The tension between competition and financial stability …

… is a topic on which I have long been planning to write the definitive essay.

Today is not that day.

In the interim, I offer a link to a post by Marc Rubinstein that makes a few points I found worth noting and expanding upon.

Firstly, he starts with the observation that there are very few neat solutions to policy choices – mostly there are just trade-offs. He cites as a case a point the efforts by financial regulators to introduce increased competition over the past forty years as a means to make the financial system cheaper and more efficient. Regulators initially thought that they could rely on market discipline to manage the tension between increased freedom to compete and the risk that this competition would undermine credit standards but this assumption was found wanting and we ended up with the GFC.

When financial regulators think about trade-offs, the one they’ve traditionally wrestled with is the trade-off between financial stability and competition. It arises because banks are special: their resilience doesn’t just impact them and their shareholders; it impacts everybody. As financial crises through the ages have shown, if a bank goes down it can have a huge social cost. And if there’s a force that can chip away at resilience, it’s competition. It may start out innocently enough, but competition often leads towards excessive risk-taking. In an effort to remain competitive, banks can be seduced into relaxing credit standards. Their incentive to monitor loans and maintain long-term relationships with borrowers diminishes, credit gets oversupplied and soon enough you have a problem. 

The Policy Triangle, Marc Rubinstein -

We have learned that regulators may try to encourage competition where possible but, when push comes to shove, financial stability remains the prime directive. As a consequence, the incumbent players have to manage the costs of compliance but they also benefit from a privileged position that has been very hard to attack. Multiple new entrants to the Australian banking system learned this lesson the hard way during the 1980s and 1990s.

For a long time the trade-off played out on that simple one dimensional axis of “efficiency and competition” versus “financial stability” but the entry of technology companies into areas of financial services creates additional layers of complexity and new trade-offs to manage. Rubinstein borrows the “Policy Triangle” concept developed by Hyun Song Shin to discuss these issues.

Hyun Song Shin, Economic Adviser and Head of Research, Bank for International Settlements
  1. Firstly, he notes that financial regulators don’t have jurisdiction over technology companies so that complicates the ways in which they engage with these new sources of competition and their impact on the areas of the financial system that regulators do have responsibility for.
  2. Secondly, he discusses the ways in which the innovative use of data by these new players introduces a whole new range of variables into the regulatory equation.

New entrants have been able to make inroads into certain areas of finance, the payments function in particular. Some regulators have supported these areas of innovation but Rubinstein notes that regulators start to clamp down once new entrants start becoming large enough to matter. The response of Chinese authorities to Ant Financial is one example as is the response of financial regulators globally to Facebook’s attempt to create a digital currency. The lessons seems to be that increased regulation and supervisions is in store for any new entrant that achieves any material level of scale.


The innovative use of data offers the promise of enhanced competition and improved ways of managing credit risk but this potentially comes at the cost of privacy. Data can also be harnessed by policy makers to gain new real-time insights into what is going on in the economy that can be used to guide financial stability policy settings.


Rubinstein has only scratched the surface of this topic but his post and the links he offers to other contributions to the discussion are I think worth reading. As stated at the outset, I hope to one day codify some thoughts on these topics but that is a work in progress. That post will consider issues like the “prisoner’s dilemma” that are I think an important part of the competition/stability trade-off. It is also important to consider the ways in which banks have come to play a unique role in the economy via the creation of money.

Tony – From the Outside

p.s. There are a few posts I have done on related topics that may be of interest

Do banks need belts and braces? – Bank Underground

Some interesting research via a Bank of England Staff Working Paper that explores the value of using multiple regulatory constraints to measure the risk of failure in banks.

Not surprisingly, they find superior utility in a portfolio of measures (risk weighted capital ratio, leverage ratio and Net Stable Funding Ratio) versus relying on a single measure of risk. This is not just due to better predictions of potential for failure but also because this is achieved at lower threshold ratios than would be the case if any of the measures was the sole basis for indicating heightened risk of failure

— Read on

Tony – From the Outside

The Bitcoin energy use debate

Bitcoin’s energy use has been one of the more interesting, and less explored, avenues of the brave new world the crypto community is building. To date I have mostly seen this play out in very simplistic arguments along the lines that Bitcoin is bad because it uses as much energy as whole countries use. On those terms it certainly sounds bad but I came across a more nuanced discussion of the question in this post on the “Principlesandinterest” blog.

