate why this would be so but I think the answer lies partly in the way that the FPC links the CCyB to a four stage model that can be interpreted as a stylised description of the business cycle. The attraction for me in the FPC’s four stage model is that it offers a coherent narrative that helps all the stakeholders understand what is happening, why it is happening, what will happen next and when it will happen.

The BCBS Review talks about the importance of communication and the FPC strategy offers a good model of how the communication strategy can be anchored to a coherent and intuitive narrative that reflects the essentially cyclical nature of the banking industry. The four stages are summarised below together with some extracts setting out the FPC rationale.

Stage 1: The post-crisis repair phase in which risks are subdued – the FPC would expect to set a CCyB rate of 0%

FPC rationale: “Risks facing the financial system will normally be subdued in a post-crisis repair and recovery phase when the financial system and borrowers are repairing balance sheets. As such, balance sheets are not overextended. Asset and property prices tend to be low relative to assessed equilibrium levels. Credit supply is generally tight and the risk appetite of borrowers and lenders tends to be low. The probability of banks coming under renewed stress is lower than average.”

Stage 2: Risks in the financial system re-emerge but are not elevated – the FPC intends to set a positive CCyB rate in the region of 1% after the economy moves into this phase.

FPC rationale: ‘In this risk environment, borrowers will not tend to be unusually extended or fragile, asset prices are unlikely to show consistent signs of over, or under, valuation, and measures of risk appetite are likely to be in line with historical averages”. As such, it could be argued that no buffer is required but the FPC view is that a pre-emptive strategy is more “robust to the inherent uncertainty associated with measuring risks to financial stability”. It also allows subsequent adjustments to be more graduated than would be possible if the CCyB was zero.

Stage 3: Risks in the financial system become elevated: stressed conditions become more likely – the FPC would expect to increase the CCyB rate beyond the region of 1%. There is no upper bound on the rate that can be set by the FPC.

FPC rationale: “As risks in the financial system become elevated, borrowers are likely to be stretching their ability to repay loans, underwriting standards will generally be lax, and asset prices and risk appetite tend to be high. Often risks are assumed by investors to be low at the very point they are actually high. The distribution of risks to banks’ capital at this stage of the financial cycle might have a ‘fatter tail’ [and] stressed outcomes are more likely.”

Stage 4: Risks in the financial system crystallise – the FPC may cut the CCyB rate, including where appropriate to 0%.

FPC rationale: “Reducing the CCyB rate pre-emptively before losses have crystallised may reduce banks’ perceived need to hoard capital and restrict lending, with consequent negative impacts for the real economy. And if losses have crystallised, reducing the CCyB allows banks to recognise those losses without having to restrict lending to meet capital requirements. This will help to ensure that capital accumulated when risks were building up can be used, thus enhancing the ability of the banking system to continue to support the economy in times of stress.”

The March 2018 meeting of the FPC advised that the CCyB applying to UK exposures would remain unchanged at the 1% default level reflecting its judgement that the UK banking system was operating under Stage 2 conditions.

Calibrating the size of the CCyB

The FPC’s approach to calibrating the size of the CCyB also offers some interesting insights. The FPC’s initial (April 2016) policy statement explained that a “CCyB rate in the region of 1%, combined with other elements of the capital framework, provides UK banks with sufficient capital to withstand a severe stress. Given current balance sheets, the FPC judges that, at this level of the CCyB, banks would have sufficient loss-absorbing capacity to weather a macroeconomic downturn of greater magnitude than those observed on average in post-war recessions in the United Kingdom — although such estimates are inherently uncertain.”

The first point to note is that the FPC has chosen to anchor their 1% default setting to a severity greater than the typical post war UK recession but not necessarily a GFC style event. There is a school of thought that maintains that more capital is always better but the FPC seems to be charting a different course. This is a subtle area in bank capital management but I like the the FPC’s implied defence of subtlety.

