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

Capital adequacy reform – new learnings from the crisis

A speech by APRA Chair Wayne Byres released today had some useful remarks on the post 2008 capital adequacy reforms and what we have learned thus far. A few observations stood out for me. Firstly, a statement of the obvious is that the reforms are getting their first real test and we are likely to find areas for improvement

“… the post-2008 reforms will be properly tested, and inevitably we will find areas they can be improved.”

The speech clarifies that just how much, if any, change is required is not clear at this stage

“Before anyone misinterprets that comment, I am not advocating a watering down of the post-2008 reforms. It may in fact turn out they’re insufficient, and we need to do more. Maybe they just need to be reshaped a bit. I do not know. But inevitably there will be things we learn, and we should not allow a determination not to backtrack on reforms to deter us from improving them.”

Everyone is focused on fighting the COVID 19 fire at the moment but a discussion paper released in 2018 offered some insights into the kinds of reforms that APRA was contemplating before the crisis took priority. It will be interesting to see how the ideas floated in this discussion paper are refined or revised in the light of what we and APRA learn from this crisis. One of the options discussed in that 2018 paper involved “APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and RWA“. It was interesting therefore to note that the speech released today referred to the internationally comparable ratios rather than APRA’s local interpretation of Basel III.

“We had been working for some years to position our largest banks in the top quartile of international peers from a capital adequacy perspective, and fortuitously they had achieved that positioning before the crisis struck. On an internationally comparable basis, our largest banks are operating with CET1 ratios in the order of 15-16 per cent, and capital within the broader banking system is at a historical high – and about twice the level heading into the 2008 crisis.”

The speech makes a particular note of what we are learning about the capacity to use capital buffers.

“One area where I think we are learning a lot at present is the ability to use buffers. It is not as easy as hoped, despite them having been explicitly created for use during a crisis. One blockage does seem to be that markets, investors and rating agencies have all adjusted to contemporary capital adequacy ratios as (as the name implies) ‘adequate capital’. But in many jurisdictions, like Australia, ratios are at historical highs. We often hear concern about our major banks’ CET1 ratios falling below 10 per cent. This is even though, until a few years ago, their CET1 ratios had never been above 10 per cent and yet they were regarded as strong banks with AA ratings. So expectations seem to have shifted and created a new de facto minimum. We need to think about how to reset that expectation.”

I definitely agree that there is more to do on the use of capital buffers and have set out my own thoughts on the topic here. One thing not mentioned in the speech is the impact of procyclicality on the use of capital ratios.

This chart from a recent Macquarie Wealth Management report summarises the disclosure made by the big four Australian banks on the estimated impact of the deterioration in credit quality that banks inevitably experience under adverse economic conditions such as are playing out now. The estimated impacts collated here are a function of average risk weights calculated under the IRB approach increasing as average credit deteriorates. This is obviously related to the impact of increased loan loss provisioning on the capital adequacy numerator but a separate factor driving the capital ratios down via its impact on the denominator of the capital ratio.

There are almost certainly issues with the consistency and comparability of the disclosure but it does give a rough sense of the materiality of this factor which I think is not especially well understood. This is relevant to some some observations in Wayne Byres speech about the capital rebuilding process.

A second possible blockage is possibly that regulatory statements permitting banks to use their buffers are only providing half the story. Quite reasonably, what banks (and their investors) need to understand before they contemplate using buffers is the expectation as to their restoration. But we bank supervisors do not have a crystal ball – we cannot confidently predict the economic pathway, so we cannot provide a firm timetable. The best I can offer is that it should be as soon a circumstances reasonably allow, but no sooner. In Australia, I would point to the example of the way we allowed Australian banks to build up capital to meet their ‘unquestionably strong’ benchmarks in an orderly way over a number of years. We should not be complacent about the rebuild, but there are also risks from rushing it.”

Given that the estimated impacts summarised in the chart above are entirely due to “RWA inflation” as credit quality deteriorates, it seems reasonable to assume that part of the capital buffer rebuild will be generated by the expected decline in average risk weights as credit quality improves. The capital buffers will in a sense partly self repair independent of what is happening to the capital adequacy numerator.

I think we had an academic understanding of the capital ratio impact of this RWA inflation and deflation process pre COVID 19 but will have learned a lot more once the dust settles.

Tony – From the Outside

Bank dividends

Matt Levine’s “Money Stuff” column (Bloomberg) offers some interesting commentary on what is happening with bank dividends in the US. Under the sub heading “People are worried about dividends” he writes:

So, again, I am generally pretty impressed by the performance of bank regulation in the current crisis, but this is unfortunate:

US banks’ annual capital plans, due to be submitted to the Federal Reserve on Monday, are expected to include proposals to continue paying dividends, reinforcing comments from prominent bank chief executives in recent days, according to people familiar with the situation.

The bankers, including Goldman Sachs boss David Solomon, Morgan Stanley boss James Gorman and Citigroup chief Mike Corbat, argued that they had the means to continue paying dividends and that cutting them would be “destabilising to investors”.

“We’re in a very different position than what we see in Europe,” said Marty Mosby, a veteran banks analyst at Vining Sparks.

“How we set it up [post-crisis capital requirements] was to be able to not have those dividends collapse [in a crisis]. That’s what creates a financial crisis: when dividends start to be ratcheted lower that shakes confidence.”

What is unfortunate is not so much that U.S. banks want to continue paying dividends; for all I know some of them are so well capitalized and so well equipped to weather this crisis that they will actually make a lot of money and have plentiful profits to pay out to shareholders. What is unfortunate is that their explicit view is that cutting dividends would be destabilizing. Common shareholders are supposed to be the lowest-ranking claimants on a bank’s money. The point of equity capital is that you don’t have to pay it out, that it doesn’t create any cash drain in difficult times. But if your view is “we need to maintain our dividend every quarter or else there will be a run on the bank,” then that means that the dividend is destabilizing; it means that your common stock is really debt; it means that your equity capital is not as good—not as equity-like—as it’s supposed to be.

