Bank deposits – turning unsecured loans to highly leveraged companies into (mostly) risk free assets – an Australian perspective

The ability to raise funding via “deposits” is one of the things that makes banks different from other types of companies. As a rule bank deposits benefit from a variety of protections that transform what is effectively an unsecured loan to a highly leveraged company into an (arguably) risk free asset.

This rule is not universal however. The NZ banking system, for example, has a distinctly different approach to bank deposits that not only eschew the protections Australian depositors take for granted but also has the power, via its Open Banking Resolution regime, to write down the value of bank deposits if required to ensure the solvency and viability of a bank. But some form of protection is common.

I previously had a go at the question of “why” bank deposits should be protected here.

This post focuses on the mechanics of “how” AUD denominated deposits held with APRA authorised deposit-taking institutions incorporated in Australia (“Australian ADIs” or “Australian banks”) are protected. In particular, I attempt to rank the relative importance of the various protections built into the Australian system. You may not necessarily agree with my ranking and that is OK – I would welcome feedback on what I may be missing.

Multiple layers of protection

Australian bank deposits benefit from multiple layers of protection:

  1. The risk taking activities of the banks are subject to a high level of supervision and regulation (that is true to varying degrees for most banking systems but Australian standards do seem to be at the more conservative end of the spectrum where Basel Committee standards offer a choice),
  2. The target level of Common Equity Tier 1 (CET1) capital required to support that risk must meet the standard of being “Unquestionably Strong”,
  3. This core capital requirement is supported by a series of supplementary layers of loss absorbing capital that can be converted into equity if the viability of the bank as a going concern comes into doubt,
  4. The deposits themselves have a priority super senior claim on the Australian assets of the bank should it fail, and
  5. The timely repayments of AUD deposits up to $250,000 per person per bank is guaranteed by the Australian Government.

Deposit preference rules …

The government guarantee might seem like the obvious candidate for the layer of protection that counts for the most, but I am not so sure. All the layers of protection obviously contribute but my vote goes to deposit preference. The capacity to bail-in the supplementary capital gets an honourable mention. These seem to me to be the two elements that ultimately underwrite the safety of the majority of bank deposits (by value) in Australia.

The other elements are also important but …

Intensive supervision clearly helps ensure that banks are well managed and not taking excessive risks but experience demonstrates that it does not guarantee that banks will not make mistakes. The Unquestionably Strong benchmark for CET1 capital developed in response to one of the recommendations of the 2014 Financial System Inquiry also helps but again does not guarantee that banks will not find some new (or not so new) way to blow themselves up.

At face value, the government guarantee seems like it would be all you need to know about the safety of bank deposits (provided you are not dealing with the high quality problem of having more than AUD250,000 in you bank account). When you look at the detail though, the role the government guarantee plays in underwriting the safety of bank deposits seems pretty limited, especially if you hold you deposit account with one of the larger ADIs. The first point to note is that the guarantee will only come into play if a series of conditions are met including that APRA consider that the ADI is insolvent and that the Treasurer determines that it is necessary.

In practice, recourse to the guarantee might be required for a small ADI heavily reliant on deposit funding but I suspect that this chain of events is extremely unlikely to play out for one of the bigger banks. That is partly because the risk of insolvency has been substantially reduced by higher CET1 requirements (for the larger ADI in particular) but also because the government now has a range of tools that allow it to bail-in rather than bail-out certain bank creditors that rank below depositors in the loss hierarchy. There are no great choices when dealing with troubled banks but my guess is that the authorities will choose bail-in over liquidation any time they are dealing with one of the larger ADIs.

If deposit preference rules, why doesn’t everyone do it?

Banking systems often seem to evolve in response to specific issues of the day rather than being the result of some grand design. So far as I can tell, it seems that the countries that have chosen not to pursue deposit preference have done so on the grounds that making deposits too safe dilutes market discipline and in the worst case invites moral hazard. That is very clearly the case in the choices that New Zealand has made (see above) and the resources they devote to the disclosure of information regarding the relative risk and strength of their banks.

I understand the theory being applied here and completely agree that market discipline should be encouraged while moral hazard is something to be avoided at all costs. That said, it does not seem reasonable to me to expect that the average bank deposit account holder is capable of making the risk assessments the theory requires, nor the capacity to bear the consequences of getting it wrong.

Bank deposits also function as one of the primary forms of money in most developed economies but need to be insulated from risk if they are to perform this role. Deposit preference not only helps to insulate this component of our money supply from risk, it also tends to transfer the risk to investors (debt and equity) who do have the skills and the capacity to assess and absorb it, thereby encouraging market discipline.

The point I am making here is very similar to the arguments that Grant Turner listed in favour of deposit protection in a paper published in the RBA Bulletin.

There are a number of reasons why authorities may seek to provide greater protection to depositors than to other creditors of banks. First, deposits are a critical part of the financial system because they facilitate economic transactions in a way that wholesale debt does not. Second, they are a primary form of saving for many individuals, losses on which may result in significant adversity for depositors who are unable to protect against this risk. These two characteristics also mean that deposits are typically the main source of funding for banks, especially for smaller institutions with limited access to wholesale funding markets. Third, non-deposit creditors are generally better placed than most depositors to assess and manage risk. Providing equivalent protection arrangements for non-deposit creditors would weaken market discipline and increase moral hazard.

Depositor Protection in Australia, Grant Turner, RBA Bulletin December Quarter 2011 (p45)

For a more technical discussion of these arguments I can recommend a paper by Gary Gorton and George Pennacchi titled “Financial Intermediation and Liquidity Creation” that I wrote about in this post.

Deposit preference potentially strengthens market discipline

I argued above that deposit preference potentially strengthens market discipline by transferring risk to debt and equity investors who have the skills to assess the risk, are paid a risk premium for doing so and, equally as importantly, the capacity to absorb the downside should a bank get into trouble. I recognise of course that this argument is strongest for the larger ADIs which have substantial layers of senior and subordinated debt that help ensure that deposits are materially insulated from bank risk. The capacity to bail-in a layer of this funding, independent of the conventional liquidation process, further adds to the protection of depositors while concentrating the role of market discipline where it belongs.

This market discipline role is one of the chief reasons I think “bail-in” adds to the resilience of the system in ways that higher equity requirements do not. The “skin in the game” these investors have is every bit as real as that the equity investors do, but they have less incentive to tolerate excessive or undisciplined risk taking.

The market discipline argument is less strong for the smaller ADIs which rely on deposits for a greater share of their funding but these entities account for a smaller share of bank deposits and can be liquidated if required with less disruption with the assistance of the government guarantee. The government guarantee seems to be more valuable for these ADIs than it is for the larger ADIs which are subject to a greater level of self-insurance.

Deposit preference plus ex ante funding of the deposit guarantee favours the smaller ADI

Interestingly, the ex ante nature of the funding of the government guarantee means that the ADIs for which it is least valuable (the survivors in general and the larger ADI’s in particular) are also the ones that will be called upon to pay the levy to make good any shortfalls not covered by deposit preference. That is at odds with the principle of risk based pricing that features in the literature about deposit guarantees but arguably a reasonable subsidy that assists the smaller ADIs to compete with larger ADI that have the benefit of risk diversification and economies of scale.

Summing up

If you want to dig deeper into this question, I have summarised the technical detail of the Australian deposit protection arrangements here. It is a little dated now but I can also recommend the article by Grant Turner published in the RBA Bulletin (December 2011) titled “Depositor Protection in Australia” which I quoted from above.

As always, it is entirely possible that I am missing something – if so let me know.

Tony – From The Outside

When safety proves dangerous …

… is the title of a post on the Farnham Street blog that provides a useful reminder of the problem of “risk compensation”; i.e. the way in which measures designed to make us safer can be a perverse prompt for us to take more risk because we feel safer. I want to explore how these ideas apply to bank capital requirements but will first outline the basic ideas covered by Farnham Street.

we all internally have a desired level of risk that varies depending on who we are and the context we are in. Our risk tolerance is like a thermostat—we take more risks if we feel too safe, and vice versa, in order to remain at our desired “temperature.” It all comes down to the costs and benefits we expect from taking on more or less risk.

The notion of risk homeostasis, although controversial, can help explain risk compensation.

The classic example is car safety measures such as improved tyres, ABS braking systems, seat belts and crumple zones designed to protect the driver and passengers. These have helped reduce car fatality rates for the people inside the car but not necessarily reduced accident rates given that drivers tend to drive faster and more aggressively because they can. Pedestrians are also at greater risk.

Farnham Street suggests the following lessons for dealing with the problem risk compensation:

  1. Safety measures are likely to be more effective is they are less visible
  2. Measures designed to promote prudent behaviour are likely to be more effective than measures which make risky behaviour safer
  3. Recognise that sometimes it is better to do nothing if the actions we take just leads to an offset in risk behaviour somewhere else
  4. If we do make changes then recognise that we may have to put in place other rules to ensure the offsetting risk compensating behaviour is controlled
  5. Finally (and a variation on #3), recognise that making people feel less safe can actually lead to safer behaviour.