Toby lays out some of the counter arguments used to support Bitcoin and in doing so gets into some of the history of how we value things. While my bias remains that Bitcoin’s energy use is a concern, Toby’s post opened my mind up to some of the broader issues associated with the question. Definitely worth reading if you are interested in the question of cryptocurrency and the nature of money.

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

JP Koning – What Tether Means When It Says It’s ‘Regulated’ – CoinDesk

Useful article on Coindesk discussing what underpins the integrity of one of the more popular forms of Stabecoins

“Newcomers to the crypto space are quickly confronted with a popular distinction between regulated stablecoins and unregulated stablecoins. But what is the difference? Tether, the largest of the stablecoins, is often described as unregulated. But Tether executives and supporters disagree with this claim. Who is right?”
— Read on

I don’t profess any real insight or expertise in this space but it does feel to me like a question that any serious student of banking needs to come to terms with.

Tony – From the Outside

Australian bank capital adequacy – “a more flexible and resilient capital framework”

This post looks at a Discussion Paper published by APRA in late 2020 titled “A more flexible and resilient capital framework for ADIs” setting out how it proposes to wrap up a number of prior consultations on a variety of aspects of ADI (authorised deposit-taking institution) capital reform in Australia. The next step in the roll out of the revised framework is to conduct a quantitive impact study (QIS) with selected ADIs to ensure that the proposed final standards are appropriately calibrated.

Key elements of the revised framework (effective 1 January 2023) include:
  • More risk-sensitive risk weights (mostly for residential mortgages but also SME lending) that are expected to reduce average risk weights by approximately 10% for Internal Ratings Based (IRB) banks and 7% for banks operating under the Standardised Approach (SA) to capital adequacy,
  • Support for enhanced competition between the big and small ADIs via a series of initiatives intended to limit the differences between the IRB and SA, approaches (though APRA also offers evidence that the existing differences are not as great as some claim),
  • Improved transparency and comparability both with international peer banks and between the big IRB banks and the smaller SA banks
  • Improved flexibility in capital requirements via an increase in the size of regulatory capital buffers.
Improved risk sensitivity (lower risk weights)

Improved risk sensitivity is obviously a two edged sword (capital requirements could increase) but APRA estimates that the overall impact of the proposed revisions will be to reduce average risk weights for IRB ADIs by 10% and by 7% for Standardised ADIs. I have published a couple of posts already on the proposed changes to residential mortgage risk weights (see here and here) so I don’t intend to cover that in any detail in this post.

The main points to note regarding residential mortgages are:

  • Standardised ADIs get
  • IRB ADIs see
    • the higher than Basel “correlation adjustment” currently used to narrow the difference between IRB and SA risk weights replaced by a simple “scalar” adjustment,
    • the existing 20% LGD floor reduced to 10% for approved LGD models and
    • recognition of the risk reduction value of Lenders’ Mortgage Insurance (LMI) in line with the SA.

I have not looked closely at the changes impacting the other RWA exposures but list them here for completeness:

  • SME lending
    • Standardised ADIs – RW applied under the SA will recognise the value of commercial property security while RW for loans not secured by property will be reduced from 100% to 75% for loans less than $1.5m and 85% otherwise
    • IRB ADIs – the thresholds for applying the Retail SME approach and the Corporate SME approach will be increased
  • Other credit portfolios
    • Standardised ADIs see no real change (existing RW are already largely aligned with the Basel framework)
    • IRB ADIs will see the overall credit scalar in the IRB RW formula increased from 1.06x to 1.1x, risk estimates will be more closely aligned to those of overseas peers (but still higher than those peers) and models will be permitted for the calculation of capital requirements for commercial property exposures
  • New Zealand based exposures
    • RWA determined under RBNZ requirements will be used for group capital requirements
Enhanced competition, increased transparency and comparability

The main points to note here are:

