Risk weights, capital and competition in the residential mortgage market

I have posted a couple of time on a Discussion Paper published by The Australian Prudential Regulation Authority (APRA) in late 2020 (“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 (see here, here and here).

This post looks at the changes to mortgage risk weights (RW) outlined in the paper and attempts to explore (with limited information) what practical impact they might have. The short version is:

  • In very broad terms, APRA is seeking to assign higher RW to residential mortgages it deems to be relatively more risky but also lower RW for those it considers less risky
  • In pursuit of this objective, APRA has proposed two new categories of residential mortgage defined by the loan purpose (i.e. “Owner occupier loans paying principal and interest” and “Other Residential” including loans for investment and all interest only loans upon to 5 years tenor)
  • “Standard residential” mortgages see increased sensitivity of RW to Loan Valuation Ratios (LVR) while “Non-Standard residential mortgages face a 100% RW across the board irrespective of their LVR
  • Increased sensitivity to LVR is achieved via a simple recalibration of RW in the Standardised approach and via a reduction in the minimum Loss Given Default (LGD) applied in the IRB approach
  • The reduced LGD floor also indirectly allows Lenders’ Mortgage Insurance (LMI) to be recognised in the IRB models thereby creating greater alignment with the Standardised approach which directly recognises the value of LMI via a roughly 20% discount in the RW assigned to high LVR loans
  • With respect to the impact of RW on competition, APRA argues both that the existing difference between the Standardised and IRB approach is overstated and that the proposed changes will further assist the Standardised ADIs to compete.

APRA is not tinkering at the margins – there are quite substantial adjustments to RWs for both Standardised and IRB ADIs. That is the short version, read on if you want (or need) to dig into the detail.

Improved risk sensitivity cuts both ways

I have looked at “improved risk sensitivity” part of the overall package previously but, with the benefit of hindsight, possibly focussed too much on the expected reduction in aggregate risk weighted assets (RWA) coupled with the expansion of the capital buffers.

It is true that RWA overall are expected to decline – APRA estimated that the overall impact of the proposed revisions would be to reduce average RWAs for IRB ADIs by 10% and by 7% for Standardised ADIs. This obviously translates into higher reported capital ratios which is the impact I initially focussed on. Risk sensitivity however works both ways and a subsequent reading of the paper highlighted (for me at least) the equally important areas in which RW are proposed to increase – residential mortgages in particular.

APRA’s proposed revised approach to residential mortgage risk

APRA was very clear that one of their overall policy objectives is to “further strengthen capital requirements for residential mortgage exposures to reflect risks posed by ADIs’ structural concentration in this asset class“. In pursuit of this objective, APRA is targeting investment and interest only lending in particular but also high LVR lending in general.

In pursuit of these aims, the existing “standard residential mortgage” category is to be further broken down into 1) “Owner Occupied Principal and Interest” loans (OP&I) and 2) “Other Residential”. The “non-standard residential mortgages category (i.e. loans that do not conform to the credit risk origination standards prescribed by APRA) is to be expanded to include interest only loans with a tenor greater than 5 years.

So we get three broad vertical categories of residential mortgage riskiness

Low RiskHigher risk Highest risk
Owner Occupied
Principal & Interest
– Interest Only (term <5yrs)
– Investor mortgage loans
– Loans to SME secured by residential property
– Interest Only (term >5yrs)
– “Non-standard” mortgages
Note: RW are reduced where loans are covered by LMI but only for Standard Residential Mortgages and only where LVR is above 80%. To be classified as a “standard” mortgage a loan must satisfy minimum enforceability, serviceability and valuation criteria prescribed by APRA.
Impact on the Standardised ADIs

The table below compares the current RWs under the standardised approach (Source: Table 2 of APS 112 – Attachment C) with the indicative RWs APRA has proposed in the December 2020 Discussion Paper (Source: Table 2).

Residential Mortgage Risk Weights – Current and Proposed for Standardised ADIs

The RW within each of the three categories are being substantially recalibrated – APRA is not tinkering at the edges.