If you are interested in this topic then I can also recommend Greg Ip’s book “Foolproof” which offers a good overview of the problem of risk compensation.

Applying these principles to bank capital requirements

The one area where I would take issue with the Farnham Street post is where it argues that bailouts and other protective mechanisms contributed to scale of the 2008 financial crisis because they led banks to take greater risks. There is no question that the scale of the crisis was amplified by the risks that banks took but it is less obvious to me that the bailouts created this problem.

The bailouts were a response to the problem that banks were too big to fail but I can’t see how they created this problem; especially given that the build up of risk preceded the bailouts. Bailouts were a response to the fact that the conventional bankruptcy and restructure process employed to deal with the failure of non-financial firms simply did not work for financial firms.

It is often asserted that bankers took risks because they expected that they would be bailed out; i.e/ that banks deliberately and consciously took risk on the basis that they would be bailed out. I can’t speak for banks as a whole but I have never witnessed that belief in the four decades that I worked in the Australian banking system. Never attribute to malice what can be equally explained by mistaken beliefs. I did see bankers placing excessive faith in the economic capital models that told them they could safely operate with reduced levels of capital. That illusion of knowledge and control is however a different problem altogether, largely to do with not properly understanding the distinction between risk and uncertainty (see here and here).

If I am right, that would suggest that making banks hold more capital might initially make them safer but might also lead to banks looking for ways to take more risk. This is a key reason why I think the answer to safer banks is not just making them hold higher and higher levels of common equity. More common equity is definitely a big part of the answer but one of the real innovations of Basel 3 was the development of new forms of loss absorbing capital that allow banks to be recapitalised by bail-in rather than bail-out.

If you want to go down the common equity is the only solution path then it will be important to ensure that Farnham Street Rule #4 above is respected; i.e. bank supervisors will need to ensure that banks do not simply end up taking risks in places that regulation or supervision does not cover. This is not a set and forget strategy based on the idea that increased “skin in the game” will automatically lead to better risk management.

Based on my experience, the risk of common equity ownership being diluted by the conversion of this “bail-in” capital is a far more effective constraint on risk taking than simply requiring banks to hold very large amounts of common equity. I think the Australian banking system has this balance about right. The Common Equity Tier 1 requirement is calibrated to a level intended to make banks “Unquestionably Strong”. Stress testing suggest that this level of capital is likely to be more than sufficient for well managed banks operating with sensible risk appetites but banks (the larger ones in particular) are also required to maintain a supplementary pool of capital that can be converted to common equity should it be required. The risk that this might be converted into a new pool of dilutive equity is a powerful incentive to not push the boundaries of risk appetite.

Tony – From the Outside

Debt jubilees revisited

I flagged a post by Michael Reddell (Croaking Cassandra) on the (admittedly wonky) topic of debt jubilees. This is not a general interest topic by any means but I am interested in economic history and the role of debt in the economy in particular so this caught my interest.

Michael has returned to the topic here focussing on a book by Michael Hudson titled “… and forgive them their debts: Lending, Foreclosure and Redemption from the Bronze Age Finance to the Jubilee Year” and a call by Steve Keen calling for widespread government funded debt forgiveness as part of the response to the COVID 19 recession. Michael is not a fan of the idea and I think sets out a quite good summary of the case against a modern debt jubilee.

I have copied a short extract from his post here

Keen, for example, emphasises the high level of housing debt in countries like New Zealand and Australia.  But it is mostly a symptom not of hard-hearted banks but of governments (central and local) that keep on rendering urban land artificially scarce, and then –  in effect –  compelling the young to borrow heavily from, in effect, the old to get on the ladder of home ownership.   I count that deeply unconscionable and unjust.  But the primary solution isn’t debt forgiveness –   never clear who is going to pay for this –  but fixing the problem at source, freeing up land use law.  The domestic-oriented elites of our society might not like it –  any more than their peers in ancient Mesopotomia were too keen on the remission –  but that is the source of the problem.  Fix that and then there might be a case for some sort of compensation scheme for those who had got so highly-indebted, but at present –  distorted market and all –  the highly indebted mostly have an asset still worth materially more (a very different situation from a subsistence borrowing in the face of extreme crop failure).

… and you can read the whole post here.

Michael has I think some good points to make regarding the causes of escalating housing debt. One thing he does not cover is the extent to which direct bail outs and extraordinary monetary policy support has contributed to the escalating level of debt. This is a huge topic in itself but I suspect that some of the increasing debt burden can be attributed to the fact that we have chosen not to allow debts to be written down or restructured in previous crises. I think there were legitimate reasons for not imposing losses on bank debt during the GFC but the subsequent development of a “bail-in” capacity should mean that bank supervisors and the government will have a better set of choices in the next banking crisis.

Tony – From The Outside

Why the real economy needs a prudential authority too

Isabella Kaminska (FT Alphaville) offers an interesting perspective on ways in which prudential initiatives in the areas of capital, liquidity and bail-in that have strengthened the banking sector post GFC might be applied to the “real economy”.

The global financial crisis taught us that laissez-faire finance, when left to its own devices, tends to encourage extreme fragility by under capitalising the system for efficiency’s sake and making it far more systemically interdependent.

Pre-2008, banks operated on the thinnest of capital layers while taking extreme liquidity risk due to the presumption that wholesale liquidity markets would always be open and available to them. It was in this way that they saved on capital and liquidity costs and increased their return on equity.  

Regulatory responses to the crisis understandably focused on boosting resilience by hiking capital buffers, liquidity ratios and also by introducing new types of loss absorbing structures. While it’s still too early to claim regulatory efforts were a definitive success, it does seem by and large the measures have worked to stymie a greater financial crisis this time around.

But what the 2008 crisis response may have overlooked is that bolstering banks to protect the economy means very little if the underlying real economy remains as thinly spread and interconnected as the financial sector always used to be.

The assessment that these banking initiatives “means very little” is possibly overstating the case.  The problems we are facing today would be an order of magnitude greater if the banking system was not able to plays its part in the solution.

The core point, however, I think is absolutely on the money, the focus on efficiency comes at the expense of resilience. More importantly, a free market system, populated by economic agents pursuing their own interests shaped by a focus on relatively short term time horizons, does not seem to be well adapted for dealing with this problem on its own. The lessons prudential regulators learned about the limits of efficient markets and market discipline also apply in the real world.

Isabella looks at the way prudential capital and liquidity requirements operate in banking and draws analogies in the real economy. With respect to liquidity, she notes for example,

“… the just-in-time supply chain system can be viewed as the real economy’s version of a fractional reserve system, with reserves substitutable for inventories.  

Meanwhile, the real economy’s presumption that additional inventories can be sourced from third party wholesale suppliers at a price as and when demand dictates, is equivalent to the banking sector’s presumption that liquidity can always be sourced from wholesale markets.

Though there is obviously one important difference.

Unlike the banking sector, the real economy has no lender of last resort that can magically conjure up more intensive care beds or toilet paper at the stroke of a keyboard when runs on such resources manifest unexpectedly.  

So what are our options? Companies could increase their inventories (analogous to holding more liquid assets) or build excess capacity (analogous to building up a capital buffer) but it is very difficult for companies acting independently to do this if their competitors choose the short term cost efficient play and undercut them on price. The Prisoner’s Dilemma trumps market discipline and playing the long game.

Isabella frames the problem as follows:

short-term supply shortages can only be responded to with real world manufacturing capability, which itself is constrained by physical availability To that extent crisis responses can only really take two forms: 1) immediate investment in the build-up of new manufacturing capacity that can address the specific system shortages or, 2) the temporary reallocation of existing resources (with some adaptation cost) to new production purposes.

The problem with the first option is that it is not necessarily time efficient. Not every country has the capability to build two new hospitals from scratch in just 10 days. Nor the capacity to create unexpected supply just-in-time to deal with the problem.

New investment may not be economically optimal either. What happens to those hospitals when the crisis abates? Do they stand empty and idle? Do they get repurposed? Who will fund their maintenance and upkeep if they go unused? And at what cost to other vital services and goods?

Isabella’s proposal …

That leaves the reallocation of existing assets as the only sensible and economically efficient mitigatory response to surge-demand related crises like pandemic flu. But it’s clear that on that front we can be smarter about how we anticipate and prepare for such reallocation shocks. An obvious thing to do is to take a leaf out of banking regulators’ books, especially with regards to bail-inable capital, capital ratios and liquidity profiles.

Isabella offers two examples to illustrate her argument; one is power companies and the other is the health system.

She notes that power utilities manage demand-surge or supply-shock risk with interruptible contracts to industrial clients. She argues that these contracts equate to a type of bail-inable capital buffer, since the contracts allow utilities to temporarily suspend services to clients (at their cost) if and when critical needs are triggered elsewhere and supplies must be diverted.

I think she has a good point about the value of real options but I am less sure that bail-in is the right analogy. Bail-in is a permanent adjustment to the capital structure in which debt is converted to equity or written off. Preferably the former in order to maintain the loss hierarchy that would otherwise apply in liquidation. A contract that enables a temporary adjustment to expenses is a valuable option but not really a bail-in style option.