  • The risk weight initiatives listed above should address a long standing complaint from the Standardised ADIs that the higher risk weights they are subject to place them at a competitive disadvantage relative to IRB ADIs
  • Note however that APRA has also provided evidence that the difference in capital requirements is not as large as is often claimed and can be justified by differences in the risk of the loan portfolios that different types of ADIs typically hold
  • The extent of any competitive disadvantage due to capital requirements will be further clarified by the requirement that IRB ADIs also publish capital ratios under the Standardised Approach
  • The extent of the differences between the capital requirements applied by APRA and those used to calculate the ratios reported by international peer banks will also be reduced thereby enhancing the transparency of the Australian ADI capital strength versus the international peer groups. This will make the “top quartile” test employed to determine the “unquestionably strong” benchmark simpler and more transparent.
Increased resilience via larger more flexible capital buffers

We noted above that RWA are expected to reduce by around 10 per cent on average for IRB banks and 7 per cent on average for standardised banks. All other things being equal this will translate into a very visible increase in reported capital ratios which requires a recalibration of the balance between minimum requirements and capital buffers:

  • The minimum Prudential Capital Requirement (PCR) remains unchanged in percentage terms (4.5%), as does the minimum threshold for Point of Non-Viability (PONV) conversion (5.125%), but these requirements fall in dollar terms due to the decline in average RWA
  • The Capital Conservation Buffer (CCB) – will be increased by 150 basis points (but only for IRB ADIs)
  • The default Countercyclical Capital Buffer (CCyB) – will be set at 100 basis points (versus zero under the current approach)

Minimum capital requirements

At face value, a reduction in minimum capital requirements sounds like a cause for concern. In theory you can argue that there is a slightly lower amount of CET1 capital available in a scenario in which a bank has breached the PONV threshold that triggers the conversion of Additional Tier 1 and any other layers of loss absorbing capital. In practice, however, this theoretical risk is more than offset by the increase in the CCB and the CCyB. APRA is at pains to emphasise that, all other things being equal, the dollar value of capital that ADI’s currently hold consistent with the Unquestionably Strong benchmarks introduced in 2017 does not change under the revised framework.

With amendments across a number of dimensions, reported capital ratios will inevitably change … However, APRA remains committed to its previous position that an ADI that currently meets the ‘unquestionably strong’ benchmarks under the current framework should have sufficient capital to meet any new requirements. Changing the presentation of capital ratios will not impact overall capital strength or the quantum of capital required to be considered ‘unquestionably strong’; but instead improves comparability, supervisory flexibility and international alignment.

“A more flexible and resilient capital framework for ADIs, APRA Discussion Paper, 8 December 2020 (page 5)

In addition to the increased base levels of CET1, the systemically important ADI are holding increasing amounts of “Additional Loss Absorbing Capital” that can be bailed-in to create CET1 capital in the event that a bank is at risk of breaching the PONV threshold. There are differences of opinion on whether APRA would be willing to pull the trigger to convert these instruments. We won’t know for sure until the time comes, but my colours are nailed to the assumption that APRA will much prefer to see shareholders get diluted rather than having to use government funds to bail-out a bank.

Capital Conservation Buffer

The 150bp expansion in the CCB only applies to IRB ADIs. APRA attributes this to the need to respond to “the greater level of risk sensitivity inherent in the IRB approach” (page 16 of the Discussion Paper). They don’t actually use the term but I think of this as a means of absorbing some of the pro-cyclicality that is inherent in any risk sensitive capital adequacy measure.

A simple way to think about this change is to link the 150bp increase to the roughly equivalent benefit of the 10% decline in RWA expected to flow from RWA changes set out in the paper. We note however that SA gets 7% decline due to improved risk sensitivity but no equivalent increase in CCB. So we get enhanced risk sensitivity in the IRB approach via the revised risk weights without exacerbating the concern about the difference in capital requirements.

However the increased risk sensitivity of the IRB approach also manifests in heightened sensitivity to an economic downturn. All other things being equal both Standardised and IRB ADIs should face similar increases in loan loss charges. The impact on IRB ADI capital ratios is however amplified by the increase in average RWs under stress. I don’t have any hard data to refer to but would not be surprised if the RWA inflation effect contributed another 150bp to the decline in capital ratios we see quoted in stress testing results under this new framework.