If you take seriously the claim that banks can’t cut dividends in a generational crisis, for fear of undermining investor confidence, then, fine, I guess, but then the obvious conclusion is that when times are good you can never let banks raise their dividends. Every time a bank raises its dividend, on this theory, it incurs more unavoidable quarterly debt and creates a new drain on its funding, one that can’t be turned off in the bad times for fear of being “destabilising to investors”

Bloomberg Opinion “Money Stuff” 7 April 2020

I get the argument that if banks have the means to pay a dividend then they should be free to make a commercial decision. People may however feel entitled to be skeptical given the ways in which some banks were slow to adjust to the new realities of the GFC. There is also a line where the position some US banks appear to be projecting risks becoming an expectation that the dividend should be stable even under a highly stressed and uncertain outlook. It is not clear if that is exactly what the US banks quoted in his column are saying but that is how Matt Levine frames it and it would clearly be a concern if that is their view. That does seem to a fair description of the view some investors and analysts are expressing.

Jamie Dimon seems to be offering a more nuanced perspective on this question. He has advised JP Morgan shareholders that the Board expects the bank to remain profitable under its base base projections but would consider suspending the dividend under an extremely adverse scenario.

Our 2019 pretax earnings were $48 billion – a huge and powerful earnings stream that enables us to absorb the loss of revenues and the higher credit costs that inevitably follow a crisis. For comparison, the Comprehensive Capital Analysis and Review (CCAR) results for 2020 that we submitted to the Federal Reserve in 2019 (which assumed outcomes like U.S. unemployment peaking at 10% and the stock market falling 50%) showed a decline in revenue of almost 20% and credit costs of approximately $20 billion more than what we experienced in 2019. We believe we would perform better than this if the Fed’s scenario were to actually occur. But even in the Fed’s scenario, we would be profitable in every quarter. These stress test results also show that following such a meaningful reduction in our revenue (and assuming we continue to pay dividends), our common equity Tier 1 (CET1) ratio would likely hold at a very strong 10%, and we would have in excess of $500 billion of liquid assets. 

Additionally, we have run an extremely adverse scenario that assumes an even deeper contraction of gross domestic product, down as much as 35% in the second quarter and lasting through the end of the year, and with U.S. unemployment continuing to increase, peaking at 14% in the fourth quarter. Even under this scenario, the company would still end the year with strong liquidity and a CET1 ratio of approximately 9.5% (common equity Tier 1 capital would still total $170 billion). This scenario is quite severe and, we hope, unlikely. If it were to play out, the Board would likely consider suspending the dividend even though it is a rather small claim on our equity capital base. If the Board suspended the dividend, it would be out of extreme prudence and based upon continued uncertainty over what the next few years will bring.

It is also important to be aware that in both our central case scenario for 2020 results and in our extremely adverse scenario, we are lending – currently or plan to do so – an additional $150 billion for our clients’ needs. Despite this, our capital resources and liquidity are very strong in both models. We have over $500 billion in total liquid assets and an incremental $300+ billion borrowing capacity at the Federal Reserve and Federal Home Loan Banks, if needed, to support these loans, as well as meet our liquidity requirements (these numbers do not include the potential use of some of the Fed’s newly created facilities). We could, of course, make our capital and liquidity buffer better by restricting our activities, but we do not intend to do that – our clients need us.

JP Morgan Chairman and CEO Letter to Shareholders 2019 Annual Report

Banks are cyclical investments – who knew?

Stress testing models must of course be treated with caution but what I think this mostly illustrates is that banks are highly cyclical investments. That may seem like a statement of the obvious but there was a narrative post GFC that banks were public utilities and that bank shareholders should expect to earn public utility style returns on their investments.

There is an element of truth in this analogy in so far as banks clearly provide an essential public service. I am also sympathetic to the argument that banking is a form of private/public partnership. This pandemic is however a timely reminder of the limits of the argument that banks are just another low risk utility style of business. Bank shareholders are much more exposed to the cyclical impacts than true utility investments.

In the interests of full disclosure, I have a substantial exposure to bank shares and I for one need a lot more than a single digit return to compensate for the pain that part of my portfolio is currently experiencing. The only upside is that I never bought into the thesis that banks are a low risk utility style investment requiring a commensurately low return.

The higher capital and liquidity requirements built up in response to the lessons of the GFC increase the odds that banks will survive the crisis and be a big part of the solution but banks are, and remain, quintessentially cyclical investments and the return bank investors require should reflect this. I think the lesson here is not to worry about the extent to which dividend cuts would be destabilising to investors but to focus on what kind of return is commensurate with the risk.

I will let APRA have the final say on what to expect …

APRA expects ADIs and insurers to limit discretionary capital distributions in the months ahead, to ensure that they instead use buffers and maintain capacity to continue to lend and underwrite insurance. This includes prudent reductions in dividends, taking into account the uncertain outlook for the operating environment and the need to preserve capacity to prioritise these critical activities. 

Decisions on capital management need to be forward-looking, and in the current environment of significant uncertainty in the outlook, this can be very challenging. APRA is therefore providing Boards with the following additional guidance.2 

During at least the next couple of months, APRA expects that all ADIs and insurers will:

– take a forward-looking view on the need to conserve capital and use capacity to support the economy;

– use stress testing to inform these views, and give due consideration to plausible downside scenarios (periodically refreshed and updated as conditions evolve); and

– initiate prudent capital management actions in response, on a pre-emptive basis, to ensure they maintain the confidence and capacity to continue to lend and support their customers. 

During this period, APRA expects that ADIs and insurers will seriously consider deferring decisions on the appropriate level of dividends until the outlook is clearer. However, where a Board is confident that they are able to approve a dividend before this, on the basis of robust stress testing results that have been discussed with APRA, this should nevertheless be at a materially reduced level. Dividend payments should be offset to the extent possible through the use of dividend reinvestment plans and other capital management initiatives. APRA also expects that Boards will appropriately limit executive cash bonuses, mindful of the current challenging environment.  

“APRA issues guidance to authorised deposit-taking institutions and insurers on capital management”, 7 April 2020

Tony (From the Outside)

Confusing capital and liquidity

I have been planning to write something on the relationship between capital and liquidity for a while. I have postponed however because the topic is complex and not especially well understood and I did not want to contribute to the body of misconceptions surrounding the topic. An article in the APRA Insight publications (2020 Issue One) has prompted me to have a go.

Capital Explained

The article published in APRA’s Insight publication under the title “Capital explained” offers a simple introduction to the question what capital is starting with the observation that …

“Capital is an abstract concept and has different meanings in different contexts.

Capital being abstract and meaning different things in different contexts is a good start but the next sentence troubles me.

“In non-technical contexts, capital is often described as an amount of cash or assets held by a company, or an amount available to invest.”