  • Increased sensitivity to LVR translates to higher RW applying in the upper LVR range but also reductions in the lower LVR range.
  • The increases in the high LVR ranges are particularly marked in the new “Other Residential” category (30-40% increases) but the reductions in the low LVR range are equally material (14-42%) for the OP&I category
  • Lender’s Mortgage Insurance (LMI) continues to be recognised at the high end of the LVR range (i.e. 80% plus) but the RW assigned to loans with LMI are higher than is currently applied.
  • In case anyone was wondering how APRA really felt about non-standard residential mortgages they receive a 100% RW irrespective of their LVR.
Risk weights under the Internal Ratings Based (IRB) Approach

It is a lot harder to figure out exactly what will happen to IRB RW but the starting point is the two new multipliers being added to the IRB RW formula. The OP&I multiplier adds 40% to RW while the Other Residential category gets a 60% loading. These replace the existing “correlation adjustment” factor that was applied to increase the average IRB RW for residential mortgages to a minimum of 25% as part of the effort to reduce the difference between IRB and Standardised capital requirements.

In aggregate, my guess is that the impacts are roughly neutral in the case of the “Other Residential” loans subject to the 60% loading and a net reduction for the OP&I category. The substitution of flat scalars for the existing correlation adjustment does however create some impacts at the upper and lower ends of the PD scale. Under the correlation approach, my understanding is that low PD exposures increase by proportionately more than the average impact and high PD exposures by less. Under scalar approach, the RW are increased by the same percentage across the PD scale. I am not sure how material the impacts are but mention them for completeness. The flat scalars certainly have the advantage of simplicity and transparency but mostly they establish a RW differential between the two types of standard residential mortgage.

The reduced LGD floor is a significant change because it offers the potential for RW to be halved for exposures that can take the maximum advantage. Consistent with the revised standardised RW, I assume that this will be at the lower end of the LVR range. IRB ADIs will have to work for this benefit however as APRA will first have to approve their LGD models. Some ADIs might be well advanced on this front but as a general rule risk modellers tend to have plenty to do and it is hard to see these models having been a priority while the 20% floor has been in place.

It is also worth noting that the risk differential between OP&I and Other Residential mortgages implied by the multipliers employed in the IRB approach is 14% (i.e. 1.6/1.4) is lower than the 20-30% difference in RW proposed to apply in the Standardised approach. This seems to reflect APRA’s response to comments received (section 4.3 of “Response to Submissions”) that the application of different multipliers could double count risks already captured in the PD and LGD assigned to the two different categories of lending by the IRB risk models.

Impacts, implications and inferences

I can see a couple of implications that follow from these proposed changes

  1. LGD models start to matter
  2. The unquestionably strong benchmark is reinforced
  3. Potential to change the competition equilibrium between the big and small banks
LGD models start to matter

The IRB framework has been a part of the Australian banking system for close to two decades but the 20% LGD Floor has meant that residential mortgage LGD models mostly don’t matter, at least for the purposes of measuring capital adequacy requirements. I am not close enough to the action to know exactly what choices were made in practice but the logical response of credit risk modellers would be to concentrate on models that will make a difference.

APRA’s decision to reduce the LGD floor changes the calculus, IRB ADIs now have an incentive to invest the time and resources required to get new LGD models approved. Loan segments able to take full advantage of the 10% floor will be able to more than offset the impact of the multipliers. The LGD has a linear impact on risk weights so a halving from 20 to 10 percent will see risk weights also halve more than offsetting the 40 to 60% loadings introduced by the multipliers.

Exactly where the cut off lies remains to be seen but it seems reasonable to assume that the increases and decreases proposed in standardised risk weights are a reasonable guide to what we might expect in IRB risk weights; i.e. LGD may start to decline below 20% somewhere around the 70% LVR with the maximum benefit (10% LGD) capping out for LVR of say 50% and below. I have to emphasise that these are just semi educated guesses (hopefully anyway) and I am happy to be corrected by anyone with practical experience in LGD modelling. The main point is that LGD modelling will now have some practical impact so it will be interesting to watch how the IRB ADI respond.

Unquestionably strong is reinforced

On one level, it could be argued that the changes in risk weights don’t matter. ADIs get to report higher capital ratios but nothing really changes in substance. Call me a wide-eyed, risk-capital idealist but I see a different narrative.

First up, we know that residential mortgages are a huge risk concentration for the Australian banks so even small changes can have an impact on their overall risk profiles.

