Capital adequacy – looking past the headline ratios

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

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

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

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

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

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

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

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

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

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

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

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

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

Summing up

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

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

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

Tony – From the Outside

APRA reflects on “… a subtle but important shift in regulatory thinking”

Wayne Byres speech to the Risk Management Association covered a range of developments but, for me, the important part was the discussion of the distinction between strength and resilience referenced in the title of this post.

This extract from the speech sets out how Mr Byres frames the distinction …

… in the post-GFC period, the emphasis of the international reforms was on strengthening the global financial system. Now, the narrative is how to improve its resilience. A perusal of APRA speeches and announcements over time shows a much greater emphasis on resilience in more recent times as well.

What is behind this shift? Put simply, it is possible to be strong, but not resilient. Your car windscreen is a great example – without doubt it is a very strong piece of glass, but one small crack and it is irreparably damaged and ultimately needs to be replaced. That is obviously not the way we want the financial system to be. We want a system that is able to absorb shocks, even from so-called “black swan” events, and have the means to restore itself to full health.

In saying that, financially strong balance sheets undoubtedly help provide resilience, and safeguarding financial strength will certainly remain the cornerstone of prudential regulation and supervision. But it is not the full story. So with that in mind, let me offer some quick reflections on the past year, and what it has revealed about opportunities for the resilience of the financial system to be further improved.

APRA Chair Wayne Byres – Speech to the 2020 Forum of the Risk Management Association – 3 December 2020

To my mind, the introduction of an increased emphasis on resilience is absolutely the right way to go. We saw some indications of the direction APRA intend to pursue in the speech that Mr Byres gave to the AFR Banking and Wealth Summit last month and will get more detail next week (hopefully) when APRA releases a consultation paper setting out a package of bank capital reforms that is likely to include a redesign of the capital buffer framework.

This package of reforms is one to watch. To the extent that it delivers on the promise of increasing the resilience of the Australian banking system, it is potentially as significant as the introduction of the “unquestionably strong” benchmark in response to the Australian Financial System Inquiry.

Tony – From the Outside

Bank capital adequacy – APRA chooses Option 2

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

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

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

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

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

while also making clear that

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

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

One observation at this stage …

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

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

Pro-cyclicality remains an issue

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

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

This is mostly simple math.

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

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

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

Tony – From the Outside

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

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

RBNZ COVID 19 Stress Tests

The RBNZ just released the results of the stress testing conducted by itself and a selection of the larger NZ banks to test resilience to the risks posed by COVID 19.

The extract below summarises the process the RBNZ followed and its key conclusions:

COVID-19 stress test consisted of two parts. First, a desktop stress test where the Reserve Bank estimated the impact on profitability and capital for nine of New Zealand’s largest banks to the impact of two severe but plausible scenarios. Second, the Reserve Bank coordinated a process in which the five largest banks used their own models to estimate the effect on their banks for the same scenarios.

  The pessimistic baseline scenario can be characterised as a one-in-50 to one-in-75 year event with the unemployment rate rising to 13.4 percent and a 37 percent fall in property prices. In the very severe scenario, the unemployment rate reaches 17.7 percent and house prices fall 50 percent. It should be noted that these scenarios are hypothetical and are significantly more severe than the Reserve Banks’ baseline scenario.

  The overall conclusion from the Reserve Bank’s modelling is that banks could draw on their existing capital buffers and continue lending to support lending in the economy during a downturn of the severity of the pessimistic baseline scenario. However, in the more severe scenario, banks capital fell below the regulatory minimums and would require significant mitigating actions including capital injections to continue lending. This reinforces the need for strong capital buffers to provide resilience against severe but unlikely events.

  The results of this stress test supports decisions that were made as part of the Capital Review to increase bank capital levels. The findings will help to inform Reserve Bank decisions on the timing of the implementation of the Capital Review, and any changes to current dividend restrictions.

“Outcome from a COVID-19 stress test of New Zealand banks”, RBNZ Bulletin Vol 83, No 3 September 2020

I have only skimmed the paper thus far but there is one detail I think worth highlighting for anyone not familiar with the detail of how bank capital adequacy is measured – specifically the impact of Risk Weighted Assets on the decline in capital ratios.

The RBNZ includes two useful charts which decompose the aggregate changes in CET1 capital ratio by year two of the scenario.

In the “Pessimistic Baseline Scenario”(PBS), the aggregate CET1 ratio declines 3.7 percentage points to 7.7 percent. This is above both the regulatory minimum and the threshold for mandatory conversion of Additional Tier 1 Capital. What I found interesting was that RWA growth contributed 2.2 percentage points to the net decline.

The RBNZ quite reasonably points out that banks will amplify the downturn if they restrict the supply of credit to the economy but I think it is also reasonable to assume that the overall level of loan outstandings is not growing and may well be shrinking due to the decline in economic activity. So a substantial portion of the decline in the aggregate CET1 ratio is due to the increase in average risk weights as credit quality declines. The C ET1 ratio is being impacted not only by the increase in impairment expenses reducing the numerator, there is a substantial added decline due to the way that risk weighted assets are measured

In the “Very Severe Scenario”(VSS), the aggregate CET1 ratio declines 5.6 percentage points to 5.8 percent. The first point to note here is that CET1 only remains above the 4.5% prudential minimum by virtue of the conversion of 1.6 percentage points of Additional Tier 1 Capital. Assuming 100% of AT1 was converted, this also implies that the Tier 1 ratio is below the 6.0% prudential minimum.