I am not sure that the author intended to endorse this non-technical description but it was not clear and I don’t think it should be left unchallenged, especially when the casual reader might be inclined to take it at face value. The fact that non-technical descriptions frequently state this is arguably a true statement but the article does not clarify that this description is a source of much confusion and seems to be conflating capital and liquid assets.

The source of the confusion possibly lies in double entry bookkeeping based explanations in which a capital raising will be associated with an influx of cash onto a company balance sheet. What happens next though is that the company has to decide what to do with the cash, it is extremely unlikely that the cash just sits in the company bank account. This is especially true in the case of a bank which has cash flowing into, and out of, the balance sheet every day. The influx of one source of funding (in this case equity) for the bank means that it will most likely choose to not raise some alternate form of funding (debt) on that day. The amount of cash it holds will be primarily driven by the liquidity targets it has set which are related to but in no way the same thing as its capital targets.

Time for me to put up or shut up.

How should we think about the relationship between capital and liquidity including the extent to which holding more liquid assets might, as is sometimes claimed, justify holding less capital.

  • Liquidity risk is mitigated by liquidity management, including holding liquid assets, but this statement offers no insight into the extent to which some residual expected or unexpected aspect of the risk still requires capital coverage (All risks are mitigated to varying extents by management but most still require some level of capital coverage)
  • So the assessment that holding more liquid assets reduces the need to hold capital is open to challenge
  • One of the core functions of capital is to absorb any increase in expenses, liabilities, loan losses or asset write downs associated with or required to resolve an underlying risk issue; the bank may need to recapitalise itself to restore the target level of solvency required to address future issues but the immediate problems are resolved without the consumption of capital compromising solvency
  • Liquid assets, in contrast, buy time to resolve problems but they do not in themselves solve any underlying issues that may be the root cause of the liquidity stress.
  • The relationship between liquidity and solvency is not symmetrical; liquidity is ultimately contingent on a bank being solvent, but a solvent bank can be illiquid.
  • While more liquid assets are not a substitute for holding capital, a more strongly capitalised bank is less likely to be subject to the kinds of liquidity stress events that draw on liquid assets so holding more capital relative to peer banks can reduce liquidity risk
  • Being relatively strong matters in scenarios where uncertainty is high and people resort to simple rules (e.g. withdraw funding from the weakest banks; even if that is not true the risk is that other people express that view and it becomes self-fulfilling)
  • It is important to recognise that the focus of relationship between capital and liquidity risk described above is the capital position relative to peer banks and market expectations, not the absolute stand-alone position
  • The “Unquestionably Strong” benchmark used in the Australian banking system to calibrate the overall target operating range for capital in the ICAAP anchors the bank’s Liquidity Risk appetite setting.
  • Expressed another way, the capital requirements of Liquidity Risk are embedded holistically in the capital buffer the target operating range maintains over prudential minimum capital requirements.

It is entirely possible that I am missing something here – I hope not but let me know if you see an error in my logic

APRA announces that it will consider a non-zero default level for the counter cyclical capital buffer

The Australian Prudential Regulation Authority (APRA) announced today that it had decided to keep the countercyclical capital buffer (CCyB) for authorised deposit-taking institutions (ADIs) on hold at zero per cent. What was really interesting however is that the information paper also flagged the likelihood of a non-zero default level in the future.

Here is the relevant extract from the APRA media release:

…. the information paper notes that APRA is also giving consideration to introducing a non-zero default level for the CCyB as part of its broader reforms to the ADI capital framework.

APRA Chair Wayne Byres said: “Given current conditions, and the financial strength built up within the banking sector, a zero counter-cyclical buffer remains appropriate.

“However, setting the countercyclical capital buffer’s default position at a non-zero level as part of the ‘unquestionably strong’ framework would not only preserve the resilience of the banking sector, but also provide more flexibility to adjust the buffer in response to material changes in financial stability risks. This is something APRA will consult on as part of the next stage of the capital reforms currently underway.

“Importantly, this would be considered within the capital targets previously announced – it does not reflect any intention to further raise minimum capital requirements.”

“APRA flags setting the countercyclical capital buffer at non-zero level”, APRA media announcement, 11 December 2019

I have argued the case for a non-zero default setting on this buffer in a long form note I published on my blog here, and published some shorter posts on the countercyclical capital buffer here, here and here). One important caveat is is that incorporating a non-zero default for the CCyB does not necessarily means that a bank needs to hold more capital. It is likely to be sufficient to simply partition a set amount of the existing capital surplus. In this regard, it is interesting that APRA has explicitly linked this potential change to the review it it initiated in the August 2018 Discussion Paper on “Improving the transparency, comparability and flexibility of the ADI capital framework”.

I covered that discussion paper in some depth here but one of the options discussed in this paper (“Capital ratio adjustments”) involves APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and Risk Weighted Assets.

Summing up, I would rate this as a positive development but we need to watch how the policy development process plays out.

Tony

Australian banking – “Unquestionably Strong” gets a bit more complicated

Students of the dark art of bank capital adequacy measurement were excited this week by the release of some proposed revisions to APRA’s “Prudential Standard APS 111 Capital Adequacy” (APS 111); i.e. the one which sets out the detailed criteria for measuring an ADI’s Regulatory Capital.

Is anyone still reading? Possibly not, but there is something I think worth noting here if you want to understand what may be happening with Australian bank capital. This is of course only a consultation at this stage but I would be very surprised if the key proposal discussed below is not adopted.

The Short Version

The consultation paper has a number of changes but the one that I want to focus on is the proposal to apply stricter constraints on the amount of equity an ADI invests in banking and insurance subsidiaries.

In order to understand how this impacts the banks, I have to throw in two more pieces of Australian bank capital jargon, specifically Level 1 and Level 2 capital.

  • 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 the 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.”

You can be forgiven for not being familiar with this distinction but the capital ratios typically quoted in any discussion of Australian bank capital strength are the Level 2 measures. The Unquestionably Strong benchmark that dominates the discussion is a Level 2 measure. The changes proposed in this consultation however operate at the Level 1 measurement (the ones that virtually no one currently pays any attention to) and not the Level 2 headline rate.

This has the potential to impact the “Unquestionably Strong” benchmark and I don’t recollect seeing this covered in the consultation paper or any public commentary on the proposal that I have seen to date.

APRA has been quite open about the extent to which these changes are a response to the RBNZ proposal to substantially increase equity requirements for NZ banks.