What she is identifying in this power utility example is more a company buying real options from its customers that reduces operating leverage by enabling the company to reduce the supply of service when it becomes expensive to supply. Companies that have high operating leverage have high fixed costs versus revenue and will, all other things being equal, tend to need to run more conservative financial leverage than companies with low operating leverage. So reduced operating leverage is a substitute for needing to hold more capital.

Isabella then explores the ways in which the liquidity, capital and bail-in analogies might be applied in healthcare. I can quibble with some of the analogies she draws to prudential capital and liquidity requirements. As an example of a capital requirement being applied to health care she proposes that …

“… governments could mandate makers of non-perishable emergency goods (such as medicines, toilet paper, face masks, hand sanitiser) to always keep two-weeks’ worth of additional supply on hand. And companies could also be mandated to maintain some share of total supply chain production capability entirely domestically, making them more resilient to globalised shocks”

 Two weeks supply looks more like a liquidity buffer than a capital buffer but that does not make the ideas any the less worth considering as a way of making the real economy more resilient. The banking system had its crisis during the GFC and the real economy is being tested this time around. There are arguments about whether the changes to banking went far enough but it is clearly a lot better placed to play its part in this crisis than it was in the last. The question Isabella poses is what kinds of structural change will be required to make the real economy more resilient in the face of the next crisis.

Another example of FT Alphaville being a reliable source of ideas and information to help you think more deeply about the world.

Tony (From the Outside)

Bank funding costs and capital structure – what I missed

A recent post looked at a Bank of England paper that offered evidence that the cost of higher capital requirements will be mitigated by a reduction in leverage risk which translates into lower borrowing costs and a decline in the required return equity. My post set out some reasons why I struggled with this finding.

My argument was that,

  • in banking systems where the senior debt rating of banks assumed to be Too Big To Fail is supported by an implied assumption of government support (such as Australia),
  • increasing the level of subordinated debt could reduce the value of that implied support,
  • however, senior debt itself does not seem to be any less risky (the senior debt rating does not improve), and
  • the subordinated debt should in theory be more risky if it reduces the value of the assumption of government support.

Fortunately, I also qualified my observations with the caveat that it was possible that I was missing something. Recent issuance of Tier 2 debt by some Australian banks offers some more empirical evidence that does seem to suggest that the cost of senior debt can decline in response to the issuance of more junior securities and that the cost of subordinated debt does not seem to be responding in the way that the theory suggests.

My original argument was I think partly correct. The prospect of the large Australian banks substantially increasing the relative share of Tier 2 debt in their liability structure has not resulted in any improvement in the AA- senior debt rating of the banks subject to this Total Loss Absorbing Capital requirement. So senior debt does not seem to be any less risky.

What I missed was the impact of the supply demand dynamic in a low interest rate environment where safe assets are in very short supply.

The senior debt in my thesis is no less risky but the debt market appears to be factoring in the fact that the pool of AA- senior debt is likely to shrink relative to what was previously expected. Investors who have been struggling for some time to find relatively safe assets with a decent yield weigh up the options. A decent yield on safe assets like they used to get in the old days would obviously be preferable but that is not on offer so they pay up to get a share of what is on offer.

The subordinated debt issued by these banks might be more risky in theory to the extent that bail-in is now more credible but if you do the analysis and conclude that the bank is well managed and low risk then you discount the risk of being bailed-in and take the yield. Again the ultra low yield on very safe assets and the shortage of better options means that you probably bid strongly to get a share of the yield on offer.

Summing up. The impacts on borrowing costs described here may look the same as what would be expected if the Modigliani-Miller effect was in play but the underlying driver appears to be something else.

It remains possible that I am still missing something but hopefully this post moves me a bit closer to a correct understanding of how capital structure impacts bank funding costs …

Tony

Deposit insurance and moral hazard

Depositors tend to be a protected species

It is generally agreed that bank deposits have a privileged position in the financial system. There are exceptions to the rule such as NZ which, not only eschews deposit insurance, but also the practice of granting deposits a preferred (or super senior) claim on the assets of the bank. NZ also has a unique approach to bank resolution which clearly includes imposing losses on bank deposits as part of the recapitalisation process. Deposit insurance is under review in NZ but it is less clear if that review contemplates revisiting the question of deposit preference.

The more common practice is for deposits to rank at, or near, the top of the queue in their claim on the assets of the issuing bank. This preferred claim is often supported by some form of limited deposit insurance (increasingly so post the Global Financial Crisis of 2008). An assessment of the full benefit has to consider the cost of providing the payment infrastructure that bank depositors require but the issuing bank benefits from the capacity to raise funds at relatively low interest rates. The capacity to raise funding in the form of deposits also tends to mean that the issuing banks will be heavily regulated which adds another layer of cost.


The question is whether depositors should be protected

I am aware of two main arguments for protecting depositors:

  • One is to protect the savings of financially unsophisticated individuals and small businesses.
  • The other major benefit relates to the short-term, on-demand, nature of deposits that makes them convenient for settling transactions but can also lead to a ‘bank run’.

The fact is that retail depositors are simply not well equipped to evaluate the solvency and liquidity of a bank. Given that even the professionals can fail to detect problems in banks, it is not clear why people who will tend to lie at the unsophisticated end of the spectrum should be expected to do any better. However, the unsophisticated investor argument by itself is probably not sufficient. We allow these individuals to invest in the shares of banks and other risky investments so what is special about deposits.

The more fundamental issue is that, by virtue of the way in which they function as a form of money, bank deposits should not be analysed as “investments”. To function as money the par value of bank deposits must be unquestioned and effectively a matter of faith or trust. Deposit insurance and deposit preference are the tools we use to underwrite the safety and liquidity of bank deposits and this is essential if bank deposits are to function as money. We know the economy needs money to facilitate economic activity so if bank deposits don’t perform this function then you need something else that does. Whatever the alternative form of money decided on, you are still left with the core issue of how to make it safe and liquid.

Quote
“The capacity of a financial instrument like a bank deposit to be accepted and used as money depends on the ability of uninformed agents to trade it without fear of loss; i.e. the extent to which the value of the instrument is insulated from any adverse information about the counterparty”

Gary Gorton and George Pennacchi “Financial Intermediaries and Liquidity Creation”

I recognise that fintech solutions are increasingly offering alternative payment mechanisms that offer some of the functions of money but to date these still ultimately rely on a bank with a settlement account at the central bank to function. This post on Alphaville is worth reading if you are interested in this area of financial innovation. The short version is that fintechs have not been able to create new money in the way banks do but this might be changing.

But what about moral hazard?

There is an argument that depositors should not be a protected class because insulation from risk creates moral hazard.

While government deposit insurance has proven very successful in protecting banks from runs, it does so at a cost because it leads to moral hazard (Santos, 2000, p. 8). By offering a guarantee that depositors are not subject to loss, the provider of deposit insurance bears the risk that they would otherwise have borne.

According to Dr Sam Wylie (2009, p. 7) from the Melbourne Business School:

“The Government eliminates the adverse selection problem of depositors by insuring them against default by the bank. In doing so the Government creates a moral hazard problem for itself. The deposit insurance gives banks an incentive to make higher risk loans that have commensurately higher interest payments. Why?, because they are then betting with taxpayer’s money. If the riskier loans are repaid the owners of the bank get the benefit. If not, and the bank’s assets cannot cover liabilities, then the Government must make up the shortfall”

Reconciling Prudential Regulation with Competition, Pegasus Economics, May 2019 (p17)

A financial system that creates moral hazard is clearly undesirable but, for the reasons set out above, it is less clear to me that bank depositors are the right set of stakeholders to take on the responsibility of imposing market discipline on banks. There is a very real problem here but requiring depositors to take on this task is not the answer.

The paper by Gorton and Pennacchi that I referred to above notes that there is a variety of ways to make bank deposits liquid (i.e. insensitive to adverse information about the bank) but they argue for solutions where depositors have a sufficiently deep and senior claim on the assets of the bank that any volatility in their value is of no concern. This of course is what deposit insurance and giving deposits a preferred claim in the bank loss hierarchy does. Combining deposit insurance with a preferred claim on a bank’s assets also means that the government can underwrite deposit insurance with very little risk of loss.

It is also important I think to recognise that deposit preference moves the risk to other parts of the balance sheet that are arguably better suited to the task of exercising market discipline. The quote above from Pegasus Economics focussed on deposit insurance and I think has a fair point if the effect is simply to move risk from depositors to the government. That is part of the reason why I think that deposit preference, combined with how the deposit insurance is funded, are also key elements of the answer.

Designing a banking system that addresses the role of bank deposits as the primary form of money without the moral hazard problem

I have argued that the discussion of moral hazard is much more productive when the risk of failure is directed at stakeholders who have the expertise to monitor bank balance sheets, the capacity to absorb the risk and who are compensated for undertaking this responsibility. If depositors are not well suited to the market discipline task then who should bear the responsibility?