“While an individual residential mortgage loan does not, on its own, pose a systemic risk to the financial system, the accumulation of lending by almost all ADIs in this asset class means that in aggregate the system is exposed to heightened risks”

APRA Discussion Paper, “A more flexible and resilient capiutral framework for ADIs”, 8 December 2020 (page 12)

To my mind, the proposed changes can work in a combination of two ways and both have the potential to make a difference. The decline in residential mortgage risk weights is largely confined to loans originated at low LVRs – less than 70% in the case of “Owner-Occupied Principal and Interest” and less than 60% in the case of “Other Residential”. High LVR risk weights (i.e. 90% plus) are reduced for Owner Occupied Principal and Interest without LMI but my understanding is that these kinds 0f loans are exceptions to the rule, granted to higher quality borrowers and not a large share of the overall exposure. High LVR loans as a rule will face higher risk weights under the proposed changes and materially higher in the case of the “Other Residential” category.

In the low LVR lending, the decline in risk weights seems to be largely offset by higher capital ratio requirements via the increased buffers. In the case of the higher risk, high-LVR lending, the higher capital ratio requirements add to the overall dollar capital requirement.

Competition in residential mortgage lending

APRA has explicitly cited “enhancing competition” as one of their objectives. I don’t have enough hard data to offer any comprehensive assessment of the extent to which competition will be enhanced. The one thing I think worth calling out is the substantial reduction in RW assigned to low LVR loans under the Standardised approach. The table below maps the changes in RW with data APRA publishes quarterly on the amount of loans originated at different LVR bands.

Owner occupiers who have managed to substantially reduce the amount they owe the bank have always been an attractive credit risk; even better if appreciation in the value of their property has further reduced the effective LVR. The proposals reinforce the attraction of this category of borrower. The IRB ADIs will not give up these customers without a fight but the Standardised ADI will have an enhanced capacity t0 compete in this segment via the reduced RW.

At this stage we can only speculate on impacts as the final form of the proposals may evolve further as APRA gets to see the results of the Quantitative Impact Statements that the ADI’s are preparing as part of the consultation process.

Summing up

We are still some way way from seeing the practical impact of these changes and we need to see the extent to which the proposals are refined in response to what APRA learns from the QIS. There does however seem to be potential for the economics of residential mortgage lending to be shaken up so this is a development worth keeping an eye on.

Tony – From the Outside

Capital adequacy is not always intuitive

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

The backstory thus far is that:

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

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

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

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

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

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

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

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

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

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

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

Tony – From the Outside

Westpac considers its options in NZ

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

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

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

As a rule, APRA’s general capital treatment of equity exposures requires that they be fully deducted from CET1 Capital in order to avoid double counting of capital. The existing rules (APS 111) however provides a long-standing variation to this general rule when measuring Level 1 capital adequacy. This variation allows an ADI at Level 1 to risk weight (after first deducting any intangibles component) its equity investments in banking and insurance subsidiaries. The risk weight is 300 percent if the subsidiary is listed or 400 per cent if it is unlisted.

APRA recognises that this improves the L1 ratios by around 100bp versus what would be the case if a full CET1 deduction were applied but was comfortable with that outcome based on exposure levels that preceded the RBNZ change in policy.

The RBNZ’s move towards higher CET1 requirements however undermines this status quo and potentially sees a greater share of the overall pool of equity in the group migrate from Australia to NZ. APRA recognises of course that the RBNZ can do whatever it deems best for NZ depositors but APRA equally has to ensure that the NZ benefits do not come at the expense of Australian depositors (and other creditors).

To address this issue, APRA has proposed to amend APS 111 to limit the extent to which an ADI may use debt to fund investments in banking and insurance subsidiaries.

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

As APRA is more concerned about large concentrated exposures, it proposed to limit the amount of the exposure to an individual subsidiary that can be leveraged to 10 per cent of an ADI’s CET1 Capital. This means capital requirements are increasing for large concentrated exposures, as amounts over the 10 per cent threshold would be required to be met dollar-for-dollar by the ADI parent company.

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

Tony – From the Outside

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.

Conclusion

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.

The dark art of measuring residential mortgage risk

Residential mortgages are one of the seemingly more plain vanilla forms of bank lending. Notwithstanding, comparing capital requirements applied to this category of lending across different types of banks can be surprisingly complicated and is much misunderstood. I have touched on different aspects of this challenge in a number of mortgage risk weight “fact check” posts (see here and here), focussing for the most part on the comparison of “standardised” capital requirements compared to those applied to banks operating under the “internal rating based” (IRB) approach.