“This review was prompted in part by recent proposals by the Reserve Bank of New Zealand (RBNZ) to materially increase capital requirements in New Zealand. The RBNZ’s proposals and APRA’s processes are a natural by-product of both regulators working to protect their respective communities from the costs of financial instability and the regulators continue to support each other as these reforms are developed.”

The changes have however been calibrated to maintain the status quo based on the amounts of capital the Australian majors currently have invested in their NZ subsidiaries.

“APRA has calibrated the proposed capital requirements so they are broadly consistent with … the current capital position of the four major Australian banks, in respect of these exposures (i.e. preserving most of the existing capital uplift).”

It follows that any material increase in the capital the majors are required to invest in their NZ subsidiaries (in response to the RBNZ’s proposed requirement) will in turn require that they have to hold commensurately more common equity on a 1:1 basis in the Level 1 ADI to maintain the existing Level 1 capital ratios.

So far as I can see, the Level 2 measure does not require that this extra capital invested in banking subsidiaries be subject to the increased CET1 deductions applied at Level 1. It follows that the Level 2 CET1 ratio will increase but the extent to which a creditor benefits from that added strength will depend on which part of the banking group they sit.

I am not saying this a problem in itself. The RBNZ has the authority to set the capital requirements it deems necessary, Australian bank shareholders can make their own commercial decisions on whether the diluted return on equity meets their requirements and APRA has to respond to protect the interests of the Australian banking system.

I am saying that measuring relative capital adequacy is getting more complicated so you need to pay attention to the detail if this matters to you. In particular, I am drawing attention to the potential for the Level 2 CET1 ratios of the Australian majors to increase in ways that the existing “Unquestionably Strong” benchmark is not calibrated to. I don’t think this matters much for Australian bank depositors who have a very safe super senior position in the Australian loss hierarchy. It probably does matter for creditors who are closer to the sharp end of the loss hierarchy including senior and subordinated bondholders.

To date, the Level 2 capital adequacy ratios have been sufficient to provide a measure of relative capital strength; a higher CET1 ratio equals greater capital strength and that was probably all you needed to know. Going forward, I think you will need to pay closer attention to what is happening at the Level 1 measure to gain a more complete understanding of relative capital strength. The Level 2 measure by itself may not tell you the full story.

The detail

As a rule, APRA’s general capital treatment of equity exposures is to require that they be 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 is comfortable with that outcome based on current exposure levels.

The RBNZ’s (near certain) move towards higher CET1 requirements however threatens to undermine this status quo and potentially see 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 is proposing 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 is proposing 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.

Summing up

What APRA is proposing to do makes sense to me. We can debate the necessity for the RBNZ to insist on virtually 100% CET1 capital (for the record, I continue to believe that a mix of CET1 and contingent convertible debt is likely to be a more effective source of market discipline). However, once it became clear that the RBNZ was committed to its revised capital requirements, APRA was I think left with no choice but to respond.

What will be interesting from here is to see whether investments of CET1 in NZ banking subsidiaries increase in response to the RBNZ requirement or whether the Australian majors choose to reduce the size of their NZ operations.

If the former (i.e. the majors are required to increase the capital committed to NZ subsidiaries) then we need to keep an eye on how this impacts the Level 2 capital ratios and what happens to the “Unquestionably Strong” CET1 benchmark that currently anchors the capital the Australian majors maintain.

This is a pretty technical area of bank capital so it is possible I am missing something; if so please let me know what it is. Otherwise keep an eye on how the capital adequacy targets of the Australian majors respond to these developments.

Tony (From the Outside)

Mortgage risk weights fact check revisited – again

The somewhat arcane topic of mortgage risk weights is back in the news. It gets popular attention to the extent they impact the ability of small banks subject to standardised risk weights to compete with bigger banks which are endorsed to use the more risk sensitive version based on the Internal Ratings Based (IRB) approach. APRA released a Discussion Paper (DP) in February 2018 titled “Revisions to the capital framework for authorised deposit-taking institutions”. There are reports that APRA is close to finalising these revisions and that this will address the competitive disadvantage that small banks suffer under the current regulation.

This sounds like a pretty simple good news story – a victory for borrowers and the smaller banks – and my response to the discussion paper when it was released was that there was a lot to like in what APRA proposed to do. I suspect however that it is a bit more complicated than the story you read in the press.

The difference in capital requirements is overstated

Let’s start with the claimed extent of the competitive disadvantage under current rules. The ACCC’s Final Report on its “Residential Mortgage Price Inquiry” described the challenge with APRA’s current regulatory capital requirements as follows:

“For otherwise identical ADIs, the advantage of a 25% average risk weight (APRA’s minimum for IRB banks) compared to the 39% average risk weight of standardised ADIs is a reduction of approximately 0.14 percentage points in the cost of funding the loan portfolio. This difference translates into an annual funding cost advantage of almost $750 on a residential mortgage of $500 000, or about $15 000 over the 30 year life of a residential mortgage (assuming an average interest rate of 7% over that period).”

You could be forgiven for concluding that this differential (small banks apparently required to hold 56% more capital for the same risk) is outrageous and unfair.

Just comparing risk weights is less than half the story

I am very much in favour of a level playing field and, as stated above, I am mostly in favour of the changes to mortgage risk weights APRA outlined in its discussion paper but I also like fact based debates.

While the risk weights for big banks are certainly lower on average than those required of small banks, the difference in capital requirements is not as large as the comparison of risk weights suggests. To understand why the simple comparison of risk weights is misleading, it will be helpful to start with a quick primer on bank capital requirements.

The topic can be hugely complex but, reduced to its essence, there are three elements that drive the amount of capital a bank holds:

  1. The risk weights applied to its assets
  2. The target capital ratio applied to those risk weighted assets
  3. Any capital deductions required when calculating the capital ratio

I have looked at this question a couple of times (most recently here) and identified a number of problems with the story that the higher risk weights applied to residential mortgages originated by small bank places them at a severe competitive disadvantage:

Target capital ratios – The target capital adequacy ratios applied to their higher standardised risk weighted assets are in some cases lower than the IRB banks and higher in others (i.e. risk weights alone do not determine how much capital a bank is required to hold).

Portfolio risk – The risk of a mortgage depends on the portfolio not the individual loan. The statement that a loan is the same risk irrespective of whether it is written by a big bank or small bank sounds intuitively logical but is not correct. The risk of a loan can only be understood when it is considered as part of the portfolio the bank holds. All other things being equal, small banks will typically be less diversified and hence riskier than a big bank.