What is sometimes lost in the quest for a failure proof banking system is a recognition of the potential for unintended consequence. All other things being equal, more capital makes a bank less at risk of insolvency but all other things are almost never equal in the real world. Banks come under pressure to find ways to offset the ROE dilution associated with more capital. I know that theory says that a bank’s cost of equity should decline as a result of holding more capital so there is no need to offset the dilution but I disagree (see this post for the first in a proposed series where I have started to set out my reasons why). Attempts to offset ROE dilution also have a tendency to result in banks taking more risk in ways that are not immediately obvious. Supervisors can of course intervene to stop this happening but their already difficult job is made harder when banks come under pressure to lift returns. This is not to challenge the “unquestionably strong” benchmark adopted by APRA but simply to note that more is not always better.

Another problem with just adding more capital is that the capital has to be usable in the sense that the capital ratio needs to be able to decline as capital is consumed by elevated losses without the bank coming under pressure to immediately restore the level of capital it is expected to hold. The FPC strategy of setting out how it expects capital ratios to increase or decrease depending on the state of the financial cycle helps create an environment in which this can happen.

Mapping the BOE approach to Australia

APRA has set the CCyB at 0% whereas the BOE approach would suggest a value of at least 1% and possibly more given that APRA has felt the need to step in to cool the market down. It is important to note that transitioning to a FPC style CCyB does not necessarily require that Australian banks need to hold more capital. One option would be to harmonise one or more elements of APRA’s approach to capital measurement (thereby increasing the reported capital ratio) and to “reinvest” the surplus capital in a CCyB. The overall quantum of capital required to be unquestionably strong would not change but the form of the capital would be more usable to the extent that it could temporarily decline and banks had more time to rebuild the buffer during the recovery phase.

Summing up

A capital adequacy framework that includes a CCyB that is varied in a semi predictable manner over the course of the financial cycle would be far more resilient than the one we currently have that offers less flexibility and is more exposed to the risk of being too late or missing the escalation of systemic risk all together.

Tell me what I am missing …

Are banks a special kind of company (or at least different)?

This is a big topic, and somewhat irredeemably technical, but I have come to believe that there are some unique features of banks that make them quite different from other companies. Notwithstanding the technical challenges, I think it is important to understand these distinguishing features if we are to have a sensible debate about the optimum financing structure for a bank and the kinds of returns that shareholders should expect on the capital they contribute to that structure.

You could be forgiven for thinking that the Australian debate about optimum capital has been resolved by the “unquestionably strong” benchmark that APRA has set and which all of the major banks have committed to meet. However, agreeing what kind of return is acceptable on unquestionably strong capital remains contentious and we have only just begun to consider how the introduction of a Total Loss Absorbing Capital (TLAC) requirement will impact these considerations.

The three distinctive features of banks I want to explore are:

The way in which net new lending by banks can create new bank deposits which in turn are treated as a form of money in the financial system (i.e. one of the unique things banks do is create a form of money);
The reality that a large bank cannot be allowed to fail in the conventional way (i.e. bankruptcy followed by reorganisation or liquidation) that other companies and even countries can (and frequently do); and
The extent to which bank losses seem to follow a power law distribution and what this means for measuring the expected loss of a bank across the credit cycle.

It should be noted at the outset that Anat Admati and Martin Hellwig (who are frequently cited as authorities on the issues of bank capital discussed in this post) disagree with most if not all of the arguments I intend to lay out. So, if they are right, then I am wrong. Consequently, I intend to first lay out my understanding of why they disagree and hopefully address the objections they raise. They have published a number of papers and a book on the topic but I will refer to one titled “The Parade of the Bankers’ New Clothes Continues: 31 Flawed Claims Debunked” as the primary source of the counter arguments that I will be attempting to rebut. They are of course Professors whereas I bring a lowly masters degree and some practical experience to the debate. Each reader will need to decide for themselves which analysis and arguments they find more compelling.