  • Senior unsecured debt
  • Non preferred senior debt (Tier 3 capital?)
  • Subordinated debt (i.e. Tier 2 capital)
  • Additional Tier 1 (AT1)
  • Common Equity Tier 1 (CET1)

There is a tension between liquidity and risk. Any security that is risky may be liquid during normal market conditions but this “liquidity” cannot be relied on under adverse conditions. Senior debt can in principle be a risky asset but most big banks will also aim to be able to issue senior debt on the best terms they can achieve to maximise liquidity. In practice, this means that big banks will probably aim for a Long Term Senior Debt Rating that is safely above the “investment grade” threshold. Investment grade ratings offer not just the capacity top issue at relatively low credit spreads but also, and possibly more importantly, access to a deeper and more reliable pool of funding.

Cheaper funding is nice to have but reliable access to funding is a life and death issue for banks when they have to continually roll over maturing debt to keep the wheels of their business turning. This is also the space where banks can access the pools of really long term funding that are essential to meet the liquidity and long term funding requirements that have been introduced under Basel III.

The best source of market discipline probably lies in the space between senior debt and common equity

I imagine that not every one will agree with me on this but I do not see common equity as a great source of market discipline on banks. Common equity is clearly a risky asset but the fact that shareholders benefit from taking risk is also a reason why they are inclined to give greater weight to the upside than to the downside when considering risk reward choices. As a consequence, I am not a fan of the “big equity” approach to bank capital requirements.

In my view, the best place to look for market discipline and the control of moral hazard in banking lies in securities that fill the gap between senior unsecured debt and common equity; i.e. non-preferred senior debt, subordinated debt and Additional Tier 1. I also see value in having multiple layers of loss absorption as opposed to one big homogeneous layer of loss absorption. This is partly because it can be more cost effective to find different groups of investors with different risk appetites. Possibly more important is that multiple layers offer both the banks and supervisors more flexibility in the size and impact of the way these instruments are used to recapitalise the bank.

Summing up …

I have held off putting this post up because I wanted the time to think through the issues and ensure (to the best of my ability) that I was not missing something. There remains the very real possibility that I am still missing something. That said, I do believe that understanding the role that bank deposits play as the primary form of money is fundamental to any complete discussion of the questions of deposit insurance, deposit preference and moral hazard in banking.

Tony

Bank funding costs and capital structure

Here is another paper for anyone interested in the optimal bank capital structure debate. It is a Bank of England Staff Working Paper titled “Bank funding costs and capital structure” by Andrew Gimber and Aniruddha Rajan.

The authors summarise their paper as follows:

“If bail-in is credible, risk premia on bank securities should decrease as funding sources junior to and alongside them in the creditor hierarchy increase. Other things equal, we find that when banks have more equity and less subordinated debt they have lower risk premia on both. When banks have more subordinated and less senior unsecured debt, senior unsecured risk premia are lower. For percentage point changes to an average balance sheet, these reductions would offset about two thirds of the higher cost of equity relative to subordinated debt and one third of the spread between subordinated and senior unsecured debt.”

Abstract

The paper adds support to the argument that the cost of higher capital requirements will be mitigated by a reduction in leverage risk which translates into lower borrowing costs and a decline in the required return on equity. In the jargon of the corporate finance wonks, the paper supports a Modigliani Miller (MM) offset.

I need to dig a bit deeper into the results but I am struggling with the finding that increasing the level of subordinated debt at the expense of senior debt results in a reduction in the cost of senior debt. In the interests of full disclosure, I recognise that this may simply reflect the fact that my experience and knowledge base is mostly limited to the Australian and New Zealand banking systems but here goes. As always, it is also possible that I am simply missing something.

The problem for me in these results

We are not debating here the principle that risk (and hence required return) increases as you move through the loss hierarchy. This is a common challenge thrown out at anyone who questions the thesis that risk should decline as you reduce leverage. My concern is that MM did not anticipate a financing structure in which the risk of certain liabilities is mitigated by the existence of an assumption that the public sector will support any bank that is deemed Too Big To Fail (TBTF).

I am not seeking to defend the right of banks to benefit from this implied subsidy. I fully support the efforts being made to eliminate this market distortion. However, so far as I can determine, the reality is that increasing the level of subordinated debt and/or equity may reduce the value of the implied TBTF assumption but senior debt itself does not seem to be any less risky so far as senior debt investors are concerned. So why should they adjust their required return?

This seems to be what we are observing in the response of the debt ratings of the major Australian banks to proposals that they be required to maintain increased levels of subordinated debt to comply with Basel III’s Total Loss Absorbing Capital (TLAC) requirement.

My second concern is not specific to the Bank of England paper but worth mentioning since we are on the topic. One of the MM predictions tested in this study is that “the risk premium on a funding source should fall as that funding source expands at the expense of a more senior one” with the study finding evidence that this is true. This proposition (now supported by another study with empirical data) is often used to argue that it really does not matter how much equity a bank is required to hold because the cost of equity will decline to compensate (the “Big Equity” argument).

What is missing, I think, is any consideration of what is the lower boundary for the return that an equity investor requires to even consider taking the junior position in the financing structure in what is ultimately one of the most cyclically exposed areas of an economy. My last post looked at a study of the returns on both risky and safe assets over a period of 145 years which suggested that risky assets have on average generated a real return of circa 7% p.a.. When you factor in an allowance for inflation you are looking at something in the range of 9%-10% p.a. In addition, there are a range of factors that suggest a bank should be looking to target a Return on Equity of at least 2%-3% over the average “through the cycle” expected return. This includes the way that loan losses are accounted for in the benign part of the cycle and I don’t think that IFRS9 is going to change this.

This is a topic I plan to explore in greater detail in a future post. For the moment, the main point is that there has to be a lower boundary to how much the cost of equity can decline to in response to changes in capital structure but this seems to be largely absent from the Big Equity debate.

I have added a bit of background below for anyone who is not familiar with the detail of how a bank financing structure tends to be more complicated than that of a typical non-financial company.

Tell me what I am missing …

Tony

Appendix: A bit of background for those new to this debate

The extent of this MM offset is one of the more contentious issues in finance that has generated a long and heated debate stretching back over more than half a century. Both sides of the debate agree that there is a hierarchy of risk in a company financing structure. Common equity is unambiguously at the high end of this risk hierarchy and hence should expect to earn the highest return. Layers in the hierarchy, and hence the relative protection from solvency risk, are introduced by creating levels of seniority/subordination amongst the various funding sources.

An industrial company could just have debt and equity in which case the MM offset is much easier to analyse (though still contentious). Bank financing structures, in contrast, introduce a variety of issues that render the debate even more complicated and contentious:

  • Prudential capital requirements introduce at least three layers of subordination/seniority via the distinction between minimum capital requirements for Common Equity Tier 1, Additional Tier 1 and Tier 2 capital
  • The transition to a “bail-in” regime potentially introduces another level of subordination/seniority in the form of an additional requirement for certain (typically large and systemically important) banks to hold Non-Preferred Senior debt (or something functionally equivalent)
  • Next comes senior unsecured debt that is one of the workhorses of the bank financing structure (which in turn may be short or long term)
  • In certain cases a bank may also issue covered bonds which are secured against a pool of assets (to keep things simple, I will skip over securitisation financing)
  • Banks are also distinguished by their capacity to borrow money in the form of bank deposits which also serve as a means of payment in the economy (and hence as a form of money)
  • Bank deposits often have the benefit of deposit insurance and/or a preferred super senior claim on the assets of the bank

Apart from the formal protections afforded by the seniority of their claim, certain liabilities (typically the senior unsecured) can also benefit from an implied assumption that the government will likely bail a bank out because it is Too Big To Fail (TBTF). Eliminating this implied subsidy is a key objective of the changes to bank capital requirements being progressively implemented under Basel III.

Until this process is complete, and the implied balance sheet value of being considered TBTF is eliminated, the response of bank funding costs to changes in leverage will not always follow the simple script defined by the MM capital irrelevancy thesis.

Australian government support for banks

The impending transition to an increased level of Loss Absorbing Capital has prompted speculation on whether this means that the assumption of government support embedded in the senior debt rating of the large Australian banks remains appropriate. This speculation is fuelled in part by precedents established in the European Union and United States where the implementation of increased loss absorption requirements has resulted in the assessment of government supportiveness being downgraded.

Standard and Poor’s addressed this question in the Australian context and the short answer is that continued high government support is the probable outcome.

“In our view, this framework does not propose–nor have the authorities more broadly taken–any concrete actions that would suggest reduced government support despite the stated intent to reduce the implicit government guarantee and the perception that some banks are too big to fail”

“Australian Government Support For Banks: Will There Be More Twists In The Tale?, 8 April 2019 – S&P Global RatingsDirect

APRA’s proposed framework for increased loss absorption

Before digging into the detail of why S&P continue to believe the Australian Government will most likely remain “highly supportive” of systemically important banks, it will be useful to quickly revisit the discussion paper APRA published in November 2018 setting out its proposed response to the Financial System Inquiry recommendation that the Government “Implement a framework for minimum loss absorbing and recapitalization capacity in line with emerging international practice, sufficient to facilitate the orderly resolution of Australian authorised deposit-taking institutions (ADIs) and minimize taxpayer support”.

