There has been a lot written on stablecoins in the wake of Terra’s crash. Matt Levine has been a reliable source of insight (definitely worth subscribing to his “Money Stuff” newsletter) but I am also following Izabella Kaminska via her new venture (The Blind Spot).
Maybe I am just inexplicably drawn to anything that seeks to explain crypto in Tradfi terms but I think this joint post by Izabella and Frances Coppola poses the right question by exploring the extent to which stablecoin issuers will always struggle to reconcile the safety of their peg promise to the token holders with the need to make a return. The full post is behind a paywall but this link takes you to a short extract that Izabella has made more broadly available.
Their key point is that financial security is costly so your business model needs an angle to make a return … to date the angles (or financial innovations) are mostly stuff that Tradfi has already explored. There is no free lunch.
If it’s financially secure, it’s usually not profitable
So, what was the impetus for issuers like Kwon to focus on these innovations? For the most part, it was probably the realisation that conventional stablecoins – due to their similarities with narrow banks – are exceedingly low-margin businesses. In a lot of cases, they may even be unprofitable.
This is because managing other people’s money prudently and in a way that always protects capital is actually really hard. Even if those assets are fully reserved, some sort of outperformance has to be generated to cover the administration costs. The safest way to do that is to charge fees, but this hinders competitiveness in the market since it generates a de facto negative interest rate. Another option is cross-selling some other service to the captured user base, like loan products. But this gets into bank-like activity.
The bigger temptation, therefore, at least in the first instance, is to invest the funds in your care into far riskier assets (with far greater potential upside) than those you are openly tracking.
But history shows that full-reserve or “narrow” banks eventually become fractional-reserve banks or disappear.
“Putting the Terra stablecoins debacle into Tradfi context”, Frances Coppola and Izabella Kaminska, The Blind Spot
I recently flagged a speech by Sam Woods (a senior official at the UK Prudential Regulation Authority) which floated some interesting ideas for what he describes as a “radically simpler, radically usable” version of the multi-layered capital buffers currently specified by the BCBS capital accord. At the time I was relying on a short summary of the speech published in the Bank Policy Institute’s “Insights” newsletter. Having now had a chance to read the speech in full I would say that there is a lot to like in what he proposes but also some ideas that I am not so sure about.
Mr Woods starts in the right place with the acknowledgment that “… the capital regime is fiendishly complex”. Complexity is rarely (if ever?) desirable so the obvious question is to identify the elements which can be removed or simplified without compromising the capacity to achieve the underlying economic objectives of the regime.
While the capital regime is fiendishly complex, its underlying economic goals are fairly simple: ensure that the banking sector has enough capital to absorb losses, preserve financial stability and support the economy through stresses.
… my guiding principle has been: any element of the framework that isn’t actually necessary to achieve those underlying goals should be removed. …
With that mind, my simple framework revolves around a single, releasable buffer of common equity, sitting above a low minimum requirement. This would be radically different from the current regime: no Pillar 2 buffers; no CCoBs, CCyBs, O-SII buffer and G-SiB buffers; no more AT1.
In practice, Mr Woods translates this simple design principle into 7 elements:
1. A single capital buffer, calibrated to reflect both microprudential and macroprudential risks.
2. A low minimum capital requirement, to maximise the size of the buffer.
3. A ‘ladder of intervention’ based on judgement for firms who enter their buffer – no mechanical triggers and thresholds.
4. The entire buffer potentially releasable in a stress.
5. All requirements met with common equity.
6. A mix of risk-weighted and leverage-based requirements.
7. Stress testing at the centre of how we set capital levels.
The design elements that appeal to me:
The emphasis on the higher capital requirements of Basel III being implemented via buffers rather than via higher minimum ratio thresholds
The concept of a “ladder of intervention” with more room for judgment and less reliance on mechanical triggers
The role of stress testing in calibrating both the capital buffer but also the risk appetite of the firm
I am not so sure about:
relying solely on common equity and “no more AT1” (Additional Tier 1)
the extent to which all of the components of the existing buffer framework are wrapped into one buffer and that “entire buffer” is potentially usable in a stress
No more Additional Tier 1?
There is little debate that common equity should be the foundation of any capital requirement. As Mr Woods puts it
Common equity is the quintessential loss-absorbing instrument and is easy to understand.