Given the size of the topic and the technical nature of the issues, I also propose to approach this over a series of posts starting with the relationship between bank lending and deposit creation. Subsequent posts will build on this foundation and consider the other distinctive features I have identified before drawing all of the pieces together by exploring some practical implications.

Do banks create “money”? If so, how does that impact the economics of bank funding?

The Bank of England (BoE) released a good paper on the first part of this question titled “Money creation in the modern economy” . The BoE paper does require some banking knowledge but I think demonstrates reasonably clearly that the majority of bank deposits are created by the act of a bank making a new loan, while the repayment of bank loans conversely reduces the pool of deposits. The related but more important question for the purposes of this discussion is whether you believe that bank deposits are a form of money.

Admati and Hellwig identify the argument that “banks are special because they create money” as Flawed Claim #5 on the grounds that treating deposits as money is an abuse of the word “money”. They are not disputing the fact that monetary economists combine cash with demand deposits in one of the definitions of money. As I understand it, the essence of their argument is that deposits are still a debt of the issuing bank while “real” money does not need to be repaid to anyone.

It is true that deposits are a bank debt and that some deposits are repayable on demand. However, I believe the bigger issues bearing on the economics of bank financing stem from the arguments Admati and Hellwig advance to debunk what they label as Flawed Claim #4 that “The key insights from corporate finance about the economics of funding, including those of Modigliani and Miller, are not relevant for banks because banks are different from other companies“.

Their argument appears to focus on using Modigliani and Miller (“M&M”) as an “analytical approach” in which the cost (contractual or expected) of the various forms of financing are connected by a universal law of risk and reward. Their argument is that this universal law (analogous to the fundamental laws of physics) demands that using more or less equity (relative to debt) must translate to a lower or higher risk of insolvency and that rational debt investors will respond by adjusting the risk premium they demand.

I have no issue with the analytical approach or the premise that funding costs should be related to risk. What happens however when one of the primary forms of debt funding is largely protected from the risk of insolvency? In the case of the major Australian banks, deposits account for over half of a bank’s total funding but are largely isolated from the risk of insolvency by a number of features. One is the Banking Act that confers a preferred claim in favour of Australian depositors over the Australian assets of the bank. The other is government guaranteed deposit insurance coverage capped at $250,000 per person per bank. The rationale for these acts of apparent government generosity is a contentious subject in itself but, for the purposes of this post, my working hypothesis is that the preferred claim and deposit insurance are a consequence of the fact that the community treats bank demand deposits as a form of money.

Consequently, the risk that an Australian depositor will face a loss of principal in the already remote event of insolvency is arguably de minimis and the way that demand deposits are priced and the way they are used as a substitute for cash reflects this risk analysis. There remains a related, though separate, risk that a bank may face a liquidity problem but depositors (to the extent they even think about this) will assume that central bank Lender of Last Resort liquidity support covers this.

Admati and Hellwig do not, to the best of my knowledge, consider the implications of these features of bank funding. In their defence, I don’t imagine that the Australian banking system was front of mind when they wrote their papers but depositor preference and deposit insurance are not unique Australian innovations. However, once you consider these factors, the conclusion I draw is that the cost of a substantial share of a bank’s debt financing is relatively (if not completely) insensitive to changes in the amount of equity the bank employs in its financing structure.

One consequence is that the higher levels of common equity that Australian banks employ now, compared to the position prior to the GFC, has not resulted in any decline in the cost of deposit funding in the way that M&M say that it should. In fact, the more conservative funding and liquidity requirements introduced under Basel III have required all banks to compete more aggressively for the forms of deposit funding that are deemed by the prudential requirements to be most stable thereby driving up the cost.

The point here is not whether these changes were desirable or not (for the record I have no fundamental issue with the Unquestionably Strong capital benchmark nor with more conservative funding and liquidity requirements). The point is that the cost of deposit funding, in Australian banking at least, has not declined in the way that Admati and Hellwig’s analytical approach and universal law demands that it should.