A discussion paper (“A more flexible and resilient capital framework for ADIs”, 8 December 2020) released by the Australian Prudential Regulation Authority (APRA) offers a good summary (see p27 “Box 2”) of the differences in capital requirements not captured by simplistic comparisons of risk weights. However, one of the surprises in the discussion paper was that APRA chose not to address one of these differences by aligning the credit conversion factors applied to off-balance sheet (non-revolving) residential mortgage exposures.

Understanding why APRA chose to maintain a different treatment of CCFs across the two approaches offers some insights into differences in the way that the two approaches recognise and measure the underlying risks.

Before proceeding we need to include a short primer on “off-balance exposures” and “CCFs”. Feel free to skip ahead if you already understand these concepts.

  • Off-balance sheet exposures are the difference between the maximum amount a bank has agreed to lend and the actual amount borrowed at any point in time.
  • The CCF is the bank’s estimate of how much of these undrawn limits will in fact have been called on (converted to an on balance sheet exposure) in the event a borrower defaults.
  • In the case of “non-revolving” residential mortgages, these off-balance sheet exposures typically arise because borrowers have got ahead of (“pre-paid”) their contractual loan repayments.

APRA noted that the credit conversion factor (CCF) currently applied to off-balance sheet exposures was much higher for IRB banks than for standardised, thereby partially offsetting the lower risk weights applied under the IRB approach. It had been expected that APRA would address this inconsistency by applying a 100% CCF under both approaches.

Contrary to this expectation, APRA has proposed to revise the CCFs applying to (non-revolving) off-balance sheet residential mortgage exposures as follows:

Current

Standardised 0-50%

IRB 100%

Proposed

40%

100% (unchanged)

The interesting nuance here is that APRA is not saying that standardised banks are likely to experience a lower percentage drawdown of credit limits in the event a borrower defaults. In the “Response to Submissions” that accompanied the Discussion Paper, APRA noted that “Borrowers do not typically enter default until they have fully drawn down on their available limit, including any prepayments ahead of their scheduled balance.

However, APRA also noted that loans with material levels of prepayment are also likely to be lower risk based on the demonstrated greater capacity to service and repay the loan.

Under the IRB approach, the greater capacity to repay the loan is generally recognised through a lower PD estimate which the IRB formula translates into lower risk weights reflecting the lower risk. In the absence of some equivalent risk recognition mechanism in the standardised approach, APRA is proposing to use a concessional CCF treatment to reflect the lower risk of loans with material levels of prepayment. It notes that the concessional CCF treatment will also contribute to ensuring the difference in residential mortgage capital requirements between the standardised and IRB approaches remains appropriate.

Summing up:

  • Looked at in isolation, 100% is arguably the “right” value for the CCF to apply to off-balance sheet exposures for a non-revolving residential mortgage irrespective of whether it is being measured under the standardised or IRB approach
  • But a “concessional” CCF is a mechanism (fudge?) that allows the standardised approach to reflect the lower risk associated with loans with material levels of prepayment

Tony – From the Outside

Low Risk Residential Mortgage Risk Weights

I have posted a number of times on the question of residential mortgage risk weights, either on the general topic of the comparison of the risk weights applied to the standardised and IRB ADIs (see here) or the reasons why risk weights for IRB ADIs can be so low (see here).

On the question of relative risk weights, I have argued that the real difference between the standardised and IRB risk weights is overstated when framed in terms of simplistic comparisons of nominal risk weights that you typically read in the news media discussion of this question. I stand by that general assessment but have conceded that I have paid insufficient attention to the disparity in risk weights at the higher quality end of the mortgage risk spectrum.

A Discussion Paper released by APRA offers a useful discussion of this low risk weight question as part of a broader set of proposals intended to improve the transparency, flexibility and resilience of the Australian capital adequacy framework.

In section 4.2.1 of the paper, APRA notes the concern raised by standardised ADIs…

A specific concern raised by standardised ADIs in prior rounds of consultation has been the difference in capital requirements for lending at low LVRs. Stakeholders have noted that the lowest risk weight under the standardised approach would be 20 per cent under the proposed framework, but this appears to be significantly lower for the IRB approach. In response to this feedback, APRA has undertaken further analysis at a more detailed level, noting the difference in capital requirements that need to be taken into account when comparing capital outcomes under the standardised and IRB approaches (see Box 2 above).