The problem with Additional Tier 1, he argues, is that these instruments …
… introduce complexity, uncertainty and additional “trigger points” in a stress and so have no place in our stripped-down concept …
I am a huge fan of simplifying things but I think it would be a retrograde step to remove Additional Tier 1 and other “bail-in” style instruments from the capital adequacy framework. This is partly because the “skin in the game” argument for common equity is not as strong or universal as its proponents seem to believe.
The “skin in the game” argument is on solid foundations where an organisation has too little capital and shareholders confronted with a material risk of failure, but limited downside (because they have only a small amount of capital invested), have an incentive to take large risks with uncertain payoffs. That is clearly undesirable but it is not a fair description of the risk reward payoff confronting bank shareholders who have already committed substantial increased common equity in response to the new benchmarks of what it takes to be deemed a strong bank.
I am not sure that any amount of capital will change the kinds of human behaviour that see banks mistakenly take on outsize, failure inducing, risk exposures because they think that they have found some unique new insight into risk or have simply forgotten the lessons of the past. The value add of Additional Tier 1 and similar “bail-in” instruments is that they enable the bank to be recapitalised with a material injection of common equity while imposing a material cost (via dilution) on the shareholders that allowed the failure of risk management to metastasise. The application of this ex post cost as the price of failure is I think likely to be a far more powerful force of market discipline than applying the same amount of capital before the fact to banks both good and bad.
In addition to the potential role AT1 play when banks get into trouble, AT1 investors also have a much greater incentive to monitor (and constrain) excessive risk taking than the common equity holders do because they don’t get any upside from this kind of business activity. AT1 investors obviously do not get the kinds of voting rights that common shareholders do but they do have the power to refuse to provide the funds that banks need to meet their bail-in capital requirements. This veto power is I think vastly underappreciated in the current design of the capital framework.
Keep AT1 but make it simpler
Any efforts at simplification could be more usefully directed to the AT1 instruments themselves. I suspect that some of the complexity can be attributed to efforts to make the instruments look and act like common equity. Far better I think to clearly define their role as one of providing “bail-in” capital to be used only in rare circumstances and for material amounts and define their terms and conditions to meet that simple objective.
There seems, for example, to be an inordinate amount of prudential concern applied to the need to ensure that distributions on these instruments are subject to the same restrictions as common equity when the reality is that the amounts have a relatively immaterial impact on the capital of the bank and that the real value of the instruments lie in the capacity to convert their principal into common equity. For anyone unfamiliar with the way that these instruments facilitate and assign loss absorption under bail-in I had a go at a deeper dive on the topic here.
One buffer to rule them all
I am not an expert on the Bank of England’s application of the Basel capital accord but I for one have always found their Pillar 2B methodology a bit confusing (and I like to think that I do mostly understand capital adequacy). The problem for me is that Pillar 2B seems to be trying to answer much the same question as a well constructed stress testing model applied to calibration of the capital buffer. So eliminating the Pillar 2B element seems like a step towards a simpler, more transparent approach with less potential for duplication and confusion.
I am less convinced that a “single capital buffer” is a good idea but this is not a vote for the status quo. The basic structure of a …
base Capital Conservation Buffer (CCB),
augmented where necessary to provide an added level of safety for systemically important institutions (either global or domestic), and
capped with a variable component designed to absorb the “normal” or “expected” rise and fall of losses associated with the business cycle
… seems sound and intuitive to me.
What I would change is the way that theCountercyclical Capital Conservation Buffer (CCyB) is calibrated. This part of the prudential capital buffer framework has been used too little to date and has tended to be applied in an overly mechanistic fashion. This is where I would embrace Mr Woods’ proposal that stress testing become much more central to the calibration of the CCyB and more explicitly tied to the risk appetite of the entity conducting the process.
it offered a way to more clearly define the point where the losses being experienced by the bank transition from expected to unexpected,
focussed risk modelling on the parts of the loss distribution that more squarely lay within their “zone of validity”, and
potentially allowed the Capital Conservation Buffer (CCB) to more explicitly deal with “unexpected losses” that threatened the viability of the bank.
I have also seen a suggestion by Douglas Elliott (Oliver Wyman) that a portion of the existing CCB be transferred into a larger CCyB which I think is worth considering if we ever get the chance to revisit the way the overall prudential buffers are designed. This makes more sense to me than fiddling with the minimum capital requirement.