Summing up, it is possible that other forms of funding have declined in cost as Admati and Hellwig claim should happen, but there is both an analytical rationale and hard evidence that this does not appear to be the case, for Australian bank deposits at least.

The next post will consider the other main (non equity) components of a bank funding structure and explore how their risk/cost has evolved in response both to the lessons that investors and rating agencies took away from the GFC and to the changes in bank regulation introduced by Basel III. A subsequent post will review issues associated with measuring the Expected Loss and hence the true “Through the Cycle” profitability of a bank before I attempt to bring all of the pieces together.

There is a lot of ground to cover yet. At this stage, I have simply attempted to lay out a case for why the cost of bank deposits in Australia has not obeyed the universal analytical law posited by Admati and Hellwig as the logical consequence of a bank holding more equity in its financing structure but if you disagree tell me what I am missing …

Tony

Post script: The arguments I have laid out above could be paraphrased as “banks deposits differ from other kinds of debt because banks themselves create deposits by lending” which Admati and Hellwig specifically enumerate as Flawed Claim #6. I don’t think their rebuttal of this argument adds much to what is discussed above but for the sake of completeness I have copied below the relevant extract from their paper where they set out why they believe this specific claim is flawed. Read on if you want more detail or have a particular interest in this topic but I think the main elements of the debate are already covered above. If you think there is something here that is not covered above then let me know.

Flawed Claim 6: Bank deposits differ from other kinds of debt because banks create deposits by lending.

What is wrong with this claim? This claim is often made in opposition to a “loanable funds” view of banks as intermediaries that collect deposits in order to fund their loans. Moreover, this “money creation through lending” is said to be the way money from the central bank gets into the economy.19 The claim rests on a confusion between stocks and flows. Indeed, if a commercial bank makes a loan to a nonfinancial firm or to a private household it provides its borrowers with a claim on a deposit account. Whereas this fact provides a link between the flow of new lending and the flow of new deposits, it is hardly relevant for the bank’s funding policy, which concerns the stocks of different kinds of debt and equity that it has outstanding, which must cover the stocks of claims on borrowers and other assets that the bank holds.

A nonfinancial firm or household that receives a loan from a bank will typically use the associated claim on a deposit account for payments to third parties. The recipients of these payments may want to put some of the money they get into deposits, but they may instead prefer to move the money out of the banking system altogether, e.g., to a money market fund or a stock investment fund. 20

From the perspective of the individual bank, the fact that lending goes along with deposit creation does not change the fact that the bank owes its depositors the full amount they deposited. The key difference between deposits and other kinds of debt is not that deposits are “like money” or that deposits may be created by lending, but rather that the bank provides depositors with services such as payments through checks and credit cards or ATM machines that make funds available continuously. The demand for deposits depends on these services, as well as the interest that the bank may offer, and it may also depend on the risk of the bank becoming insolvent or defaulting.21

The suggestion that bank lending is the only source of deposit creation is plainly false.22 Deposits are created when people bring cash to the bank, and they are destroyed when people withdraw cash. In this case, the reduction in deposits – like any reduction in funding – goes along with a reduction in the bank’s assets, i.e., a shortening of its balance sheet, but this reduction affects the bank’s cash reserves rather than its lending. The impact of such withdrawals on banks and entire banking systems are well known from the Great Depression or from the recent experience of Greece. In Greece in the spring and summer of 2015, depositors also were worried about the prospect that in the event of the country’s exit from the euro, their denomination of their deposits would be changed, whereas a stack of bills under a matrass would not be affected.