But APRA’s assessment is that the difference is not material when you look beyond the simplistic comparison of risk weights and consider the overall difference in capital requirements

APRA does not consider that there is a material capital difference between the standardised and IRB approaches at the lower LVR level. For loans with an LVR less than 60 per cent, APRA has estimated that the pricing differential that could be reasonably attributed to differences in the capital requirements between the two approaches would be lower than the differential at the average portfolio outcome.

In explaining the reasons for this conclusion, APRA addresses some misconceptions about the IRB approach to low LVR lending compared to the standardised approach

In understanding the reasons for this outcome, it is important to understand the differences in how the standardised and IRB approaches operate. In particular, there are misconceptions around the capital requirement that would apply to low LVR lending under the IRB approach. For example, it would not be appropriate to solely equate the lowest risk weight reported by IRB ADIs in market disclosures with low LVR loans. The IRB approach considers a more complex range of variable interactions compared to the standardised approach. Under the standardised approach, a low risk weight is assigned to a loan with a low LVR at origination.

One of the key points APRA makes is that IRB ADIs do not get to originate loans at the ultra low risk weights that have been the focus of much of the concern raised by standardised ADIs.

In particular, IRB estimates are more dynamic through the life of the loan, for example, they are more responsive to a change in borrower circumstances or movements in the credit cycle. Standardised risk weights generally do not change over the life of a loan. For an IRB ADI, the lowest risk weight is generally applied to loans that have significantly prepaid ahead of schedule. A low LVR loan on the standardised approach is not necessarily assigned the lowest risk weight under the IRB approach at origination.

APRA states that it is not appropriate to introduce “dynamic”factors into the standardised risk weight framework.

APRA is not proposing to include dynamic factors in determining risk weights under the standardised approach for the following reasons:

– the standardised approach is intended to be simple and aligned with Basel III. For the standardised approach, APRA considers it more appropriate to focus on origination rather than behavioural variables as this has more influence on the quality of the portfolio and leads to less procyclical capital requirements; and

– the average difference between standardised and IRB capital outcomes is much narrower at the point of origination, which is the key point for competition. While the difference between standardised and IRB capital outcomes could widen over the life of the loan, APRA has ensured that the difference in average portfolio outcomes remains appropriate

But that it does intend to introduce a 5 per cent risk weight floor into the IRB approach to act as a backstop.

That said, APRA is proposing to implement a 5 per cent risk-weight floor for residential mortgage exposures under the IRB approach, to act as a simple backstop in ensuring capital outcomes do not widen at the lower risk segment of the portfolio. This is consistent with the approach taken by other jurisdictions and will limit the difference in capital outcomes between the standardised and IRB approaches for lower risk exposures. This risk-weight floor is in addition to other factors that will reduce the difference in capital outcomes between standardised and IRB ADIs, such as the higher CCB for IRB ADIs and lower CCF estimates for standardised ADIs.

As always, it remains possible that I am missing something. The explanation offered by APRA however gives me confidence that my broad argument about the overstatement of the difference has been broadly correct. Equally importantly, the changes to residential mortgage risk weights proposed in the Discussion Paper will further reduce the gap that does exist.

Tony – From the Outside

Capital adequacy – looking past the headline ratios

Comparing capital adequacy ratios is full of traps for the unwary. I recently flagged a speech by Wayne Byres (Chairman of APRA) that indicated APRA will be releasing a package of capital adequacy changes that will be more aligned with the international minimum standards and result in higher reported capital ratios.

While waiting for this package to be released, I thought it might be useful to revisit the mechanics of the S&P Risk Adjusted Capital (RAC) ratio which is another lens under which Australian bank capital strength is viewed. In particular I want to highlight the way in which the S&P RAC ratio is influenced by S&P’s assessment of the economic risks facing banks in the countries in which the banks operate.

The simplest way to see how this works is to look at an example from 2019 when S&P announced an upgrade of the hybrid (Tier 1 and Tier 2) issues of the Australian major banks. The senior debt ratings were left unchanged but the hybrid issues were all upgraded by 1 notch. Basel III compliant Tier 2 ratings were raised to “BBB+” (from “BBB”) and Tier 1 were raised to “BBB-” (from “BB+”).