As part of this process I would also be inclined to revisit the design of the Capital Conservation Ratio (CCR) applied as CET1 capital falls below specified quartiles of the Capital Conservation Buffer. This is another element of the Basel Capital Accord that is well intentioned (banks should respond to declining capital by retaining an increasing share of their profits) that in practice tends to be much more complicated in practice than it needs to be.
Sadly, explaining exactly why the CCR is problematic as currently implemented would double the word count of this post (and probably still be unintelligible to anyone who has not had to translate the rules into a spreadsheet) so I will leave that question alone for today.
Mr Woods has done us all a service by raising the question of whether the capital buffer framework delivered by the Basel Capital Accord could be simplified while improving its capacity to achieve its primary prudential and economic objectives. I don’t agree with all of the elements of the alternative he puts up for discussion but that is not really the point. The important point is to realise that the capital buffer framework we have today is not as useful as it could be and that really matters for helping ensure (as best we can) that we do not find ourselves back in a situation where government finds that bailing out the banks is its least worst option.
I have offered my thoughts on things we could do better but the ball really sits with the Basel Committee to reopen the discussion on this area of the capital adequacy framework. That will not happen until a broader understanding of the problems discussed above emerges so all credit to Mr Woods for attempting to restart that discussion.
I came across this proposal via the Bank Policy Institute’s weekly “Insights” email update
I have not read the speech yet but the summary offered by the BPI suggests that the proposal is worth reviewing in part because it highlights that a key part of the Basel III framework remains a work in progress
Here is the BPI’s summary
Prudential Regulatory Authority chief Sam Woods suggested making the U.K.’s bank capital framework simpler and more flexible. In a speech this week, Woods said regulators should make capital buffers more usable – in other words, entice banks to dip into them to lend during stressful times. The suggested framework, which Woods compared to a concept car and dubbed the “Basel Bufferati,” would be “radically simpler, radically usable, and a million miles away from the current debate but which might prove instructive over the longer term.” It centers on “a single, releasable buffer of common equity, sitting above a low minimum requirement.” It would also replace automatic thresholds with a “ladder of intervention” and feature a mix of risk-weighted and leverage-based requirements. The buffer would be determined using the results of the stress tests that would sit on top of standardized risk weights, which is a concept similar to the current U.S. regime. Therefore, “a lot of the sophistication which currently resides in modelling risk-weights would move into stress testing.”
APRA has included a detailed indicative timeline in an attachment to the letter covering key policy releases, reporting requirements, industry workshops and the process for capital model approvals associated with the revised framework
To provide a clear roadmap for consultation and industry engagement, APRA has set out an indicative timeline in Attachment A. The timeline covers key policy releases, reporting requirements, industry workshops and the process for capital model approvals. Over the course of 2021, APRA intends to:
• Conduct a targeted data study, to assess potential changes to the calibration of the prudential standards;
• Initiate regular workshops with industry as the standards and guidance are finalised, to provide a forum for updates and FAQs; and
• Release final prudential standards, draft prudential practice guides (PPGs) and initial details of reporting requirements by the end of the year.
Over the course of 2022, APRA intends to finalise the PPGs and reporting requirements. There are a number of related policy revisions that will also be progressed next year, including the fundamental review of the trading book and public disclosure requirements. APRA intends to conduct a parallel run of capital reporting on the new framework in late 2022.
APRA Letter to ADIs “ADI Capital Reforms: Roadmap to 2023”, 2 June 2021
Two key dates are
July 2021 – “Targeted Quantitative Impact Study” (due for completion August 2021)
November 2021 – Release of final Prudential Standards
It is not clear what, if any, information APRA will be releasing publicly between now and November 2021 when the Prudential Standards are published. I am hopeful however that the November release will be accompanied by some form of Information Paper setting out what APRA learned from the QIS and the industry workshops that it will be conducting along the way.
In this post, I lay out some problems that I have encountered in attempting to reconcile what it will mean for a D-SIB ADI to be “Unquestionably Strong” under the proposed new framework that APRA outlined in its December 2020 Discussion Paper (“A more flexible and resilient capital framework for ADIs”). Spoiler alert – I think the capital buffers adding up to a 10.5% CET1 prudential requirement may need to be recalibrated once all of the proposed changes to risk weights are tied down. I also include some questions regarding the impact of the RBNZ’s requirement for substantially higher capital requirements for NZ domiciled banks.