Capital deductions – You also have to include capital deductions and the big banks are required to hold capital for a capital deduction linked to the difference between their loan loss provisions and a regulatory capital value called “Regulatory Expected Loss”. The exact amount varies from bank to bank but I believe it increases the effective capital requirement by 10-12% (i.e. an effective RW closer to 28% for the IRB banks).

IRRBB capital requirement – IRB banks must hold capital for Interest Rate Risk in the Banking Book (IRRBB) while the small standardised banks do not face an explicit requirement for this risk. I don’t have sufficient data to assess how significant this is, but intuitively I would expect that the capital that the major banks are required to hold for IRRBB will further narrow the effective difference between the risk weights applied to residential mortgages.

How much does reducing the risk weight differential impact competition in the residential mortgage market?

None of the above is meant to suggest that the small banks operating under the standardised approach don’t have a case for getting a lower risk weight for their higher quality lower risk loans. If the news reports are right then it seems that this is being addressed and that the gap will be narrower. However, it is important to remember that:

  • The capital requirement that the IRB banks are required to maintain is materially higher than a simplistic application of the 25% average risk weight (i.e. the IRB bank advantage is not as large as it is claimed to be).
  • The standardised risk weight does not seem to be the binding constraint so reducing it may not help the small banks much if the market looks through the change in regulatory risk measurement and concludes that nothing has changed in substance.

One way to change the portfolio quality status quo is for small banks to increase their share of low LVR loans with a 20% RW. Residential mortgages do not, for the most part, get originated at LVR of sub 50% but there is an opportunity for small banks to try to refinance seasoned loans where the dynamic LVR has declined. This brings us to the argument that IRB banks are taking the “cream” of the high quality low risk lending opportunities.

The “cream skimming” argument

A report commissioned by COBA argued that:

“While average risk weights for the major banks initially rose following the imposition of average risk weight on IRB banks by APRA, two of the major banks have since dramatically reduced their risk weights on residential mortgages with the lowest risk of default. The average risk weights on such loans is now currently on average less than 6 per cent across the major banks.”

“Despite the imposition of an average risk weight on residential home loans, it appears some of the major banks have decided to engage in cream skimming by targeting home loans with the lowest risk of default. Cream skimming occurs when the competitive pressure focuses on the high-demand customers (the cream) and not on low- demand ones (the skimmed milk) (Laffont & Tirole, 1990, p. 1042). Cream skimming has adverse consequences as it skews the level of risk in house lending away from the major banks and towards other ADIs who have to deal with an adversely selected and far riskier group of home loan applicants.”

“Reconciling Prudential Regulation with Competition” prepared by Pegasus Economics May 2019 (page 43)

It is entirely possible that I am missing something here but, from a pure capital requirement perspective, it is not clear that IRB banks have a material advantage in writing these low risk loans relative to the small bank competition. The overall IRB portfolio must still meet the 25% risk weight floor so any loans with 6% risk weights must be offset by risk weights (and hence riskier loans) that are materially higher than the 25% average requirement. I suspect that the focus on higher quality low risk borrowers by the IRB banks was more a response to the constraints on capacity to lend than something that was driven by the low risk weights themselves.

Under the proposed revised requirements, small banks in fact will probably have the advantage in writing sub 50% LVR loans given that they can do this at a 20% risk weight without the 25% floor on their average risk weights and without the additional capital requirements the IRB banks face.

I recognise there are not many loans originated at this LVR band but there is an opportunity in refinancing seasoned loans where the combined impact of principal reduction and increased property value reduces the LVR. In practice the capacity of small banks to do this profitably will be constrained by their relative expense and funding cost disadvantage. That looks to me to be a bigger issue impacting the ability of small banks to compete but that lies outside the domain of regulatory capital requirements.

Maybe this potential arbitrage does not matter in practice but APRA could quite reasonably impose a similar minimum average RW on Standardised Banks if the level playing field argument works both ways. This should be at least 25% but arguably higher once you factor in the fact that the small banks do not face the other capital requirements that IRB banks do. Even if APRA did not do this, I would expect the market to start looking more closely at the target CET1 for any small bank that accumulated a material share of these lower risk weight loans.

Implications

Nothing in this post is meant to suggest that increasing the risk sensitivity of the standardised risk weights is a bad idea. It seems doubtful however that this change alone will see small banks aggressively under cutting large bank competition. It is possible that small bank shareholders may benefit from improved returns on equity but even that depends on the extent to which the wholesale markets do not simply look through the change and require smaller banks to maintain the status quo capital commitment to residential mortgage lending.

What am I missing …

How much capital is enough? – The NZ perspective

The RBNZ has delivered the 4th instalment in a Capital Review process that was initiated in March 2017 and has a way to run yet. The latest consultation paper addresses the question “How much capital is enough?”.  The banking industry has until 29 March 2019 to respond with their views but the RBNZ proposed answer is:

  • A Tier 1 capital requirement of 16% of RWA for systemically important banks and 15% of RWA for all other banks
  • The Tier 1 minimum requirement to remain unchanged at 6% (with AT1 capital continuing to be eligible to contribute a maximum of 1.5 percentage points)
  • The proposed increased capital requirement to be implemented via an overall prudential capital buffer of 9-10% of RWA comprised entirely of CET1 capital;
    • Capital Conservation Buffer 7.5% (currently 2.5%)
    • D-SIB Buffer 1.0% (no change)
    • Counter-cyclical buffer 1.5% (currently 0%)

The increase in the capital ratio requirement is proposed to be supplemented with a series of initiatives that will increase the RWA of IRB banks:

  • The RBNZ proposes to 1) remove the option to apply IRB RW to sovereign and bank exposures,  2) increase the IRB scalar (from 1.06 to 1.20) and 3) to introduce an output floor set at 85% of the Standardised RWA on an aggregate portfolio basis
  • As at March 2018, RWA’s produced by the IRB approach averaged 76% of the Standardised Approach and the RBNZ estimate that the overall impact will be to increase the aggregate RWA to 90% of the outcome generated by the Standardised approach (i.e. the IRB changes, not the output floor, drive the increase in RWA)
  • Aggregate RWA across the four IRB banks therefore increases by approximately 16%, or $39bn, compared to March 2018 but the exact impact will depend on how IRB banks respond to the higher capital requirements

The RBNZ has also posed the question whether a Tier 2 capital requirement continues to be relevant given the substantial increase in Tier 1 capital.