S&P explained that the upgrade was driven by a revision in S&P’s assessment of the economic risks facing the Australian banks; in particular the “orderly decline in house prices following a period of rapid growth”. As a consequence of the revised assessment of the economic risk environment,

  • S&P now apply lower risk weights in their capital analysis,
  • This in turn resulted in stronger risk-adjusted capital ratios which now exceed the 10% threshold where S&P deem capital to be “strong” as opposed to “adequate”,
  • Which resulted in the Stand-Alone Credit Profile (SACP) of the Australian majors improving by one-notch and hence the upgrades of the hybrids.

Looking past the happy news for the holders of major bank hybrid issues, what was interesting was how much impact the revised assessment of the economic outlook has on the S&P risk weights. The S&P assessment of the economic outlook is codified in the BICRA score (short for the Banking Industry Country Risk Assessment) which assigns a numeric value from 1 (lowest risk) to 10 (highest risk). This BICRA score in turn determines the risk weights used in the S&P Risk Adjusted Capital ratio.

As a result of S&P revising its BICRA score for Australia from 4 to 3, the risk weights are materially lower with a commensurate benefit to the S&P assessment of capital adequacy (see some selected risk weights in the table below):

BICRA
Residential MortgagesBankCorporate, IPCRE, Business LendingCredit Cards
3302375105
4373387118
% Change
18.9%30.3%13.8%11.0%

The changes were fairly material across the board but the impact on residential mortgages (close to 20% reduction in the risk weight) is particulate noteworthy given the fact that this class of lending dominates the balance sheets of the Australian majors. It is also important to remember that, what the S&P process gives, it can also takeaway. This substantial improvement in the RAC ratio could very quickly reverse if S&P revised its economic outlook score or industry rating.

The other aspect of this process that is worth noting is the way in which the risk weights are anchored to S&P defined downturn scenarios and an 8% capital ratio. In the wake of the Royal Commission into Australian Banking, there has been a lot of focus on the idea of large banks being “Unquestionably Strong”. APRA subsequently determined that a 10.5% CET1 benchmark for capital strength was sufficient for a bank to be deemed to meet this test.

In that context, the S&P assessment that an 8-10% RAC ratio is “adequate” sounds a bit underwhelming. However, my understanding is the S&P risk weights are calibrated to an “A” or “substantial” stress scenario which is defined by the following Key Economic Indicators (KEI)

  • GDP decline of up to 6%
  • Unemployment of up to 15%
  • Stock market decline of ups to 60%

The loss rates expected in response to this level of stress are translated into equivalent risk weights using a 8% RAC ratio. The capital required by an 8% RAC ratio may only be “adequate” in S&P terms, but starts to look a lot more robust when you understand the severity of the scenario driving the risk weights that drive that requirement.

Summing up

I am not suggesting that there is anything fundamentally wrong with the S&P process, my purpose is simply to offer some observations regarding how the ratios in the capital adequacy assessment should be interpreted:

  1. Firstly to recognise that the process is by design anchored to an 8% capital ratio and risk weights that are calibrated to a very severe (“Substantial” is the term S&P uses) stress scenario, and
  2. Secondly, that the process is very sensitive to the BICRA score

This is not an area in which I will claim deep expertise so it is entirely possible that I am missing something. There are people who understand the S&P rating process far better than I do and I am very happy to stand corrected if I have mis-understood or mis-represented anything above.

Tony – From the Outside

Bank capital adequacy – APRA chooses Option 2

APRA released a discussion paper in August 2018 titled “Improving the transparency, comparability and flexibility of the ADI capital framework” which offered two alternative paths.

  • One (“Consistent Disclosure”) under which the status quo would be largely preserved but where APRA would get involved in the comparability process by adding its imprimatur to the “international harmonised ratios” that the large ADIs use to make the case for their strength compared to their international peers, and
  • A second (“Capital Ratio Adjustments”) under which APRA would align its formal capital adequacy measure more closely with the internationally harmonised approach.

I covered those proposals in some detail here and came out in favour of the second option. I don’t imagine APRA pay much attention to my blog but in a speech delivered to the AFR Banking and Wealth Summit Wayne Byres flagged that APRA do in fact intend to pursue the second option.