The idea that Australian Authorised Deposit Taking Institutions (“ADIs” but more commonly referred to as “banks”) needed to be “Unquestionably Strong” originated in a recommendation of the Australian Financial System Inquiry (2014) based on the rationale that Australian ADIs should both be and, equally importantly, be perceived to be more resilient than the international peers with which they compete for funding in the international capital markets.In July 2017, APRA translated the FSI recommendation into practical guidance in an announcementsupported by a longer information paper.
For most people, this all condensed into a very simple message, the systemically important Australian ADIs needed to maintain a Common Equity Tier 1 (CET1) ratio of at least 10.5%. The smaller ADIs have their own Unquestionably Strong benchmark but most of the public scrutiny seems to have focussed on the larger systemically important ADIs.
In the background, an equally important discussion has been playing out regarding the extent to which the Unquestionably Strong framework should take account of the “comparability” and “transparency” of that measure of strength and the ways in which “flexibility” and “resilience” could be added to the mix. This discussion kicked off in earnest with a March 2018 APRA discussion paper (which I covered here) and has come to a conclusion with the December 2020 release of the APRA Discussion Paper explored in the post above.
December 2020 – “Unquestionably Strong” meets “A more flexible and resilient capital framework for ADIs”
I have written a couple of posts on APRA’s December 2020 Discussion Paper but have thus far focussed on the details of the proposed changes to risk weights and capital buffers (here, here and here). This was partly because there was a lot to digest in these proposals but also because I simply found the discussion of how the proposed new framework reconciled to the Unquestionably Strong benchmark to be a bit confusing.
What follows is my current understanding of what the DP says and where we are headed.
On one level, the answer is quite simple – Exhibit A from the Discussion Paper (page 17) …
For systemically important ADI (D-SIB ADIs), the Unquestionably Strong 10.5% CET1 benchmark will be enshrined in a series of expanded capital buffers that will come into force on 1 January 2023 and add up to 10.5%.
However, we also know that APRA has at the same time outlined a range of enhancements to risk weights that are expected to have the effect of reducing aggregate Risk Weighted Assets and thereby result in higher capital adequacy ratios.
APRA has also emphasised that the net impact of the changes is intended to be capital neutral; i.e. any D-SIB ADI that meets the Unquestionably Strong benchmark now (i.e. that had a CET1 ratio of at least 10.5% under the current framework) will be Unquestionably Strong under the new framework
However this implies that the expected increase in reported CET1 under the new framework will not represent surplus capital so it looks like Unquestionably Strong will require a CET1 ratio higher than 10.5% once the new framework comes into place.
The only way I can reconcile this is to assume that APRA will be revisiting the calibration of the proposed increased capital buffers once it gets a better handle on how much capital ratios will increase in response to the changes it makes to bring Australian capital ratios closer to those calculated by international peers under the Basel minimum requirements. If this was spelled out in the Discussion Paper I missed it.
What about the impact of RBNZ requiring more capital to be held in New Zealand?
Running alongside the big picture issues summarised above (Unquestionably Strong, Transparency, Comparability, Flexibility, Resilience”, APRA has also been looking at how it should respond to the issues posed by the RBNZ policy applying substantial increases to the capital requirements for banks operating in NZ. I wrote two post on this issue (see here and here) that make the following points
To understand what is going on here you need to understand the difference between “Level 1” and Level 2” Capital Adequacy (part of the price of entry to this discussion is understanding more APRA jargon)
The increased share of the group capital resources required to be maintained in NZ will not have any impact on the Level 2 capital adequacy ratios that are the ones most commonly cited when discussing Australian ADI capital strength
In theory, maintaining the status quo share of group capital resources maintained in Australia would require some increase in the Level 2 CET1 ratio (i.e. the one that is used to express the Unquestionably Strong benchmark)
In practice, the extent to which the Level 2 benchmark is impacted depends on the maternity of the NZ business so it may be that there is nothing to see here
It is hard to tell however partly because there is not a lot of disclosure on the details of the Level 1 capital adequacy ratios (at least not a lot that I could find) and partly because the Level 1 capital measure is (to my mind) not an especially reliable (or indeed intuitive) measure of the capital strength
There is I think a general consensus that the Australian D-SIB ADIs all currently exceed the requirements of what it means to be Unquestionably Strong under the current capital adequacy framework
This implies that they have surplus capital that may potentially be returned to shareholders
APRA has laid out what I believe to be pretty sensible and useful enhancements to that framework (the expanded and explicitly more flexible capital buffers in particular)
These changes have however (for me at least) made it less clear what it will mean for an ADI to be Unquestionably Strong post 1 January 2023 when the proposed changes to Risk Weighted Assets come into effect
Any and all contributions to reducing my ignorance and confusion will be gratefully accepted – let me know what I am missing
I have posted a couple of time on a Discussion Paper published by The Australian Prudential Regulation Authority (APRA) in late 2020 (“A more flexible and resilient capital framework for ADIs”) setting out how it proposes to wrap up a number of prior consultations on a variety of aspects of ADI (authorised deposit-taking institution) capital reform in Australia (see here, here and here).
