The impending transition to an increased level of Loss Absorbing Capital has prompted speculation on whether this means that the assumption of government support embedded in the senior debt rating of the large Australian banks remains appropriate. This speculation is fuelled in part by precedents established in the European Union and United States where the implementation of increased loss absorption requirements has resulted in the assessment of government supportiveness being downgraded.
Standard and Poor’s addressed this question in the Australian context and the short answer is that continued high government support is the probable outcome.
“In our view, this framework does not propose–nor have the authorities more broadly taken–any concrete actions that would suggest reduced government support despite the stated intent to reduce the implicit government guarantee and the perception that some banks are too big to fail”“Australian Government Support For Banks: Will There Be More Twists In The Tale?, 8 April 2019 – S&P Global RatingsDirect
APRA’s proposed framework for increased loss absorption
Before digging into the detail of why S&P continue to believe the Australian Government will most likely remain “highly supportive” of systemically important banks, it will be useful to quickly revisit the discussion paper APRA published in November 2018 setting out its proposed response to the Financial System Inquiry recommendation that the Government “Implement a framework for minimum loss absorbing and recapitalization capacity in line with emerging international practice, sufficient to facilitate the orderly resolution of Australian authorised deposit-taking institutions (ADIs) and minimize taxpayer support”.
APRA proposed that selected Australian banks (mostly D-SIBs) be required to hold more loss absorbing capital via an increase in the minimum Prudential Capital Requirement (PCR) applied the Total Capital Ratio (TCR) they are required to maintain under Para 23 of APS 110.
“The minimum PCRs that an ADI must maintain at all times are:APS 110 Paragraph 23
(a) a Common Equity Tier 1 Capital ratio of 4.5 per cent;
(b) a Tier 1 Capital ratio of 6.0 per cent; and
(c) a Total Capital ratio of 8.0 per cent.
APRA may determine higher PCRs for an ADI and may change an ADI’s PCRs at any time.”
This means that banks have discretion over what form of capital they use but it is assumed they will choose Tier 2 capital as the lowest cost way to meet the requirement.
A post I did on APRA’s discussion paper, identified 5 issues posed by APRA’s proposed response including the question “To what extent would the public sector continue to stand behind the banking system once the proposed level of self insurance is in place?”. My assessment at that time was that …
“… the solution that APRA has proposed seems to me to give the official family much greater options for dealing with future banking crises without having to call on the taxpayer to underwrite the risk of recapitalising failed or otherwise non-viable banks.
It does not, however, eliminate the need for liquidity support. ... The reality is that banking systems built on mostly illiquid assets will likely face future crises of confidence where the support of the central bank will be necessary to keep the financial wheels of the economy turning. ….
… the current system requires the central bank to be the lender of last resort. That support is extremely valuable and is another design feature that sets banks apart from other companies. It is not the same however, as bailing out a bank via a recapitalisation.“Does more loss absorption and “orderly resolution” eliminate the TBTF subsidy”, posted on From The Outside (November 2018)
I noted that the proposed increase in loss absorbing capital would give APRA and the RBA much greater options for dealing with the solvency aspect of any future crisis but my main point in that initial response to the policy proposal was that the need for a liquidity support backstop remained. In my experience, solvency and liquidity are frequently conflated in the public discussion of bail-outs and my point was that recognising that they are not the same facilitates a more sensible discussion of the role of bail-in and government support. The steps APRA is proposing to take to reduce the implied level of government support do not change the fact that the central bank standing ready to act as the Lender of Last Resort (“LOLR”) will remain a design feature of the financial system we have, not a bug.
The distinction between solvency an liquidity is important but, with the benefit of hindsight, I should have paid equal attention to the extent to which the Australian government might still be expected to go beyond liquidity support if required and the way in which the Australian approach to bail-in differs from that being developed in the U.S. and the E.U.
Standard and Poors continues to rate the Australian government as “highly supportive”
Notwithstanding some ambiguity introduced by the government’s response to the FSI recommendation, S&P continue to believe that the Australian government will remain “highly supportive” towards the systemically important private sector banks. They clarify that support in this context means “… the propensity of a government to provide extraordinary support (typically a capital injection) …”.