The speech does not get into too much detail but it listed the following features the proposed new capital regime will exhibit:

– more risk-based – by adjusting risk weights in a range of areas, some up (e.g. for higher risk housing) and some down (e.g. for small business);
 – more flexible – by changing the mix between minimum requirement and buffers, utilising more of the latter;
 – more transparent – by better aligning with international minimum standards, and making the underlying strength of the Australian framework more visible;
 – more comparable – by, in particular, making sure all banks disclose a capital ratio under the common, standardised approach; and
 – more proportionate – by providing a simpler framework suitable for small banks with simple business models.

while also making clear that

… probably the most fundamental change flowing from the proposals is that bank capital adequacy ratios will change. Specifically, they will tend to be higher. That is because the changes we are proposing will, in aggregate, reduce risk-weighted assets for the banking system. Given the amount of capital banks have will be unchanged, lower risk-weighted assets will produce higher capital ratios.

However, that does not mean banks will be able to hold less capital overall. I noted earlier that a key objective is to not increase capital requirements beyond the amount needed to meet the ‘unquestionably strong’ benchmarks. Nor is it our intention to reduce that amount. The balance will be maintained by requiring banks to hold larger buffers over their minimum requirements.

One observation at this stage …

It is hard to say too much at this stage given the level of detail released but I do want to make one observation. Wayne Byres listed four reasons for the changes proposed;

  1. To improve risk sensitivity
  2. To make the framework more flexible, especially in times of stress
  3. To make clearer the fundamental strength of our banking system vis-a-vis international peers
  4. To ensure that the unquestionably strong capital built up prior to the pandemic remains a lasting feature of the Australian banking system.

Pro-cyclicality remains an issue

With respect to increasing flexibility, Wayne Byres went on to state that “Holding a larger proportion of capital requirements in the form of capital buffers main that there is more buffer available to be utilised in times of crisis” (emphasis added).

It is true that the capital buffer will be larger in basis points terms by virtue of the RWA (denominator in the capital ratio) being reduced. However, it is also likely that the capital ratio will be much more sensitive to the impacts of a stress/crisis event.

This is mostly simple math.

  1. I assume that loan losses eating into capital are unchanged.
  2. It is less clear what happens to capital deductions (such as the CET1 deduction for Regulatory Expected Loss) but it is not obvious that they will be reduced.
  3. Risk Weights we are told will be lower and more risk sensitive.
  4. The lower starting value for RWA in any adverse scenario means that the losses (we assume unchanged) will translate into a larger decline in the capital ratio for any given level of stress.
  5. There is also the potential for the decline in capital ratios under stress to be accentuated (or amplified) to the extent the average risk weights increase in percentage terms more than they would under the current regime.

None of this is intended to suggest that APRA has made the wrong choice but I do believe that the statement that “more buffer” will be available is open to question. The glass is however most definitely half full. I am mostly flagging the fact that pro-cyclicality is a feature of any risk sensitive capital adequacy measure and I am unclear on whether the proposed regime will do anything to address this.

The direction that APRA has indicated it intends to take is the right one (I believe) but I think there is an opportunity to also address the problem of pro-cyclicality. I remain hopeful that the consultation paper to be released in a few weeks will shed more light on these issues.

Tony – From the Outside

p.s. the following posts on my blog touch on some of the issues that may need to be covered in the consultation

  1. The case for lower risk weights
  2. A non zero default for the counter cyclical capital buffer
  3. The interplay of proposed revisions to APS 111 and the RBNZ requirement that banks in NZ hold more CET1 capital
  4. Does expected loss loan provisioning reduce pro-cyclicality
  5. My thoughts on a cyclical capital buffer

Restructuring Basel’s capital buffers

Douglas Elliott at Oliver Wyman has written a short post which I think makes a useful contribution to the question of whether the capital buffers in the BCBS framework are serving their intended purpose.

The short version is that he argues the Countercyclical Capital Buffer (CCyB) has worked well while the Capital Conservation Buffer (CCB) has not. The solution he proposes is that the “the Basel Committee should seriously consider shrinking the CCB and transferring the difference into a target level of the CCyB in normal times”. Exactly how much is up for debate but he uses an example where the base rate for the CCyB is 1.0% and the CCB is reduced by the same amount to maintain the status quo.

The idea of having a non-zero CCyB as the default setting is not new. The Bank of England released a policy statement in April 2016 that had a non zero CCyB at its centre (I wrote about that approach in this post from April 2018). What distinguishes Elliott’s proposal is that he argues that the increased CCyB should be seeded by a transfer from the CCB. While I agree with many of his criticisms of the CCB (mostly that it is simply not usable in practice), my own view is that a sizeable CCB offers a margin of safety that offers a useful second line of defence against the risk that a bank breaches its minimum capital requirement. My perspective is heavily influenced by a concern that both bankers and supervisors are prone to underestimate the extent to which they face an uncertain world.