Viewed from this perspective the expanded CCB not only neutralises the benefit of lower IRB risk weights, it also helps absorb the increased sensitivity to declines in capital ratios that IRB ADIs can be expected to experience under a stress scenario.

Counter-cyclical Capital Buffer

The CCyB has, for me at least, always been a sound idea badly executed. It 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 Basel Committee 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 whatever that might be) 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 pro-actively responding to excess credit growth has been a core part of the rationale underpinning its development.

The idea of having a buffer that can be released in response to a downturn makes perfect sense but the analytical structure the Basel Committee developed to guide its deployment seems unnecessarily complex. The simple non-zero default level that APRA proposes to adopt is arguably a better (if not the best) approach and one that other countries are already pursuing (see here, here and here).

None of this pro-cyclicality benefit is spelled out in the material APRA released so I may be reading too much into the material. If I am analysing it correctly if is a subtle but still useful benefit of the package of changes that APRA is pursuing.


Broadly speaking, I think there is a lot to like in the revised framework that APRA is pursuing

  • Risk weights that are both more risk sensitive but also more closely aligned under the two approaches to capital adequacy measurement (IRB and Standardised)
  • An increased share of the capital requirement allocated to buffers that can be used rather than minimum requirements that can’t
  • A better approach to setting the CCyB

My primary concern is that the amplified pro-cyclicality in capital ratios that is seemingly inherent in any risk sensitive capital framework seems likely to increase but there is very little discussion of this factor . There are tools to manage the impact but one of the key lessons I have taken away from four decades in this game is that the markets hate surprises. Far better to quantify the extent of any amplified pro-cyclicality in capital ratios prior to the next crisis than to try to explain the impacts when capital ratios start to decline more quickly than expected during the next downturn/crisis.

Let me know what I am missing …

Tony – From the Outside

Some of the backstory

The idea that Australian banks needed to be “Unquestionably Strong” has dominated the local capital adequacy discussion for the past few years. The idea originated in a recommendation of the Australian Financial System Inquiry (2014) based on the rationale that Australian banks should both be and, equally importantly, be perceived to be more resilient than the international peers with which they compete for funding in the international capital markets.In July 2017, APRA translated the FSI recommendation into practical guidance in an announcement supported by a longer information paper.

For most people, this all condensed into a very simple message, the systemically important Australian banks needed to maintain a Common Equity Tier 1 ratio of at least 10.5%. The smaller banks have their own Unquestionably Strong benchmark but most of the public scrutiny seems to have focussed on the larger banks.

In the background, an equally important discussion has been playing out regarding the extent to which the Unquestionably Strong framework should take account of the “comparability” and “transparency” of that measure of strength and the ways in which “flexibility” and “resilience” could be added to the mix. This discussion kicked off in earnest with a March 2018 discussion paper (covered in more detail here) and has come to a conclusion with the December 2020 release of the APRA Discussion Paper explored in the post above.

Allowing companies to fail

I suspect (but can’t prove) that creative destruction is one of the under appreciated factors that underpin the health of the economy. There is quite a lot of evidence however that creative destruction has been suppressed since the 2008 Global Financial Crisis. The rights and wrongs of the extent to which bail-outs were and continue to be necessary is too big a topic to cover in this post.

For the record, I do believe that the bail-outs of the banks were necessary at the time but that “bail-in” gives bank supervisors a very real option to avoid having to do this in the future. The increase in capital requirements are also likely to reduce the risk of a bail-in being required. Others may disagree and my views chiefly relate to the Australian banking system which is where my professional expertise is based. The issues associated with COVID-19 raise a whole lot of related but, in many ways, different issues. At the risk of stating the obvious, it’s complicated.

Against that background, I found this short article published on the VoxEU website worth reading as another reminder of the value of allowing companies to fail and/or be restructured. The conclusion of the article (copied below) gives you the key points the authors derive from their research

We investigate a large number of stakeholders that could be negatively affected by a fire sale but find little evidence for negative externalities. The main effect of fire sales is a wealth transfer from the seller to the buyer. Thus, from a welfare perspective, the costs associated with fire sales of corporate assets are much lower than previously thought based on an analysis of seller costs only. From a policy perspective, these findings indicate that the merits of bailouts as a response to the potential losses associated with fire sales are limited, especially given the moral hazard and the other distortions caused by these bailouts. 