Some preliminary thoughts …

There is a lot to unpack in this paper so this post will only scratch the surface of the issues it raises …

  • The overall number that the RBNZ proposes (16%) is not surprising.It looks to be at the lower end of what other prudential regulators are proposing in nominal terms
  • But is in the same ball park once you allow for the substantial increase in IRB RWA and the fact that it is pretty much entirely CET1 capital
  • What is really interesting is the fundamentally different approach that the RBNZ has adopted to Tier 2 capital and bail-in versus what APRA (and arguably the rest of the world) has adopted
    • The RBNZ proposal that the increased capital requirement take the form of CET1 capital reflects its belief that “contingent convertible instruments” should be excluded from what counts as capital
    • Exactly why the RBNZ has adopted this position is a complex post in itself (their paper on the topic can be found here) but the short version (as I understand it) is that they think bail-in capital instruments triggered by non-viability are too complex and probably won’t work anyway.
    • Their suggestion that Tier 2 probably does not have a role in the capital structure they have proposed is logical if you accept their premise that Point of Non-Viability (PONV) triggers and bail-in do not work.
  • The RBNZ highlight a significantly enhanced role for prudential capital buffersI am generally in favour of bigger, more dynamic, capital buffers rather than higher fixed minimum requirements and I have argued previously in favour of the base rate for the counter-cyclical being a positive value (the RBNZ propose 1.5%)
    • But the overall size of the total CET1 capital buffer requirement requires some more considered thought about 1) the role of bail-in  structures and PONV triggers in the capital regulation toolkit (as noted above) and 2) whether the impacts of the higher common equity requirement will be as benign as the RBNZ analysis suggests
  • I am also not sure that the indicative capital conservation responses they have outlined (i.e. discretionary distributions limited to 60% of net earnings in the first 250bp of the buffer, falling to 30% in the next 250bp and no distributions thereafter) make sense in practice.
    • This is because I doubt there will be any net earnings to distribute if losses are sufficient to reduce CET1 capital by 250bp so the increasing capital conservation requirement is irrelevant.
  • Last, but possibly most importantly, we need to consider the impact on the Australian parents of the NZ D-SIB banks and how APRA responds. The increase in CET1 capital proposed for the NZ subsidiaries implies that, for any given amount of CET1 capital held by the Level 2 Banking Group, the increased strength of the NZ subsidiaries will be achieved at the expense of the Australian banking entities
    • Note however that the impact of the higher capital requirement in NZ will tend to be masked by the technicalities of how bank capital ratios are calculated.
      • It probably won’t impact the Level 2 capital ratios at all since these are a consolidated view of the combined banking group operations of the Group as a whole
      • The Level 1 capital ratios for the Australian banks also treat investments in bank subsidiaries relatively generously (capital invested in unlisted subsidiaries is treated as a 400% risk weighted asset rather than a capital deduction).

Conclusion

Overall, I believe that the RBNZ is well within its rights to expect the banks it supervises to maintain a total level of loss absorbing capital of 16% or more. The enhanced role for capital buffers is also a welcome move.

The issue is whether relying almost entirely on CET1 capital is the right way to achieve this objective. This is however an issue that has been debated for many decades with no clear resolution. It will take some time to fully unpack the RBNZ argument and figure out how best to articulate why I disagree. In the interim, any feedback on the issues I have outlined above would be most welcome.

Tony

Does more loss absorption and “orderly resolution” eliminate the TBTF subsidy?

The Australian Government’s 2014 Financial System Inquiry (FSI) recommended that APRA implement a framework for minimum loss-absorbing and recapitalisation capacity in line with emerging international practice, sufficient to facilitate the orderly resolution of Australian authorised deposit-taking institutions (ADIs) and minimise taxpayer support (Recommendation 3).

In early November, APRA released a discussion paper titled “Increasing the loss absorption capacity of ADIs to support orderly resolution” setting out its response to this recommendation. The paper proposes that selected Australian banks be required to hold more loss absorbing capital. Domestic Systemically Important Banks (DSIBs) are the primary target but, depending partially on how their Recovery and Resolution Planning addresses the concerns APRA has flagged, some other banks will be captured as well.

The primary objectives are to improve financial safety and stability but APRA’s assessment is that competition would also be “Marginally improved” on the basis that “requiring larger ADIs to maintain additional loss absorbency may help mitigate potential funding advantages that flow to larger ADIs“. This assessment may be shaped by the relatively modest impact (5bp) on aggregate funding costs that APRA has estimated or simple regulatory conservatism. I suspect however that APRA is under selling the extent to which the TBTF advantage would be mitigated if not completely eliminated by the added layer of loss absorption proposed. If I am correct, then this proposal would in fact, not only minimise the risk to taxpayers of future banking crises, but also represent an important step forward in placing Australian ADIs on a more level playing field.

Why does the banking system need more loss absorption capacity?

APRA offers two reasons:

  1. The critical role financial institutions play in the economy means that they cannot be allowed to fail in a disorderly manner that would have adverse systemic consequences for the economy as a whole.
  2. The government should not be placed in a position where it believes it has no option but to bail out one or more banks

The need for extra capital might seem counter-intuitive, given that ADI’s are already “unquestionably strong”, but being unquestionably strong is not just about capital, the unstated assumption is that the balance sheet and business model are also sound. The examples that APRA has used to calibrate the degree of total loss absorption capacity could be argued to reflect scenarios in which failures of management and/or regulation have resulted in losses much higher than would be expected in a well-managed banking system dealing with the normal ups and downs of the business cycle.

At the risk of over simplifying, we might think of the first layers of the capital stack (primarily CET1 capital but also Additional Tier 1) being calibrated to the needs of a “good bank” (i.e. well-managed, well-regulated) while the more senior components (Tier 2 capital) represent a reserve to absorb the risk that the good bank turns out to be a “bad bank”.

What form will this extra capital take?

APRA concludes that ADI’s should be required to hold “private resources” to cope with this contingency. I doubt that conclusion would be contentious but the issue is the form this self-insurance should take. APRA proposes that the additional loss absorption requirement be implemented via an increase in the minimum Prudential Capital Requirement (PCR) applied to the Total Capital Ratio (TCR) that Authorised Deposit-Taking Institutions (ADIs) are required to maintain under Para 23 of APS 110.

“The minimum PCRs that an ADI must maintain at all times are:
(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.”