For anyone interested, this post sets out my views on how the cyclical capital buffer framework should be constructed and calibrated. This issue is especially relevant for Australian banks because APRA has an unresolved discussion paper which includes a proposal to increase the size of the capital buffers the Australian banks are expected to maintain. I covered that discussion paper here. A speech that APRA Chair Wayne Byres gave in May 2020 covering some of the things APRA had learned from dealing with the economic fallout of COVID-19 is also worth checking out (covered in this post).

Tony – From the Outside

APRA’s ADI capital regime – Unfinished business

Corporate Plans can be pretty dry reading but I had a quick skim of what is on APRA’s agenda for the next four years. The need to deal with consequences of COVID 19 obviously remains front and centre but APRA has reiterated its commitment to pursue the objectives laid out in its previous corporate plan.

Looking outward (what APRA refers to as “community outcomes”) there are four unchanged objectives

  • maintaining financial system resilience;
  • improving outcomes for superannuation members;
  • transforming governance, culture, remuneration and accountability across all regulated institutions; and
  • improving cyber resilience across the financial system.

Looking inward, APRA’s priorities are:

  • improving and broadening risk-based supervision;
  • improving resolution capacity;
  • improving external engagement and collaboration;
  • transforming data-enabled decision-making; and
  • transforming leadership, culture and ways of working.

What is interesting – from a bank capital management perspective

What I found interesting was a reference in APRA’s four year roadmap for strategy execution to a commitment to “Finalisation of ADI capital regime” (page 26). The schematic provides virtually no detail other than a “Milestone” to be achieved by December 2020 and for the project to be completed sometime in 2022/23.

Based on the outline in the strategic roadmap, my guess is that we will see a consultation paper on capital adequacy released later this year. I don’t have any real insights on exactly what APRA has in mind but a discussion paper APRA released in August 2018 titled “Improving the transparency, comparability and flexibility of the ADI capital framework” may offer some clues.

The DP outlines

“… options to modify the ADI capital framework to improve transparency and comparability of reported capital ratios. The main conceptual approaches APRA is considering and seeking feedback on are:

  • developing more consistent disclosures without modifying the underlying capital framework; and
  • modifying the capital framework by adjusting the methodology for calculating capital ratios.”

The First Approach– “Consistent disclosure” – seems to be a beefed up version of the status quo in which APRA gets more directly involved in the comparability process by adding its imprimatur to the internationally harmonised ratios some Australian banks currently choose to disclose as an additional informal measure of capital strength.

“Under this approach, ADIs would continue to determine regulatory capital ratios using APRA’s definitions of capital and RWA. However, APRA would also specify a methodology for ADIs to determine certain adjustments to capital and RWA that could be used for disclosure (Pillar 3) purposes. As noted above, the methodology would focus on aspects of relative conservatism that are material in size and able to be calculated simply and objectively.”

APRA argues that “The supplementary disclosure would allow all stakeholders to better assess the capital strength of an ADI on a more comparable basis. However, it would result in two APRA-endorsed capital ratios: an APRA regulatory capital ratio to be compared against minimum requirements, and an additional disclosure-only capital ratio for, in particular, international comparison.”

Second Approach – “Capital ratio adjustments” would involve APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and RWA.

The DP explains that this “… alternative approach would involve APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and RWA. This would involve removing certain aspects of relative conservatism from ADIs’ capital ratio calculations and lifting minimum regulatory capital ratio requirements in tandem. This increase in regulatory capital ratio requirements could be in the form of a transparent adjustment to minimum capital ratio requirements—for the purposes of this paper, such an adjustment is termed the ‘APRA Overlay Adjustment’.”

“To maintain overall capital adequacy, the APRA Overlay Adjustment would need to be calculated such that the total dollar amount of Prudential Capital Requirement (PCR) and Capital Conservation Buffer (CCB) would be the same as that required if these measures were not adopted. In other words, the risk-based capital requirements of ADIs would be unchanged in absolute dollar terms, maintaining financial safety, but adjustments to the numerator and the denominator of the capital ratio to be more internationally comparable would increase reported capital ratios.”

APRA clarify that

“These options are not mutually exclusive, and there is potential for both approaches to be adopted and applied in different areas.”

I offered my views on these options here.

Tony – From the Outside