This post looks at the changes to mortgage risk weights (RW) outlined in the paper and attempts to explore (with limited information) what practical impact they might have. The short version is:
In very broad terms, APRA is seeking to assign higher RW to residential mortgages it deems to be relatively more risky but also lower RW for those it considers less risky
In pursuit of this objective, APRA has proposed two new categories of residential mortgage defined by the loan purpose (i.e. “Owner occupier loans paying principal and interest” and “Other Residential” including loans for investment and all interest only loans upon to 5 years tenor)
“Standard residential” mortgages see increased sensitivity of RW to Loan Valuation Ratios (LVR) while “Non-Standard residential mortgages face a 100% RW across the board irrespective of their LVR
Increased sensitivity to LVR is achieved via a simple recalibration of RW in the Standardised approach and via a reduction in the minimum Loss Given Default (LGD) applied in the IRB approach
The reduced LGD floor also indirectly allows Lenders’ Mortgage Insurance (LMI) to be recognised in the IRB models thereby creating greater alignment with the Standardised approach which directly recognises the value of LMI via a roughly 20% discount in the RW assigned to high LVR loans
APRA is not tinkering at the margins – there are quite substantial adjustments to RWs for both Standardised and IRB ADIs. That is the short version, read on if you want (or need) to dig into the detail.
Improved risk sensitivity cuts both ways
I have looked at “improved risk sensitivity” part of the overall package previously but, with the benefit of hindsight, possibly focussed too much on the expected reduction in aggregate risk weighted assets (RWA) coupled with the expansion of the capital buffers.
It is true that RWA overall are expected to decline – APRA estimated that the overall impact of the proposed revisions would be to reduce average RWAs for IRB ADIs by 10% and by 7% for Standardised ADIs. This obviously translates into higher reported capital ratios which is the impact I initially focussed on. Risk sensitivity however works both ways and a subsequent reading of the paper highlighted (for me at least) the equally important areas in which RW are proposed to increase – residential mortgages in particular.
APRA’s proposed revised approach to residential mortgage risk
APRA was very clear that one of their overall policy objectives is to “further strengthen capital requirements for residential mortgage exposures to reflect risks posed by ADIs’ structural concentration in this asset class“. In pursuit of this objective, APRA is targeting investment and interest only lending in particular but also high LVR lending in general.
In pursuit of these aims, the existing “standard residential mortgage” category is to be further broken down into 1) “Owner Occupied Principal and Interest” loans (OP&I) and 2) “Other Residential”. The “non-standard residential mortgages category (i.e. loans that do not conform to the credit risk origination standards prescribed by APRA) is to be expanded to include interest only loans with a tenor greater than 5 years.
So we get three broad vertical categories of residential mortgage riskiness
Owner Occupied Principal & Interest
– Interest Only (term <5yrs) – Investor mortgage loans – Loans to SME secured by residential property
– Interest Only (term >5yrs) – “Non-standard” mortgages
Note: RW are reduced where loans are covered by LMI but only for Standard Residential Mortgages and only where LVR is above 80%. To be classified as a “standard” mortgage a loan must satisfy minimum enforceability, serviceability and valuation criteria prescribed by APRA.
Impact on the Standardised ADIs
The table below compares the current RWs under the standardised approach (Source: Table 2 of APS 112 – Attachment C) with the indicative RWs APRA has proposed in the December 2020 Discussion Paper (Source: Table 2).