APRA’s proposed revisions to capital requirements for residential mortgages

… there is a lot to like in what APRA have proposed but also some issues that would benefit from further thought

Many readers will be aware that APRA released a Discussion Paper (DP) last week titled “Revisions to the capital framework for authorised deposit-taking institutions”. The paper sets out APRA’s proposed changes to ADI capital requirements defined by the Internal Ratings Based Approach (IRB) and Standardised Approach to Credit Risk, Interest Rate Risk in the Banking Book (IRRBB) and Operational Risk. The focus of this post will be the proposals impacting credit risk capital requirements for residential mortgage lending. This post presupposes that the reader is familiar with the detail of what APRA has proposed. For those of you who have not yet got around to reading the whole paper I have added a short summary of the proposals below (see “APRA’s proposals – in more detail”).

My gut reaction is that there is a lot to like in what APRA have proposed but there are also issues that deserve further consideration in order to address the risk of unintended consequence and to better deliver on the objectives of consistency, transparency and competitive neutrality.

Proposals which make sense to me:

The increased risk sensitivity of the proposed standardised RWs for residential mortgages is, I believe, a material enhancement of the capital adequacy framework
There are arguments (and indeed evidence) for why investor property loans can be as low risk as owner occupier loans (most of the time) but APRA’s desire to address the systemic tail risk of this form of lending is I think an understandable policy objective for a prudential regulator to pursue
Continuing to pursue higher IRB RW via changes to the correlation factor also looks to be a better approach than the 20% floor on LGD currently applied and thankfully also up for revision
Applying a higher correlation factor to low PD loans also makes intuitive sense, especially if your primary concern is the systemic risk associated with the residential mortgage lending that dominates the balance sheets of your banking system
In addition, the potential for the correlation adjustment to reduce the sensitivity of residential mortgage RWA to the economic cycle (and hence reduce the risk of pro-cyclical stress on capital ratios) is particularly welcome though I believe there is much more to do on this general issue
The support for Lender’s Mortgage Insurance (LMI) is also welcome

Areas where I believe the proposed revised capital framework could be improved (or at least benefit from some more thought):

The discussion of relative standardised and IRB RW does not address the fact IRB banks are required to hold additional capital to cover any shortfall between loan loss provisions and Regulatory Expected Loss (REL)
Residential mortgage portfolios subject to the standardised approach should be subject to a minimum average RW in the same way that IRB portfolios are currently constrained by the 25% floor
Applying a fixed scalar to Credit RWA can be problematic as the composition of the loan portfolio continues to evolve

The discussion of comparative IRB and Standardised RW you typically encounter seems to assume that the two approaches are identical in every aspect bar the RW but people working at the coal face know that the nominal RW advantage the IRB banks have has been partly offset by a higher exposure measure the RW are applied to. It appears that APRA’s proposed revisions will partly address this inconsistency by requiring banks using the Standardised Approach to apply a 100% Credit Conversion Factor (CCF) to undrawn loan limits. IRB banks are also required to take a Common Equity Tier 1 deductions for the shortfall between their loan loss provisions and REL. The proposed revisions do nothing to address this area of inconsistency and in fact the Discussion Paper does not even acknowledge the issue.

Residential mortgage portfolios subject to the standardised approach should be subject to a minimum average RW in the same way that IRB portfolios are constrained. The majority of new residential mortgages are originated at relatively high LVR (most at 70% plus and a significant share at 80% plus), but the average LVR will be much lower as principal is repaid (and even more so if you allow for the appreciation of property values). The introduction of a 20% RW bucket for standardised banks poses the question whether these banks will have an advantage in targeting the refinancing of seasoned loans with low LVR’s. The IRB banks would seek to retain these customers but they will still be constrained by the 25% average RW mandated by the FSI while the standardised banks face no comparable constraint.

This is unlikely to be an issue in the short term but one of the enduring lessons learned during my time “on the inside” is that banks (not just the big ones) are very good at identifying arbitrages and responding to incentives. It is widely recognised that housing loans have become the largest asset on Australian bank balance sheets (The Royal Commission issued a background paper that cited 42% of assets as at September 2017) but the share was significantly less when I started in banking. There has been a collection of complex drivers at play here (a topic for another post) but the relatively low RW has not harmed the growth of this kind of lending. Consequently, it is dangerous to assume that the status quo will persist if incentives exist to drive a different outcome.