APRA proposed that selected Australian banks (mostly D-SIBs) be required to hold more loss absorbing capital via an increase in the minimum Prudential Capital Requirement (PCR) applied the Total Capital Ratio (TCR) they are required to maintain under Para 23 of APS 110.

“The minimum PCRs that an ADI must maintain at all times are:
(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 it is assumed they will choose Tier 2 capital as the lowest cost way to meet the requirement.

A post I did on APRA’s discussion paper, identified 5 issues posed by APRA’s proposed response including the question “To what extent would the public sector continue to stand behind the banking system once the proposed level of self insurance is in place?”. My assessment at that time was that …

“… the solution that APRA has proposed seems to me to give the official family much greater options for dealing with future banking crises without having to call on the taxpayer to underwrite the risk of recapitalising failed or otherwise non-viable banks.

It does not, however, eliminate the need for liquidity support. ... The reality is that banking systems built on mostly illiquid assets will likely face future crises of confidence where the support of the central bank will be necessary to keep the financial wheels of the economy turning. ….

… the current system requires the central bank to be the lender of last resort. That support is extremely valuable and is another design feature that sets banks apart from other companies. It is not the same however, as bailing out a bank via a recapitalisation.

“Does more loss absorption and “orderly resolution” eliminate the TBTF subsidy”, posted on From The Outside (November 2018)

I noted that the proposed increase in loss absorbing capital would give APRA and the RBA much greater options for dealing with the solvency aspect of any future crisis but my main point in that initial response to the policy proposal was that the need for a liquidity support backstop remained. In my experience, solvency and liquidity are frequently conflated in the public discussion of bail-outs and my point was that recognising that they are not the same facilitates a more sensible discussion of the role of bail-in and government support. The steps APRA is proposing to take to reduce the implied level of government support do not change the fact that the central bank standing ready to act as the Lender of Last Resort (“LOLR”) will remain a design feature of the financial system we have, not a bug.

The distinction between solvency an liquidity is important but, with the benefit of hindsight, I should have paid equal attention to the extent to which the Australian government might still be expected to go beyond liquidity support if required and the way in which the Australian approach to bail-in differs from that being developed in the U.S. and the E.U.

Standard and Poors continues to rate the Australian government as “highly supportive”

Notwithstanding some ambiguity introduced by the government’s response to the FSI recommendation, S&P continue to believe that the Australian government will remain “highly supportive” towards the systemically important private sector banks. They clarify that support in this context means “… the propensity of a government to provide extraordinary support (typically a capital injection) …”.

The factors underpinning S&P’s (admittedly subjective) assessment are:

  • The Australian economy’s dependence on continued access to offshore funding via the Australian banks
  • The potential risk of contagion across the four major banks due to their interconnectedness
  • No evidence of in-principle political or social opposition to government support should it prove necessary
  • APRA’s proposed framework for increased loss absorption does not hinder government support (in contrast to the resolution frameworks adopted in the European Union and the United States where bail-in is a pre-requisite for a government funded bail-out)
  • Notwithstanding the broad range of powers that APRA has for dealing with a stressed financial institution, S&P do not see any clearly laid out framework that would allow senior creditors to be captured by a bail-in
  • A track record of prompt and decisive action to support banks where required.

The ambiguity referenced above stems from the Government’s response to the FSI in which it stated that it “… agrees that steps should be taken to reduce any implicit government guarantee and the perception that some banks are too big to fail”.

My prior post referred to APRA’s proposed solution giving “… the official family much greater options for dealing with future banking crises without having to call on the taxpayer…”. The fact that the government will have the option to use pre-positioned capital instruments to recapitalise failing banks in the future does not necessarily mean that they have forgone the option of using public funds, if that is deemed to be a better (or least worst) option. It is also worth noting that the Government’s response itself does not contemplate eliminating the implicit guarantee and the perception that some banks are too big to fail, simply to reducing them.

What would stop the Government using bail-in to recapitalise a bank?

The interesting question here is what would preclude the government from using the bail-in option, choosing instead to use public funds to recapitalise one or more non-viable banks. So long as investors in these instruments bought them with full knowledge of the downside, there is no obvious reason why they should be protected. The bigger issue seems to be whether the banking system can cope with this particular class of investor temporarily choosing to withdraw from funding Australian banks.

Here I think it is important to distinguish between a constraint on access to senior funding and a constraint on access to the kinds of contingent debt/capital instruments used to meet the Total Loss Absorption Requirement. The history of bond defaults suggests that investors eventually forgive or forget but it is also safer to assume that any banking system subject to bail-in might be temporarily excluded from access to the kinds of contingent convertible debt instruments that were used to recapitalise it.

That I suspect is a manageable scenario provided the recapitalisation of the banking system is sufficient to address any concerns that the senior bond holders may have regarding the solvency and/or viability of the banks impacted. Some degree of over-capitalisation of the banks may be necessary to achieve this and the cost of funding can be expected to increase also. This is part of the price of failure. There is however no in principle reason why bail-in of Additional Tier 1, Tier 2 and Tier 3 capital should impact the senior debt so long as it is clear that senior debt is not subject to the same risk of bail-in.

In the absence of access to Additional Tier 1, Tier 2 or Tier 3 capital, these banks will probably be required to temporarily rely on a greater share of common equity to meet their Total Capital Requirement but that can be regenerated through profit retention. I don’t see the capital rebuilding task being materially different to what would have applied if the bank was initially required to meet its TLAC requirement entirely via CET1 capital (as the RBNZ proposes). This is also where the official family can provide liquidity support with minimal risk of the taxpayer facing a loss. Once the bank has regained the trust of the investors, the option of increasing the share of non CET1 capital in the TLAC mix can be re-established.

The importance of the assumption of government support should not be underestimated

This is a complex topic and one where reasonable people can form different interpretations of the facts so let me know if I am missing something …

Table 1 from the S&P report illustrates that an improvement in the Stand Alone Credit Profile (SACP) of one of the Australian majors is not enough on its own to offset a downgrade in S&P’s assessment of government supportiveness. The SACP of the Australian majors is currently assessed at “a-” with government support translating to a 2 notch improvement in the Issuer Credit Rating (ICR) to “AA-“. If the government support assessment is downgraded, the ICR declines 1 notch to “A+” and is not improved even if the SACP is enhanced to “a”.

Tony (From the Outside)

The Bankers’ New Clothes: Arguments for simpler capital and much reduced leverage

It always pays to make sure you expose yourself to the opposite view. This post looks at some of the arguments for simpler and higher bank capital requirements put forward by Professors Admati and Hellwig. They have published a number of papers and a book on the topic but this post refers chiefly to their book “The Bankers’ New Clothes” and to a paper ‘The Parade of the Banker’s New Clothes Continues: 31 Flawed Claims Debunked”. As I understand it, the key elements of their argument are that:

  • Banks are inherently risky businesses,
  • Excessive borrowing by banks increases their inherent riskiness, but
  • Banks are only able to maintain this excessive level of borrowing because
    • Flawed risk based capital models underestimate the true capital requirements of the business
    • Market discipline also allows excessive borrowing because it is assumed that the government will bail out banks if the situation turns out badly

They identify a variety of ways of dealing with the problem of excessive leverage (controls on bank lending, liquidity requirements and capital requirements) but argue that substantially more common equity is the best solution because:

  • It directly reduces the probability that a bank will fail (i.e. all other things being equal, more common equity reduces the risk of insolvency),
  • A higher level of solvency protection has the added benefit of also reducing the risk of illiquidity, and
  • Contrary to claims by the banking industry, there is no net cost to society in holding more common equity because the dilution in ROE will be offset by a decline in the required return on equity

They concede that there will be some cost associated with unwinding the Too Big To Fail (TBTF) benefit that large banks currently enjoy on both the amount banks can borrow and on the cost of that funding but argue there is still no net cost to society in unwinding this undeserved subsidy. The book, in particular, gets glowing reviews for offering a compelling case for requiring banks to operate with much lower levels of leverage and for pointing out the folly of risk based capital requirements.

There are a number of areas where I find myself in agreement with the points they argue but I can’t make the leap to accept their conclusion that much a higher capital requirement based on a simple leverage ratio calculation is the best solution. I have written this post to help me think through the challenges they offer my beliefs about how banks should be capitalised.

It is useful, I think, to first set out the areas where we (well me at least) might agree in principle with what they say; i.e.