The RW within each of the three categories are being substantially recalibrated – APRA is not tinkering at the edges.
Increased sensitivity to LVR translates to higher RW applying in the upper LVR range but also reductions in the lower LVR range.
The increases in the high LVR ranges are particularly marked in the new “Other Residential” category (30-40% increases) but the reductions in the low LVR range are equally material (14-42%) for the OP&I category
Lender’s Mortgage Insurance (LMI) continues to be recognised at the high end of the LVR range (i.e. 80% plus) but the RW assigned to loans with LMI are higher than is currently applied.
In case anyone was wondering how APRA really felt about non-standard residential mortgages they receive a 100% RW irrespective of their LVR.
Risk weights under the Internal Ratings Based (IRB) Approach
It is a lot harder to figure out exactly what will happen to IRB RW but the starting point is the two new multipliers being added to the IRB RW formula. The OP&I multiplier adds 40% to RW while the Other Residential category gets a 60% loading. These replace the existing “correlation adjustment” factor that was applied to increase the average IRB RW for residential mortgages to a minimum of 25% as part of the effort to reduce the difference between IRB and Standardised capital requirements.
In aggregate, my guess is that the impacts are roughly neutral in the case of the “Other Residential” loans subject to the 60% loading and a net reduction for the OP&I category. The substitution of flat scalars for the existing correlation adjustment does however create some impacts at the upper and lower ends of the PD scale. Under the correlation approach, my understanding is that low PD exposures increase by proportionately more than the average impact and high PD exposures by less. Under scalar approach, the RW are increased by the same percentage across the PD scale. I am not sure how material the impacts are but mention them for completeness. The flat scalars certainly have the advantage of simplicity and transparency but mostly they establish a RW differential between the two types of standard residential mortgage.
The reduced LGD floor is a significant change because it offers the potential for RW to be halved for exposures that can take the maximum advantage. Consistent with the revised standardised RW, I assume that this will be at the lower end of the LVR range. IRB ADIs will have to work for this benefit however as APRA will first have to approve their LGD models. Some ADIs might be well advanced on this front but as a general rule risk modellers tend to have plenty to do and it is hard to see these models having been a priority while the 20% floor has been in place.
It is also worth noting that the risk differential between OP&I and Other Residential mortgages implied by the multipliers employed in the IRB approach is 14% (i.e. 1.6/1.4) is lower than the 20-30% difference in RW proposed to apply in the Standardised approach. This seems to reflect APRA’s response to comments received (section 4.3 of “Response to Submissions”) that the application of different multipliers could double count risks already captured in the PD and LGD assigned to the two different categories of lending by the IRB risk models.
Impacts, implications and inferences
I can see a couple of implications that follow from these proposed changes
LGD models start to matter
The unquestionably strong benchmark is reinforced
Potential to change the competition equilibrium between the big and small banks
LGD models start to matter
The IRB framework has been a part of the Australian banking system for close to two decades but the 20% LGD Floor has meant that residential mortgage LGD models mostly don’t matter, at least for the purposes of measuring capital adequacy requirements. I am not close enough to the action to know exactly what choices were made in practice but the logical response of credit risk modellers would be to concentrate on models that will make a difference.
APRA’s decision to reduce the LGD floor changes the calculus, IRB ADIs now have an incentive to invest the time and resources required to get new LGD models approved. Loan segments able to take full advantage of the 10% floor will be able to more than offset the impact of the multipliers. The LGD has a linear impact on risk weights so a halving from 20 to 10 percent will see risk weights also halve more than offsetting the 40 to 60% loadings introduced by the multipliers.
Exactly where the cut off lies remains to be seen but it seems reasonable to assume that the increases and decreases proposed in standardised risk weights are a reasonable guide to what we might expect in IRB risk weights; i.e. LGD may start to decline below 20% somewhere around the 70% LVR with the maximum benefit (10% LGD) capping out for LVR of say 50% and below. I have to emphasise that these are just semi educated guesses (hopefully anyway) and I am happy to be corrected by anyone with practical experience in LGD modelling. The main point is that LGD modelling will now have some practical impact so it will be interesting to watch how the IRB ADI respond.