This competitive imbalance could be addressed quite simply if the standardised banks were also subject to a requirement that their average RW was also no lower than 25% (or some alternative floor ratio that adjusted for the differences in exposure and REL noted above).

Another lesson learned “on the inside” is that fixed scalars look simple but are often not. They work fine when the portfolio of assets they are scaling up is stable but will gradually generate a different outcome to what was intended as the composition of the loan book evolves over time. I don’t have an easy solution to this problem but, if you must use them, it helps to recognise the potential for unintended consequence at the start.

Read on below if you have not read the Discussion Paper or want more detail on the revisions APRA has proposed and how these changes are proposed to be reconciled with the FSI recommendation. This is my first real post so feedback would be much appreciated.

Above all, tell me what I am missing …

Tony

Note: The original version of this post published 22 February 2018 stated that inconsistent measurement of the exposures at default between the standardised and IRB approaches was not addressed by APRA’s proposed revisions. I believe now that the proposed application of a 100% CCF in the Standardised Approach would in fact address one of the areas of inconsistency. The treatment of Regulatory Expected Loss remains an issue however. The post was revised on 24 February to clarify these points.

APRA’s proposals – in more detail

Good quality loans fully secured by mortgages on occupied residential property (either rented or occupied by the borrower) have been assigned concessionary risk weights (RW) ever since risk weighted capital adequacy ratios were introduced under Basel I (1988). The most concessionary risk weight was initially set at 50% and reduced to 35% in the Basel II Standardised Approach (2006).

APRA currently applies the concessionary 35% RW to standard eligible mortgages with Loan Valuation Ratios (LVR) of 80% or better (or up to 90% LVR if covered by Lender’s Mortgage Insurance) while the best case scenario for a non-standard mortgage is a 50% RW. Progressively higher RW (50/75/100) are applied for higher risk residential mortgages.

Under the Standardised Approach, APRA proposes:

The classification of a Standard Eligible Mortgage will distinguish between lowest risk “Owner-occupied P&I” and a higher risk “Other residential mortgages” category which is intended to be conceptually similar to the “material dependence” concept employed by Basel III to distinguish loans where repayment depends materially on the cash flows generated by the property securing the loan
6 RW bands for each of these two types of residential mortgage (compared to 5 bands currently)
Standard Eligible Mortgages with lower LVR loans to be assigned lower RW but these loans must also meet defined serviceability, marketability and valuation criteria to qualify for the concessionary RW
The higher RW applied to “Other residential mortgages” may take the form of a fixed risk-weight schedule (per the indicative RW in Table 3 of the Discussion Paper) but might also be implemented via a multiplier, applied to the RW for owner-occupied P&I loans, which might vary over time “… depending on prevailing prudential or financial stability objectives or concerns”
Relatively lower capital requirements to continue to apply where loans are covered by LMI but its preferred approach is to apply a RW loading to loans with LVR in excess of 80% that are not insured (i.e. the indicative RW in Table 3 assume that LMI covers the high LVR loans)
Non-Standard residential mortgages should no longer benefit from any RW concession and be assigned a flat 100% RW irrespective of LVR and LMI

While the IRB requirements impacting residential mortgages are largely unchanged under Basel III, APRA proposes the following changes to the Australian IRB Approach to reflect local requirements and conditions:

Increased capital requirements for investment and interest-only exposures; to be implemented via a higher correlation factor for these loans
The (currently fixed) correlation factor applied to residential mortgages to be amended to depend on probability of default (PD); reflecting empirical evidence that “… the default risk of lower PD exposures is more dependent on the economic cycle and can consequently increase at a relatively higher rate in a downturn”
A reduction in the minimum Loss Given Default (LGD) from 20% to 10% (subject to APRA approval of the LGD model); in order to facilitate “… better alignment of LGD estimates to key drivers of loss such as LVR and LMI”
Capital requirements for non-standard mortgages use the standardised approach; increasing consistency between the IRB an standardised approaches