  • Financial crises clearly do impose significant costs on society and excessive borrowing does tend to make a financial system fragile (the trick is to agree what is “excessive”)
  • Better regulation and supervision have a role to play in minimising the risk of bank failure (i.e. market discipline alone is probably not enough)
  • Public policy should consider all costs, not just those of the banking industry
  • All balance sheets embody a trade-off between enterprise risk, return and leverage (i.e. increasing leverage does increase risk)

It is less clear however that:

  • The economics of bank financing are subject to exactly the same rules as that which apply to non-financial companies (i.e. rather than asserting that banks should be compared with non-financial companies, it is important to understand how banks are different)
  • A policy of zero failure for banks is necessarily the right one, or indeed even achievable (i.e. would it be better to engineer ways in which banks can fail without dragging the economy down with them)
  • Fail safe mechanisms, such as the bail in of pre-positioned liabilities, have no prospect of working as intended
  • The assertion that “most” of the new regulation intended to make banks safer and easier to resolve has been “rejected, diluted or delayed” is a valid assessment of what has actually happened under Basel III
  • That liquidity events requiring lender of last resort support from the central bank are always a solvency problem

Drawing on some previous posts dealing with these issues (see here, here and here), I propose to focus on the following questions:

  • How does the cost of bank financing respond to changes in leverage?
  • Are the risk based capital requirements as fundamentally flawed as the authors claim?
  • Are risk management incentives for bankers always better when they are required to hold increasing levels of common equity?
  • Do the increased loss absorption features of Basel III compliant hybrids (in particular, the power to trigger conversion or bail in of the instruments) offer a way to impose losses on failed banks without disrupting the economy or requiring public support

How does leverage affect the cost of bank financing?

Increasing the proportion of equity funding, the authors argue, reduces the risk that shareholders are exposed to because each dollar of equity they have invested

“ will be affected less intensely by the uncertainty associated with the investments”

“when shareholders bear less risk per dollar invested, the rate of return they require is lower”

“Therefore, taking the costs of equity as fixed and independent of the mix of equity and debt involves a fundamental fallacy”.

Banker’sNew Clothes (p101)

The basic facts they set out are not really contentious; the mix of debt and equity does impact required returns. The authors focus on what happens to common equity but changing leverage impacts both debt and equity. This is very clear in the way that rating agencies consider all of the points nominated by the authors when assigning a debt rating. Reduced equity funding will likely lead to a decline in the senior and subordinated debt ratings and higher costs (plus reduced access to funding in absolute dollar terms) while higher equity will be a positive rating factor.

Banks are not immune to these fundamental laws but it is still useful to understand how the outcomes are shaped by the special features of a bank balance sheet. My views here incorporate two of the claims they “debunk” in their paper; specifically

Flawed Claim #4: The key insights from corporate finance about the economics of funding, including those of Modigliani and Miller, are not relevant for banks because banks are different from other companies

Flawed Claim #5: Banks are special because they create money

One of the features that defines a bank is the ability to take deposits. The cost of deposits however tends to be insulated from the effects of leverage. This is a design feature. Bank deposits are a major component of the money supply but need to be insensitive to adverse information about the issuing bank to function as money.

Wanting bank deposits to be information insensitive does not make them so. That is a function of their super senior position in the liability loss hierarchy, supplemented in many, if not most, banking systems by some form of limited deposit insurance (1). I credit a paper by Gary Gorton and George Pennacchi titled “Financial Intermediaries and Liquidity Creation” for crytalising this insight (an earlier post offers a short summary of that paper). Another paper titled “Why Bail-In? And How?” by Joseph Sommer proposes a different rationale for deposits having a super senior position insulated from the risk of insolvency but the implications for the impact of leverage on bank financing costs are much the same.

A large bank also relies on senior unsecured financing. This class of funding is more risky than deposits but still typically investment grade. This again is a design feature. Large banks target an investment grade rating in order to deliver, not only competitive financing costs, but equally (and perhaps more importantly) access to a larger pool of potential funding over a wider range of tenors. The investment grade rating depends of course on there being sufficient loss absorbing capital underwriting that outcome. There is no escaping this law of corporate finance. 

The debt rating of large banks is of course also tied up with the issue of banks being treated as Too Big To Fail (TBTF). That is a distortion in the market that needs to be addressed and the answer broadly is more capital though the rating agencies are reasonably agnostic on the form this capital should take in so far as the senior debt rating is concerned. Subject to having enough common equity anchoring the capital structure, more Tier 2 subordinated debt (or Tier 3 bail-in) will work just as well as more common equity for the purposes of reducing the value of implied government support currently embedded in the long term senior debt rating.

Admati and Hellwig are right – there is no free lunch in corporate finance

At this stage, all of this risk has to go somewhere. On that point I completely agree with Admati and Hellwig. There is no free lunch, the rating/risk of the senior tranches of financing depend on having enough of the right kinds of loss absorbing capital standing before them in the loss hierarchy. Where I part company is on the questions of how much capital is enough and what form it should take.

How much capital is (more than) enough?

Admati and Hellwig’s argument for more bank capital has two legs. Firstly, they note that banks are typically much more leveraged than industrial companies and question how can this be given the fundamental law of capital irrelevancy defined by Modigliani and Miller. Secondly, they argue that risk based capital requirements are fundamentally flawed and systematically under estimate how much capital is required.

Why are banks different?

Admati and Hellwig note that banks have less capital than industrial companies and conclude that this must be a result of the market relying on the assumption that banks will be bailed out. The existence of a government support uplift in the senior debt ratings of large banks is I think beyond debate. There is also broad support (even amongst many bankers) that this is not sound public policy and should ideally be unwound.

It is not obvious however that this wholly explains the difference in observed leverage. Rating agency models are relatively transparent in this regard (S&P in particular) and the additional capital required to achieve a rating uplift equivalent to the existing government support factor would still see banks more leveraged than the typical industrial company. Bank balance sheets do seem to be different from those of industrial companies.

Flawed risk models

The other leg to their argument is that risk based capital fundamentally under estimates capital requirements. I am broadly sympathetic to the sceptical view on how to use the outputs of risk models and have been for some time. An article I wrote in 2008, for example, challenged the convention of using a probability of default associated with the target debt rating to precisely calibrate the amount of capital a bank required.

The same basic concept of highly precise, high confidence level capital requirements is embedded in the Internal Ratings Based formula and was part of the reason the model results were misinterpreted and misused. Too many people assigned a degree of precision to the models that was not warranted. That does not mean however that risk models are totally useless.

Professors Admati and Hellwig use simple examples (e.g. how does the risk of loss increase if a personal borrower increases leverage on a home loan) to argue that banks need to hold more capital. While the basic principle is correct (all other things equal, leverage does increase risk), the authors’ discussion does not draw much (or possibly any?) attention to the way that requiring a borrower to have equity to support their borrowing reduces a bank’s exposure to movements in the value of the loan collateral.

In the examples presented, any decline in the value of the assets being financed flows through directly to the value of equity, with the inference that this would be true of a bank also. In practice, low risk weights assigned by banks to certain (low default – well secured) pools of lending reflect the existence of borrower’s equity that will absorb the first loss before the value of the loan itself is called into question.

A capital requirement for residential mortgages (typically one of the lowest risk weights and also most significant asset classes) that looks way too low when you note that house prices can easily decline by 10 or 20%, starts to make more sense when you recognise that that there is (or should be) a substantial pool of borrower equity taking the brunt of the initial decline in the value of collateral. The diversity of borrowers is also an important factor in reducing the credit risk of the exposures (though not necessarily the systemic risk of an overall meltdown in the economy). Where that is not the case (and hence the renewed focus on credit origination standards and macro prudential policy in general), then low risk weights are not justified.

I recognise that this argument (incorporating the value of the borrower’s equity) does not work for traded assets where the mark to market change in the value of the asset flows directly to the bank’s equity. It does however work for the kinds of assets on bank balance sheets that typically have very low risk weights (i.e. the primary concern of the leverage ratio advocates). It also does not preclude erring on the side of caution when calculating risk weights so long as the model respects the relative riskiness of the various assets impacting the value of equity.

How much also depends on the quality of risk management (and supervision)

The discussion of how much capital a bank requires should also recognise the distinction between how much a well managed bank needs and how much a poorly managed bank needs. In a sense, the authors are proposing that all banks, good and bad, should be made to hold the capital required by bad banks. Their focus on highlighting the risks of banking obscures the fact that prudent banking mitigates the downside and that well managed banks are not necessarily consigned to the extremes of risk the authors present as the norm of banking.

While not expressed in exactly that way, the distinction I am drawing is implicit in Basel III’s Total Loss Absorbing Capital (TLAC) requirements now being put in place. TLAC adds a substantial layer of additional loss absorption on top of already substantially strengthened common equity requirements. The base layer of capital can be thought of as what is required for a well managed, well supervised bank with a sound balance sheet and business model. APRA’s “Unquestionably Strong” benchmark for CET1 is a practical example of what this requirement looks like. The problem of course is that all banks argue they are good banks but the risk remains that they are in fact bad banks and we usually don’t find out the difference until it is too late. The higher TLAC requirement provides for this contingency.

What should count as capital?

I looked at this question in a recent post on the RBNZ’s proposal that virtually all of their TLAC requirement should be comprised of common equity. Admati and Hellwig side with the RBNZ but I believe that a mix of common equity and bail-in capital (along the lines proposed by APRA) is the better solution.