These outcomes provide food for thought but I few points I think wroth considering further before accepting the headline results at face value:

  • The headline results are materially impacted by the pro cyclicality of the advanced forms of Risk Weighted Asset measurement – risk sensitive measures offer useful insights but we also need to understand they ways in which they can also amplify the impacts of adverse scenarios rather than just taking the numbers at face value
  • The headline numbers are all RBNZ Desktop results – it would be useful to get a sense of exactly how much the internal stress test modelling conducted by the banks varied from the RBNZ Desktop results – The RBNZ stated (page 12) that the bank results were similar to its for the PBS but less severe in the VSS.

As always, it is entirely possible that I am missing something but I feel that the answer to bank resilience is not just a higher capital ratio. A deeper understanding of the pro cyclicality embedded in the system will I think allow us to build a better capital adequacy framework. As yet I don’t see this topic getting the attention it deserves.

Tony – From the Outside

APRA’s ADI capital regime – Unfinished business

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

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

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

Looking inward, APRA’s priorities are:

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

What is interesting – from a bank capital management perspective

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

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

The DP outlines

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

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

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

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

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

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

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

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

APRA clarify that

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

I offered my views on these options here.

Tony – From the Outside

Banks Are Managing Their Stress – Bloomberg

The ever reliable Matt Levine discusses the latest stress test results for the US banks. In particular the disconnect between the severity of the assumptions in the hypothetical scenario and the actual results observed to date. He notes that it is still early and plenty of room for the actual outcomes to catch up with the hypothetical. However, one of the issues with stress testing is the way you model the way people (and governments) respond to stress.

As Matt puts it …

But another important answer is that, when a crisis actually happens, people do something about it. They react, and try to make it better. In the case of the coronavirus crisis, the Fed and the U.S. government tried to mitigate the effect of a real disaster on economic and financial conditions. Unemployment is really high, but some of the consequences are mitigated by stimulus payments and increased unemployment benefits. Asset prices fell sharply, but then rose sharply as the Fed backstopped markets. Financing markets seized up, and then the Fed fixed them.

The banks themselves also acted to make things better, at least for themselves. One thing that often happens in a financial crisis is that banks’ trading desks make a killing trading for clients in turbulent markets, which helps to make up for some of the money they lose on bad loans. And in fact many banks had blowout first quarters in their trading divisions: Clients wanted to trade and would pay a lot for liquidity, and banks took their money.

In a hypothetical stress test, you can’t really account for any of this. If you’re a bank, and the Fed asks you to model how you’d handle a huge financial crisis, you can’t really write down “I would simply make a ton of money trading derivatives.” It is too cute, too optimistic. But in reality, lots of banks just went and did that.

Similarly, you obviously can’t write down “I would simply rely on the Fed to backstop asset prices and liquidity.” That is super cheating. Much of the purpose of the stress tests is to make it so the Fed doesn’t have to bail out the banking system; the point is to demonstrate that the banks can survive a financial crisis on their own without government support. But in reality, having a functioning financial system is better than not having that, so the Fed did intervene; keeping people in their homes is better than foreclosing on them, so the government supported incomes. So the banks are doing much better than you might expect with 13.3% unemployment.

So it is likely that the Fed’s stress test is both not harsh enough, in its economic scenario, and too harsh, in its assumption about how that scenario will affect banks.

Notwithstanding the potential for people to respond to and mitigate stress, there is still plenty of room for reality to catch up with and exceed the hypothetical scenario. Back to Matt…

But the fact that the stress test imagines an economic crisis that is much nicer than reality is still a little embarrassing, and the Fed can’t really say “everything is fine even in the terrible downside case of 10% unemployment, the banks are doing great.” So it also produced some new stress-test results (well, not quite a full stress test but a “sensitivity analysis”) assuming various scenarios about the recovery from the Covid crisis (“a rapid V-shaped recovery,” “a slower, more U-shaped recovery,” and “a W-shaped double dip recession”). The banks are much less well capitalized in those scenarios than they are either (1) now or (2) in the original stress tests, though mostly still okay, and the Fed is asking the banks to reconsider stress and capital based on current reality. Also stop share buybacks:

Worth reading

Tony – From the Outside

Capital adequacy reform – what we have learned from the crisis

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tony – From the Outside

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

Bank dividends

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

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

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

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

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

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

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

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

Bloomberg Opinion “Money Stuff” 7 April 2020

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

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

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

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

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

JP Morgan Chairman and CEO Letter to Shareholders 2019 Annual Report

Banks are cyclical investments – who knew?

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

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

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

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

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

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

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

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

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

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

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

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

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

Tony (From the Outside)