APRA’s proposals seek to strike a balance between risk sensitivity and simplicity but must also take account of the FSI recommendations that ADI capital levels be unquestionably strong while also narrowing the difference between standardised and IRB RWs for residential mortgages. APRA is undertaking a Quantitative Impact Study (QIS) to better understand the impact of its proposals but the DP flagged that APRA does not expect the changes to correlation factors to meet its objectives for increased capital for residential mortgage exposures.

APRA could just further ramp up the correlation factor to generate the target IRB RW (which I assume continues to be 25%) but the DP notes that this would create undesirable inconsistencies with the correlation factors applied to other asset classes. Consequently, the DP indicates that the target increase in IRB RWA will likely be pursued via

A fixed multiplier (scalar) applied to total Credit RWA (i.e. althoughBasel III removes the 1.06 Credit RWA scalar, APRA is considering retaining a scalar with a value yet to be determined); and
If necessary, by applying additional specific RWA scalars for residential (and commercial) property.

These scalars will be subject to consultation with the industry and APRA has committed to review the 10.5% CET1 benchmark for unquestionably strong capital should the net result of the proposed revisions result in an overall increase in RWA’s relative to current methodologies.

Why this blog?

making sense of what I have learned about banks with a focus on bank capital management.

Late in 2017 I decided to take some time out from work (the paid kind to be precise). My banking career has spanned a variety of roles working in a large Australian bank but the unifying theme for much of that time was a focus on bank capital management. This is a surprisingly rich topic (yes honestly) and one that I am not done with yet. Accordingly, I want to devote some of my time out to an attempt to make sense of what I have learned and apply that knowledge to topical banking issues. It was suggested that I write a book but I have opted for a blog format in part because it will hopefully allow for a two way dialogue with like minded bank capital tragics.

An alternative title for this blog was “The education of a banker; a work in progress” which sought to convey the idea that I believe I have learned quite a lot about banking over the past four decades but the plan is to keep learning. Some of the perspectives I offer are to, the best of my knowledge, based on very firm foundations while others are ones which reasonable people can disagree upon or outright speculative. To the best of my ability, all of the views expressed will be “lightly held” in the sense that I am just as interested in identifying reasons why they might be wrong as I am in affirmation.

I settled on “From the Outside” based on an informal survey of a group of like minded people with who I have already devoted many emails and coffee catchups debating the issues I intend to explore. The title highlights that I bring a perspective forged working inside a bank over many years but now looking at the questions from the outside. Each reader will need decide for themselves whether I achieve a balanced view or have become irredeemably institutionalised. I will seek to correct what I believe to be unfounded criticisms of banks (for the record, I don’t think the current ROE major Australian banks are targeting is excessive) while at the same time there are other areas where I believe Australian banks need to do better (engaging with long time customers in a way that recognises their loyalty would be a great place to start).

The focus of the blog will no doubt evolve over time (and hopefully in response to feedback) but the initial plan is to explore a sequence of big picture themes in parallel with topical issues that arise from time to time. I also plan to share my thoughts on books and papers I have read that I think readers might find worth following up.

The big picture themes will likely encompass questions like the ways in which banks are different from other companies and the implications this has for thinking about questions like their cost of equity, optimal capital structure, risk appetite, risk culture, prudential regulation etc. Topical issues would encompass discussion papers, academic research, opinion pieces, prudential regulation and anything else that intersected with banking, finance and economics.

I am currently working my way through APRA’s Feb 2018 discussion paper on Revisions to the capital framework for ADI’s. I think there is a lot to like in the proposals APRA has set out but also some gaps and possible unintended consequences that are worth exploring.

… and so it begins

Tony

Continue reading “Why this blog?”