Read my earlier post for the long version, but the essence of my argument is that bail-in capital introduces a better discipline over bank management risk appetite than does holding more common equity. Calibrating common equity requirements to very high standards should always be the foundation of a bank capital structure. Capital buffers in particular should be calibrated to withstand very severe external shocks and to be resilient against some slippage in risk management.

The argument that shareholders’ need to have more “skin in the game” is very valid where the company is undercapitalised. Bail-in capital is not a substitute for getting the basics right. A bank that holds too little common equity, calibrated to an idealised view of both its own capabilities and of the capacity of the external environment to surprise the modellers, will likely find itself suppressing information that does not fit the model. Loss aversion then kicks in and management start taking more risk to win back that which was lost, just as Admati and Hellwig argue.

However, once you have achieved a position that is unquestionably strong, holding more common equity does not necessarily enhance risk management discipline. My experience in banking is that it may in fact be more likely to breed an undesirable sense of complacency or even to create pressure to improve returns. I know that the later is not a a winning strategy in the long run but in the short run the market frequently does not care.

What is the minimum return an equity investor requires?

One of the problems I find with a simplistic application of Modigliani & Miller’s (M&M) capital irrelevancy argument is that it does not seem to consider if there is a minimum threshold return for an equity investment below which the investment is no longer sufficiently attractive to investors who are being asked to take first loss positions in a company; i.e. where is the line between debt and equity where a return is simply not high enough to be attractive to equity investors?

Reframing the question in this way suggests that the debate between the authors and the bankers may be more about whether risk based capital adequacy models (including stress testing) can be trusted than it is about the limitations of M&M in the real world.

Summary

The author’s solution to prudential supervision of banks is a shock and awe approach to capital that seeks to make the risk of insolvency de minimus for good banks and bad. I have done my best to be open to their arguments and indeed do agree with a number of them. My primary concern with the path they advocate is that I do not believe the extra “skin in the game” generates the risk management benefits they claim.

I see more potential in pursuing a capital structure based on

  • a level of common equity that is robustly calibrated to the needs of a well managed (and well supervised) bank
  • incorporating a well designed counter cyclical capital buffer,
  • supplemented with another robust layer of bail-in capital that imposes real costs (and accountability) on the shareholders and management of banks for whom this level of common equity proves insufficent.

The authors argue that the authorities would never use these bail-in powers for fear of further destabilising funding markets. This is a valid area of debate but I believe they conflate the risks of imposing losses on bank depositors with the kinds of risks that professional bond investors have traditionally absorbed over many centuries of banking. The golden era in which the TBTF factor shielded bank bondholders from this risk is coming to the end but this broader investment class of bond holders has dealt with defaults by all kinds of borrowers. I am not sure why banks would be special in this regard if countries can default. The key issue is that the investors enter into the contract with the knowledge that they are at risk and are being paid a risk premium commensurate with the downside (which may not be that large if investors judge the banks to be well managed).

This is a complex topic so please let me know if I have missed something fundamental or have otherwise mis-represented Admati and Hellwig’s thesis. In the interim, I remain mostly unconvinced …

Tony

  1. It is worth noting that NZ has adopted a different path with respect to deposit protection, rejecting both deposit preference and deposit insurance. They also have a unique policy tool (Open Bank Resolution) that allows the RBNZ to impose losses on deposits as part of the resolution process. They are reviewing the case for deposit insurance and I believe should also reconsider deposit preference.

What should count as bank capital?

My last post looked at a RBNZ consultation paper which addressed the question “How much capital is enough?”. The overall quantum of capital the RBNZ arrived at (16% of RWA plus) seemed reasonable but it was less obvious that relying almost entirely on CET1 was the right solution. That prompted me to revisit an earlier consultation paper in which the RBNZ set out its case for why it did not want contingent capital instruments to play a significant role in the capital structure of the banks it supervises. This post explores the arguments the RBNZ marshals to support its position as part of a broader exploration of the debate over what counts as capital.

The traditional approach to this question assumes that common equity is unquestionably the best form of capital from the perspective of loss absorption. Consequently, the extent to which alternative forms of funding count as capital is judged by common equity benchmarks; e.g. the extent to which the funding is a permanent commitment (i.e. no maturity date) and the returns paid to investors depend on the profitability or capacity of the company to pay (failure to pay is not an event of default).

There is no dispute that tangible common equity unquestionably absorbs loss and is the foundation of any company’s capital structure but I believe contingent convertible capital instruments do potentially add something useful to the bank capital management toolkit. I will attempt to make the case that a foundation of common equity, supplemented with some debt that converts to common equity if required, is better than a capital structure comprised solely or largely of common equity.

The essence of my argument is that there is a point in the capital structure where adding contingent convertible instruments enhances market discipline relative to just adding more common equity. The RBNZ discusses the potential value of these structures in their consultation paper:

49. The theoretical literature on contingent debt explores how these instruments might reduce risk (i.e. lower the probability of insolvency) for an individual bank.  

50. Two effects have been identified. Firstly, adding contingent debt to a bank’s balance sheet directly increases the loss absorbing potential of the bank, relative to issuing pure debt (but not relative to acquiring more common equity). This follows directly from the fact that removing the debt is an essential part of every contingent debt instrument. Secondly, depending on the terms, contingent capital may cause bank management to target a lower level of risk (incentive effects). In other words, in theory, a contingent debt instrument both reduces the probability a bank will incur losses and absorbs losses that do eventuate. Because of both these factors, contingent debt is expected, in theory, to reduce the risk of bank failure.  

51. Focusing on the second of these effects, management incentives, it matters whether, when the debt is written off, holders are compensated in the form of newly issued shares (“conversion”). If conversion is on such a scale as to threaten existing shareholders with a loss of control of the bank, it will be optimal for bank management to target a lower level of risk exposure for a given set of circumstances than would have been the case otherwise. For example, bank management may be less tolerant of asset volatility, and more likely to issue new equity to existing shareholders, when capital is low rather than risk triggering conversion.”

RBNZ Capital Review Paper 2: What should qualify as bank capital? Issues and Options (para 49 – 51) – Emphasis added

So the RBNZ does recognise the potential value of contingent debt instruments which convert into common equity but chose to downplay the benefits while placing much greater weight on a series of concerns it identified.

What’s in a name – The RBNZ Taxonomy of Capital

Before digging into the detail of the RBNZ concerns, it will be helpful to first clarify terminology. I am using the term Contingent Convertible Instruments for my preferred form of supplementary capital whereas much of the RBNZ paper focuses on what it refers to as “Contingent debt instruments“, which it defines in part as “debt that absorbs loss via write-off, which may or may not be followed by conversion”.

I had not picked this up on my first read of the RBNZ paper but came to realise we are talking slightly at cross purposes. The key words to note are “contingent” and “convertible”.

  • The “contingent” part of these instruments is non-negotiable if they are to be accepted as bank regulatory capital. The contingency is either a “non-viability event” (e.g. the supervisor determines that the bank must increase common equity to remain viable) or a CET1 ratio of 5.125% or less (what APRA terms a “loss absorption trigger” and the RBNZ refers to as a “going-concern trigger”)
  • “Conversion” however is optional. Loss absorption is non-negotiable for bank regulatory capital but it can be achieved in two ways. I have argued that loss absorption is best achieved by converting these capital instruments into common equity but prudential regulation is satisfied so long as the instruments are written-off.

I had taken it as given that these instruments would be convertible but the RBNZ places more emphasis on the possibility that conversion “may or may not” follow write-off. Small point but worth noting when evaluating the arguments.

Why does conversion matter?

The RBNZ understandably focuses on the write-off part of the loss absorption process whereas I focus on conversion because it is essential to preserving a loss hierarchy that allocates losses to common equity in the first instance. If we ignore for a moment the impact of bail-in (either by conversion or write-off), the order in which losses are applied to the various sources of funding employed by a bank follows this loss hierarchy:

  • Going Concern:
    • Common Equity Tier 1 (CET1)
    • Additional Tier 1 (AT1)
  • Insolvency – Liquidation or restructuring:
    • Tier 2 (T2)
    • Senior unsecured
    • Super senior
      • Covered bonds
      • Deposits
      • Insured deposits

Under bail-in, writing off a contingent capital instrument generates an increase in common equity that accrues to the existing ordinary shareholders thereby negating the traditional loss hierarchy that requires common equity to be exhausted before more senior instruments can be required to absorb loss.

Conversion is a far better way to effect loss absorption because ordinary shareholders still bear the brunt of any loss, albeit indirectly via the dilution of their shareholding (and associated share price losses). In theory, conversion shields the AT1 investors from loss absorption because they receive common equity equivalent in value to the book value of their claim on the issuer. In practice, it is less clear that the AT1 investors will be able to sell the shares received at the conversion price or better but they are still better off than if they had simply seen the value of their investment written-off. If you are interested in digging deeper, this post looks at how loss absorption works under bail-in.

The RBNZ does recognise this dynamic but still chose to reject these advantages so it is time to look at their concerns.

RBNZ concerns with contingent capital

The RBNZ identified six concerns to justify its in principle decision to exclude the use of contingent capital instruments in the NZ capital adequacy framework.