The factors underpinning S&P’s (admittedly subjective) assessment are:
- The Australian economy’s dependence on continued access to offshore funding via the Australian banks
- The potential risk of contagion across the four major banks due to their interconnectedness
- No evidence of in-principle political or social opposition to government support should it prove necessary
- APRA’s proposed framework for increased loss absorption does not hinder government support (in contrast to the resolution frameworks adopted in the European Union and the United States where bail-in is a pre-requisite for a government funded bail-out)
- Notwithstanding the broad range of powers that APRA has for dealing with a stressed financial institution, S&P do not see any clearly laid out framework that would allow senior creditors to be captured by a bail-in
- A track record of prompt and decisive action to support banks where required.
The ambiguity referenced above stems from the Government’s response to the FSI in which it stated that it “… agrees that steps should be taken to reduce any implicit government guarantee and the perception that some banks are too big to fail”.
My prior post referred to APRA’s proposed solution giving “… the official family much greater options for dealing with future banking crises without having to call on the taxpayer…”. The fact that the government will have the option to use pre-positioned capital instruments to recapitalise failing banks in the future does not necessarily mean that they have forgone the option of using public funds, if that is deemed to be a better (or least worst) option. It is also worth noting that the Government’s response itself does not contemplate eliminating the implicit guarantee and the perception that some banks are too big to fail, simply to reducing them.
What would stop the Government using bail-in to recapitalise a bank?
The interesting question here is what would preclude the government from using the bail-in option, choosing instead to use public funds to recapitalise one or more non-viable banks. So long as investors in these instruments bought them with full knowledge of the downside, there is no obvious reason why they should be protected. The bigger issue seems to be whether the banking system can cope with this particular class of investor temporarily choosing to withdraw from funding Australian banks.
Here I think it is important to distinguish between a constraint on access to senior funding and a constraint on access to the kinds of contingent debt/capital instruments used to meet the Total Loss Absorption Requirement. The history of bond defaults suggests that investors eventually forgive or forget but it is also safer to assume that any banking system subject to bail-in might be temporarily excluded from access to the kinds of contingent convertible debt instruments that were used to recapitalise it.
That I suspect is a manageable scenario provided the recapitalisation of the banking system is sufficient to address any concerns that the senior bond holders may have regarding the solvency and/or viability of the banks impacted. Some degree of over-capitalisation of the banks may be necessary to achieve this and the cost of funding can be expected to increase also. This is part of the price of failure. There is however no in principle reason why bail-in of Additional Tier 1, Tier 2 and Tier 3 capital should impact the senior debt so long as it is clear that senior debt is not subject to the same risk of bail-in.
In the absence of access to Additional Tier 1, Tier 2 or Tier 3 capital, these banks will probably be required to temporarily rely on a greater share of common equity to meet their Total Capital Requirement but that can be regenerated through profit retention. I don’t see the capital rebuilding task being materially different to what would have applied if the bank was initially required to meet its TLAC requirement entirely via CET1 capital (as the RBNZ proposes). This is also where the official family can provide liquidity support with minimal risk of the taxpayer facing a loss. Once the bank has regained the trust of the investors, the option of increasing the share of non CET1 capital in the TLAC mix can be re-established.
The importance of the assumption of government support should not be underestimated
This is a complex topic and one where reasonable people can form different interpretations of the facts so let me know if I am missing something …
Table 1 from the S&P report illustrates that an improvement in the Stand Alone Credit Profile (SACP) of one of the Australian majors is not enough on its own to offset a downgrade in S&P’s assessment of government supportiveness. The SACP of the Australian majors is currently assessed at “a-” with government support translating to a 2 notch improvement in the Issuer Credit Rating (ICR) to “AA-“. If the government support assessment is downgraded, the ICR declines 1 notch to “A+” and is not improved even if the SACP is enhanced to “a”.