APS 110 Paragraph 23

This means that banks have discretion over what form of capital they use, but APRA expect that banks will use Tier 2 capital that counts towards the Total Capital Ratio as the lowest cost way to meet the requirement. Advocates of the capital structure irrelevance thesis would likely take issue with this part of the proposal. I believe APRA is making the right call (broadly speaking) in supporting more Tier 2 rather than more CET1 capital, but the pros and cons of this debate are a whole post in themselves. The views of both sides are also pretty entrenched so I doubt I will contribute much to that 50 year old debate in this post.

How much extra loss absorbing capital is required?

APRA looked at three things when calibrating the size of the additional capital requirement

  • Losses experienced in past failures of systemically important banks
  • What formal requirements other jurisdictions have applied to their banks
  • The levels of total loss absorption observed being held in an international peer group (i.e. what banks choose to hold independent of prudential minimums)

Based on these inputs, APRA concluded that requiring DSIBs to maintain additional loss absorbing capital of between 4-5 percentage points of RWA would be an appropriate baseline setting to support orderly resolution outcomes. The calibration will be finalised following the conclusion of the consultation on the discussion paper but this baseline requirement looks sufficient to me based on what I learned from being involved in stress testing (for a large Australian bank).

Is more loss absorption a good idea?

The short answer, I think, is yes. The government needs a robust way to recapitalise banks which does not involve risk to the taxpayer and the only real alternative is to require banks to hold more common equity.

The devil, however, is in the detail. There are a number of practical hurdles to consider in making it operational and these really need to be figured out (to the best of out ability) before the fact rather than being made up on the fly under crisis conditions.  The proposal also indirectly raises some conceptual issues with capital structure that are worth understanding.

How would it work in practice?

The discussion paper sets out “A hypothetical outcome from resolution action” to explain how an orderly resolution could play out.

“The approximate capital levels the D-SIBs would be expected to maintain following an increase to Total Capital requirements, and a potential outcome following the use of the additional loss absorbency in resolution, are presented in Figure 6. Ultimately, the outcome would depend on the extent of losses.

If the stress event involved losses consistent with the largest of the FSB study (see Figure 2), AT1 and Tier 2 capital instruments would be converted to ordinary shares or written off. After losses have been considered, the remaining capital position would be wholly comprised of CET1 capital. This conversion mechanism is designed to allow for the ADI to be stabilised in resolution and provide scope to continue to operate, and particularly to continue to provide critical functions.”

IMG_5866.JPG

Source – APRA Discussion Paper (page 24)

What I have set out below draws from APRA’s example while adding detail that hopefully adds some clarity on what should be expected if these scenarios ever play out.

  • In a stress event, losses first impact any surplus CET1 held in excess of the Capital Conservation Buffer (CCB) requirement, and then the CCB itself (the first two layers of loss absorption in Figure 6 above)
  • As the CCB is used up, the ADI is subject to progressive constraints on discretionary distributions on CET1 and AT1 capital instruments
  • In the normal course of events, the CCB should be sufficient to cope with most stresses and the buffer is progressively rebuilt through profit retention and through new issuance, if the ADI wants to accelerate the pace of the recapitalisation process
  • The Unquestionably Strong capital established to date is designed to be sufficient to allow ADIs to withstand quite severe expected cyclical losses (as evidenced by the kinds of severe recession stress scenarios typically used to calibrate capital buffers)
  • In more extreme scenarios, however, the CCB is overwhelmed by the scale of losses and APRA starts to think about whether the ADI has reached a Point of Non-Viability (PONV) where ADI’s find themselves unable to fund themselves or to raise new equity; this is where the proposals in the Discussion Paper come into play
  • The discussion paper does not consider why such extreme events might occur but I have suggested above that one reason is that the scale of losses reflects endogenous weakness in the ADI (i.e. failures of risk management, financial control, business strategy) which compound the losses that would be a normal consequence of downturns in the business cycle
  • APRA requires that AT1 capital instruments, classified as liabilities under Australian Accounting Standards, must include a provision for conversion into ordinary shares or write off when the CET1 capital ratio falls to, or below 5.125 per cent
  • In addition, AT1 and Tier 2 capital instruments must contain a provision, triggered on the occurrence of a non-viability trigger event, to immediately convert to ordinary shares or be written off
  • APRA’s simple example show both AT1 and Tier 2 being converted to CET1 (or write-off) such that the Post Resolution capital structure is composed entirely of CET1 capital

Note that conversion of the AT1 and Tier 2 instruments does not in itself allocate losses to these instruments. The holders receive common equity equivalent to the book value of their instrument which they can sell or hold. The ordinary shareholders effectively bear the loss via the forced dilution of their shareholdings. The main risk to the ATI and Tier 2 holders is that, when they sell the ordinary shares received on conversion, they may not get the same price that which was used to convert their instrument. APRA also imposes a floor on the share price that is used for conversion which may mean that the value of ordinary shares received is less than the face value of the instrument being converted. The reason why ordinary shareholders should be protected in this way under a resolution scenario is not clear.

The devil is in the detail – A short (probably incomplete) list of issues I see with the proposal:

  1. Market capacity to supply the required quantum of additional Tier 2 capital required
  2. Conversion versus write-off
  3. The impact of conversion on the “loss hierarchy”
  4. Why not just issue more common equity?
  5. To what extent would the public sector continue to stand behind the banking system once the proposed level of self insurance is in place?

Market capacity to supply the required level of additional loss absorption

APRA has requested industry feedback on whether market appetite for Tier 2 capital will be a problem but its preliminary assessment is that:

” … individual ADIs and the industry will have the capacity to implement the changes necessary to comply with the proposals without resulting in unnecessary cost for ADIs or the broader financial system.

Preliminary estimates suggest the total funding cost impact from increasing the D-SIBs’Total Capital requirements would not be greater than five basis points in aggregate based on current spreads. Assuming the D-SIBs meet the increased requirement by increasing the issuance of Tier 2 capital instruments and reducing the issuance of senior unsecured debt, the impact is estimated by observing the relative pricing of the different instruments. The spread difference between senior unsecured debt and Tier 2 capital instruments issued by D- SIBs is around 90 to 140 basis points.”