We recognise that the economic shock caused by the COVID-19 pandemic is unparalleled since the WWII and the Great Depression, and hence, some emergency measures and bailouts were likely necessary to prevent a meltdown of economic activity. However, one difference between the current crisis and the Global Crisis is the apparent lack of fire sales of struggling companies or investments into such companies at fire-sale prices. Warren Buffett’s Berkshire Hathaway, for instance, invested $5 billion in Goldman Sachs in September 2008 and $3 billion in General Electric in October 2008, while Warren Buffett’s firm has not undertaken any major investments during the COVID-19 crisis (Financial Times 2020). Our results therefore suggest that, at least at the margin, fire sales would have been an effective alternative to bailouts, especially for large bailouts such as for the airlines in the US.

“The merits of fire sales and bailouts in light of the COVID-19 pandemic”, Jean-Marie Meier and Henri Servaes, 18 January 2021.

Dee Hock, the Father of Fintech

Marc Rubinstein writing in his “Net Interest” newsletter has a fascinating story about the history of Visa. The article is interesting on a number of levels.

It is partly a story of the battle currently being played out in the “payments” area of financial services but it also introduced me to the story of Dee Hock who convinced Bank of America to give up ownership of the credit card licensing business that it had built up around the BankAmericard it had launched in 1958. His efforts led to the formation of a new company, jointly owned by the banks participating in the credit card program, that was the foundation of Visa.

The interesting part was that Visa was designed from its inception to operate in a decentralised manner that balanced cooperation and competition. The tension between cooperation (aka “order”) and competition (sometimes leading to “disorder”) is pervasive in the world of money and finance. Rubinstein explores some of the lessons that the current crop of decentralised finance visionaries might take away from this earlier iteration of Fintech. Rubinstein’s post encouraged me to do a bit more digging on Hock himself (see this article from FastCompany for example) and I have also bought Hock’s book (“One from Many: VISA and the Rise of Chaordic Organization“) to read.

There is a much longer post to write on the issues discussed in Rubinstein’s post but that is for another day (i.e. when I think I understand them so I am not planning to do this any time soon). At this stage I will just call out one of the issues that I think need to be covered in any complete discussion of the potential for Fintech to replace banks – the role “elasticity of credit” plays in monetary systems.

“Elasticity of credit”

It seems pretty clear that the Fintech companies offer a viable (maybe compelling) alternative to banks in the payment part of the monetary system but economies also seem to need some “elasticity” in the supply of credit. It is not obvious how Fintech companies might meet this need so maybe there remains an area where properly regulated and supervised banks continue to have a role to play. That is my hypothesis at any rate which I freely admit might be wrong. This paper by Claudio Borio offers a good discussion of this issue (for the short version see here for a post I did on Borio’s paper).


Tony – From the Outside

The potential for computer code to supplant the traditional operating framework of the economy and society

I am very far from expert on the issues discussed in the podcast this post links to, I am trying however to “up-skill”. The subject matter is a touch wonky so this is not a must listen recommendation. That said, the questions of DeFi and cryptocurrency are ones that I believe any serious student of banking and finance needs to understand.

In the podcast Demetri Kofinas (Host of the Hidden Forces podcast) is interviewed by two strong advocates of DeFi and crypto debating the potential of computer code to supplant legal structures as an operating framework for society. Demetri supports the idea that smart contracts can automate agreements but argues against the belief that self-executing software can or should supplant our legal systems. Computer code has huge potential in these applications but he maintains that you will still rely on some traditional legal and government framework to protect property rights and enforce property rights. He also argues that it is naïve and dangerous to synonymize open-source software with liberal democracy.

I am trying to keep an open mind on these questions but (thus far) broadly support the positions Demetri argues. There is a lot of ground to cover but Demetri is (based on my non-expert understanding of the topic) one of the better sources of insight I have come across.

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