  1. Possible under-estimation of the tax effects of contingent debt
  2. Reliance on parent entities as purchasers of AT1 contingent debt
  3. Not suitable for retail investors
  4. Banks structured as mutual societies cannot offer contingent debt that includes conversion into common equity
  5. Potential for regulatory arbitrage arising from the tension between tax and capital regulation
  6. Difficulties with exercising regulatory oversight of contingent debt

I don’t imagine the RBNZ is much concerned with my opinion but I don’t find the first three concerns to be compelling. I set out my reasons later in the post but will focus for the moment on three issues that I think do bear deeper consideration. You do not necessarily have to agree with the RBNZ assessment, or the weight they assign to them, but I believe these concerns must be addressed if we are to make the case for contingent debt.

Stronger arguments against contingent debt

1) Contingent debt gives the larger, listed banks a competitive advantage over mutual societies that are unable to issue ordinary shares

The RBNZ notes that all New Zealand banks are able to issue a version of contingent debt that qualifies as capital, but that some types of banks may have access to a broader – and cheaper – range of capital opportunities than others. The current definition of capital is thus in part responsible for a somewhat uneven playing field.

The primary concern seems to be banks structured as mutual societies which are unable to issue ordinary shares. They cannot offer contingent debt that includes conversion and must rely on the relatively more expensive option of writing-off of the debt to effect loss absorption.

I think this is a reasonable concern but I also believe there may be ways to deal with it. One option is for these banks to issue Mutual Equity Interests as has been proposed in Australia. Another option (also based on an Australian proposal) is that the increased requirements for loss absorbing capital be confined to the banks which cannot credibly be allowed to fail or be resolved in any other way. I recognise that this option benefits from the existence of deposit insurance which NZ has thus far rejected.

I need to do bit more research on this topic so I plan to revisit the way we deal with small banks, and mutuals in particular, in a future post.

2) Economic welfare losses due to regulatory arbitrage opportunities in the context of contingent debt

The tax treatment of payments to security holders is one of the basic tests for determining if the security is debt or equity but contingent debt instruments don’t fall neatly into either box. The conversion terms tied to PONV triggers make the instruments equity like when the issuer is under financial stress while the contractual nature of the payments to security holders makes them appear more debt like under normal operating conditions.

I can see a valid prudential concern but only to the extent the debt like features the tax authority relied on in making its determination regarding tax-deductibility somehow undermined the ability of the instrument to absorb loss when required.

There have been instances where securities have been mis-sold to unsophisticated investors (the Monte dei Paschi di Sienna example cited by the RBNZ is a case in point) but it is less obvious that retail investment by itself is sufficient cause to rule out this form of capital.

The only real difference I see over conventional forms of debt is the line where their equity like features come into play. Conventional debt is only ever at risk of loss absorption in the event of bankruptcy where its seniority in the loss hierarchy will determine the extent to which the debt is repaid in full. These new forms of bank capital bring forward the point at which a bank balance sheet can be restructured to address the risk that the restructuring undermines confidence in the bank. The economics of the restructuring are analogous so long as losses are allocated by conversion rather than by write-off alone.

3) Difficulties experienced with the regulatory oversight of contingent debt

Possibly their core concern is that overseeing instrument compliance is a complex and resource-intensive process that the RBNZ believes does not fit well with its regulatory model that emphasises self-discipline and market discipline. The RBNZ highlights two concerns in particular.

  • Firstly the RBNZ has chosen to respond to the challenge of vetting these instruments by instituting a “non-objection process” that places the onus on issuers to confirm that their instruments comply with the capital adequacy requirements.
  • Secondly, notwithstanding the non objection process, the added complexity of the instruments relative to common equity, still requires significant call on prudential resources.

This I think, is the strongest objection the RBNZ raises against contingent debt. Contingent debt securities are clearly more complex than common equity so the RBNZ quite reasonably argues that they need to bring something extra to the table to justify the time, effort and risk associated with them. There is virtually no justification for them if they do, as the RBNZ asserts, work against the principles of self and market discipline that underpin its regulatory philosophy.

Three not so compelling reasons for restricting the use of contingent capital instruments (“in my humble opinion’)

1) Possible under-estimation of the tax effects of contingent debt

The first concern relates to the RBNZ requirement that banks must acknowledge any potential tax implications arising from contingent debt and reflect these potential “tax offsets” in the reported value of capital. Banks are required to obtain a binding ruling from the NZ tax authority (or voluntarily take a tax ”haircut”). The RBNZ acknowledges that a binding ruling can provide comfort that tax is fully accounted for under prudential requirements, but quite reasonably argues that this will only be the case if the ruling that is sought is appropriately specified so as to capture all relevant circumstances.

The RBNZ’s specific concern seems to be what happens when no shares are issued in the event of the contingent loss absorption feature being triggered and hence no consideration is paid to investors in exchange for writing off their debt claim. The bank has made a gain that in principle would create a tax lability but it also seems reasonable to assume that the write off could only occur if the bank was incurring material losses. It follows then that the contingent tax liability created by the write off is highly likely to be set off against the tax losses such that there is no tax to pay.

I am not a tax expert so I may well be missing something but I can’t see a practical risk here. Even in the seemingly unlikely event that there is a tax payment, the money represents a windfall gain for the public purse. That said, I recognise that the reader must still accept my argument regarding the value of having the conversion option to consider it worth dealing with the added complexity.

2) A reliance on parent entities as purchasers of AT1 contingent debt

I and the RBNZ both agree that one of the key planks in the case for accepting contingent debt as bank capital is the beneficial impact on bank risk taking generated by the risk of dilution but the RBNZ argues this beneficial impact is less than it could be when the instrument is issued by a NZ subsidiary to its publicly listed parent.

I may be missing something here but the parent is exposed to dilution if the Non-Viability or Going Concern triggers are hit so I can’t see how that reduces the incentive to control risk unless the suggestion is that NZ management will somehow have the freedom to pursue risky business strategies with no input from their ultimate owners.

3) Retail investors have acquired contingent debt

The RBNZ cites some statistical evidence that suggests that, in contrast to the experience overseas, there appears to be limited uptake by wholesale investors of contingent debt issued by the big four banks. This prompts them to question whether the terms being offered on instruments issued outside the parent group are not sufficiently attractive for sophisticated investors. This concern seems to be predicated on the view that retail will always be the least sophisticated investors so banks will seek to take advantage of their relative lack of knowledge.

It is arguably true that retail investors will tend be less sophisticated than wholesale investors but that should not in itself lead to the conclusion that any issue targeted at retail is a cynical attempt at exploitation or that retail might legitimately value something differently to the way other investors do. The extent that the structures issued by the Australian parents have thus far concentrated on retail, for example, might equally be explained by the payment of franking credit that was more highly valued by the retail segment. Offshore institutions might also have been negative on the Australian market therefore pushing Australian banks to focus their efforts in the domestic market.

I retain an open mind on this question and need to dig a bit deeper but I don’t see how the fact that retail investment dominates the demand for these structures at a point in time can be construed to be proof that they are being mis-sold.

The RBNZ’s answer ultimately lies in their regulatory philosophy

The reason that the RBNZ rejects the use of these forms of supplementary capital ultimately appears to lie in its regulatory philosophy which is based on the following principles

  • Self discipline on the part of the financial institutions they supervise
  • Market discipline
  • Deliberately conservative
  • Simplicity

The RBNZ also acknowledges the value of adopting BCBS consistent standards but this is not a guiding principle. It reserves the right to adapt them to local needs and, in particular, to be more conservative. It should also be noted that the RBNZ has quite deliberately rejected adopting deposit insurance on the grounds (as I understand it) that this encourages moral hazard. They take this a step further by foregoing any depositor preference in the loss hierarchy and by a unique policy of Open Bank Resolution (OBR) under which deposits are explicitly included in the liabilities which can be written down in need to assist in the recapitalisation of an insolvent bank.

In theory, the RBNZ might have embraced contingent convertible instruments on the basis of their consistency with the principles of self and market discipline. The threat of dilution via conversion of the instrument into common equity creates powerful incentives not just for management to limit excessive risk taking but also for the investors to exert market discipline where they perceive that management is not exercising self-discipline.

In practice, the RBNZ seems to have discounted this benefit on the grounds that that there is too much risk, either by design or by some operational failure, that these instruments might not convert to common equity. They also seem quite concerned with structures that eschew conversion (i.e. loss absorption effected by write-off alone) but they could have just excluded these instruments rather than a blanket ban. Having largely discounted or disregarded the potential benefit, the principles of deliberate conservatism and simplicity dictate their proposed policy position, common equity rules.

Summing up

This post only scratches the surface of this topic. My key point is that contingent convertible capital instruments potentially add something useful to the bank capital management toolkit compared to relying entirely on common equity. The RBNZ acknowledge the potential upside but ultimately argue that the concerns they identify outweigh the potential benefits. I have reviewed their six concerns in this post but need to do a bit more work to gain comfort that I am not missing something and that my belief in the value of bail-in based capital instruments is justified.

Tony