I have no expert insights on this question beyond a gut feel that the required level of Tier 2 capital cannot be raised without impacting the current spread between Tier 2 capital and senior debt, if at all. The best (only?) commentary I have seen to date is by Chris Joye writing in the AFR (see here and here). The key points I took from his opinion pieces are:

  • The extra capital requirement translates to $60-$80 billion of extra bonds over the next four years (on top of rolling over existing maturities)
  • There is no way the major banks can achieve this volume
  • Issuing a new class of higher ranking (Tier 3) bonds is one option, though APRA also retains the option of scaling back the additional Tier 2 requirement and relying on its existing ability to bail-in senior debt

Chris Joye know a lot more about the debt markets than I do, but I don’t think relying on the ability to bail-in senior debt really works. The Discussion Paper refers to APRA’s intention that the “… proposed approach is … designed with the distinctive features of the Australian financial system in mind, recognising the role of the banking system in channelling foreign savings into the economy “ (Page 4). I may be reading too much into the tea leaves, but this could be interpreted as a reference to the desirability of designing a loss absorbing solution which does not adversely impact the senior debt rating that helps anchor the ability of the large banks to borrow foreign savings. My rationale is that the senior debt rating impacts, not only the cost of borrowing, but also the volume of money that foreign savers are willing to entrust with the Australian banking system and APRA specifically cites this factor as shaping their thinking. Although not explicitly stated, it seems to me that APRA is trying to engineer a solution in which the D-SIBs retain the capacity to raise senior funding with a “double A” rating.

Equally importantly, the creation of a new class of Tier 3 instruments seems like a very workable alternative to senior bail-in that would allow the increased loss absorption target to be achieved without impacting the senior debt rating. This will be a key issue to monitor when ADI’s lodge their response to the discussion paper. It also seems likely that the incremental cost of the proposal on overall ADI borrowing costs will be higher than the 5bp that APRA included in the discussion paper. That is not a problem in itself to the extent this reflects the true cost of self insurance against the risk of failure, just something to note when considering the proposal.

Conversion versus write-off

APRA has the power to effect increased loss absorption in two ways. One is to convert the more senior elements of the capital stack into common equity but APRA also has the power to write these instruments off. Writing off AT1 and/or T2 capital, effectively represents a transfer of value from the holders of these instruments to ordinary shareholders. That is hard to reconcile with the traditional loss hierarchy that sees common equity take all first losses, with each of the more senior tranches progressively stepping up as the capacity of more junior tranches is exhausted.

Consequently I assume that the default option would always favour conversion over write-off. The only place that I can find any guidance on this question is Attachment J to APS 111 (Capital Adequacy) which states

Para 11. “Where, following a trigger event, conversion of a capital instrument:

(a)  is not capable of being undertaken;

(b)  is not irrevocable; or

(c) will not result in an immediate and unequivocal increase in Common Equity Tier 1 Capital of the ADI,

the amount of the instrument must immediately and irrevocably be written off in the accounts of the ADI and result in an unequivocal addition to Common Equity Tier 1 Capital.”

That seems to offer AT1 and Tier 2 holders comfort that they won’t be asked to take losses ahead of common shareholders but the drafting of the prudential standard could be clearer if there are other reasons why APRA believe a write-off might be the better resolution strategy. The holders need to understand the risks they are underwriting but ambiguity and uncertainty are to helpful when the banking system is in, or a risk of, a crisis.

The impact of conversion on the “loss hierarchy”

The concept of a loss hierarchy describes the sequence under which losses are first absorbed by common equity and then by Additional Tier 1 and Tier 2 capital, if the more junior elements prove insufficient. Understanding the loss hierarchy is I think fundamental to understanding capital structure in general and this proposal in particular:

  • In a traditional liquidation process, the more senior elements should only absorb loss when the junior components of the capital stack are exhausted
  • In practice, post Basel III, the more senior elements will be required to participate in recapitalising the bank even though there is still some book equity and the ADI technically solvent (though not necessarily liquid)
  • This is partly because the distributions on AT1 instruments are subject to progressively higher capital conservation restrictions as the CCB shrinks but mostly because of the potential for conversion to common equity (I will ignore the write-off option to keep things simple)

I recognise that APRA probably tried to simplify this explanation but the graphic example they used (see Figure 6 above) to explain the process shows the Capital Surplus and the CCB (both CET1 capital) sitting on top of the capital stack followed by Tier 2, Additional Tier 1 and finally the minimum CET1 capital. The figure below sets out what I think is a more logical illustration of the capital stack and loss .

IMG_2739

Losses initially impact CET1 directly by reducing net tangible assets per share. At the point of a non-viability based conversion event, the losses impact ordinary shareholders via the dilution of their shareholding. AT1 and Tier 2 holders only share in these losses to the extent that they sell the ordinary shares they receive for less than the conversion price (or if the conversion price floor results in them receiving less than the book value of their holding).

Why not just issue more common equity?

Capital irrelevancy M&M purists will no doubt roll their eyes and say surely APRA knows that the overall cost of equity is not impacted by capital structure tricks. The theory being that any saving in the cost of using lower cost instruments, will be offset by increases in the costs (or required return) of more subordinated capital instruments (including equity).

So this school argues you should just hold more CET1 and the cost of the more senior instruments will decline. The practical problem I think is that, the cost of senior debt already reflects the value of the implied support of being too big, or otherwise systemically important, to be allowed to fail. The risk that deposits might be exposed to loss is even more remote partly due to deposit insurance but, possibly more importantly, because they are deeply insulated from risk by the substantial layers of equity and junior ranking liabilities that must be exhausted before assets are insufficient to cover deposit liabilities.

To what extent would the public sector continue to stand behind the banking system once the proposed level of self insurance is in place?

Assuming the market capacity constraint question could be addressed (which I think it can), 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. I know some people argue that this is a distinction without a difference but I disagree. 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.

There are alternative ways to construct a banking system. Mervyn King, for example, has advocated a version of the Chicago Plan under which all bank deposits must be 100% backed by liquid reserves that would be limited to safe assets such as government securities or reserves held with the central bank. Until we decide to go down that path, or something similar, 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.

Conclusion

I have been sitting on this post for a few weeks while trying to consider the pros and cons. As always, the risk remains that I am missing something. That said, this looks to me like a necessary (and I would argue desirable) enhancement to the Australian financial system that not only underpins its safety and stability but also takes us much closer to a level playing field. Big banks will always have the advantage of sophistication, scale and efficiency that comes with size but any funding cost advantage associated with being too big to fail now looks to be priced into the cost of the additional layers of loss absorption this proposal would require them to put in place.

Tony