Unquestionably strong is reinforced
On one level, it could be argued that the changes in risk weights don’t matter. ADIs get to report higher capital ratios but nothing really changes in substance. Call me a wide-eyed, risk-capital idealist but I see a different narrative.
First up, we know that residential mortgages are a huge risk concentration for the Australian banks so even small changes can have an impact on their overall risk profiles.
“While an individual residential mortgage loan does not, on its own, pose a systemic risk to the financial system, the accumulation of lending by almost all ADIs in this asset class means that in aggregate the system is exposed to heightened risks”
APRA Discussion Paper, “A more flexible and resilient capiutral framework for ADIs”, 8 December 2020 (page 12)
To my mind, the proposed changes can work in a combination of two ways and both have the potential to make a difference. The decline in residential mortgage risk weights is largely confined to loans originated at low LVRs – less than 70% in the case of “Owner-Occupied Principal and Interest” and less than 60% in the case of “Other Residential”. High LVR risk weights (i.e. 90% plus) are reduced for Owner Occupied Principal and Interest without LMI but my understanding is that these kinds 0f loans are exceptions to the rule, granted to higher quality borrowers and not a large share of the overall exposure. High LVR loans as a rule will face higher risk weights under the proposed changes and materially higher in the case of the “Other Residential” category.
In the low LVR lending, the decline in risk weights seems to be largely offset by higher capital ratio requirements via the increased buffers. In the case of the higher risk, high-LVR lending, the higher capital ratio requirements add to the overall dollar capital requirement.
Competition in residential mortgage lending
APRA has explicitly cited “enhancing competition” as one of their objectives. I don’t have enough hard data to offer any comprehensive assessment of the extent to which competition will be enhanced. The one thing I think worth calling out is the substantial reduction in RW assigned to low LVR loans under the Standardised approach. The table below maps the changes in RW with data APRA publishes quarterly on the amount of loans originated at different LVR bands.
Owner occupiers who have managed to substantially reduce the amount they owe the bank have always been an attractive credit risk; even better if appreciation in the value of their property has further reduced the effective LVR. The proposals reinforce the attraction of this category of borrower. The IRB ADIs will not give up these customers without a fight but the Standardised ADI will have an enhanced capacity t0 compete in this segment via the reduced RW.
At this stage we can only speculate on impacts as the final form of the proposals may evolve further as APRA gets to see the results of the Quantitative Impact Statements that the ADI’s are preparing as part of the consultation process.
We are still some way way from seeing the practical impact of these changes and we need to see the extent to which the proposals are refined in response to what APRA learns from the QIS. There does however seem to be potential for the economics of residential mortgage lending to be shaken up so this is a development worth keeping an eye on.
I did a short post yesterday scratching the surface of the issues associated with Westpac’s announcement that it is reviewing its options in New Zealand. In this post I will offer a little more background and comment focussed on the impact of Australian capital adequacy requirements.
These combined changes obviously impact the economics of an Australian ADI owning a NZ regulated banks but to have any hope of understanding what is going on I believe we first need to define two pieces of Australian ADI capital jargon, Level 1 and Level 2
Level 1 is the ADI itself on a stand alone basis (note that is a simplification but close enough to the truth for the purposes of this post).
Level 2 is defined in APRA’s consultation paper as “The consolidation of the ADI and all its subsidiaries other than non-consolidated subsidiaries; or if the ADI is a subsidiary of a non-operating holding company (NOHC), the consolidation of the immediate parent NOHC and all the immediate parent NOHC’s subsidiaries (including any ADIs and their subsidiaries) other than non-consolidated subsidiaries.”
For completeness I should probably also define “ADI” which is an Authorised Deposit Taking Institution (more colloquially referred to as a bank).
You can be forgiven for not being familiar with the Level 1 – Level 2 distinction but the capital ratios typically quoted in any discussion of Australian ADI capital strength are the Level 2 measures. The Unquestionably Strong benchmark that dominates the discussion is a Level 2 measure.
Part of the problem with the RBNZ initiative is that the increase in capital required to be held in the NZ part of the Group has no impact on the Level 2 capital ratio that is used to define the “Unquestionably Strong” benchmark the Australian ADI are expected to meet. The RBNZ is of course within its rights to set what ever capital requirement it deems appropriate but APRA then has to ensure that the increase in NZ based capital does not come at the expense of Australian stakeholders.
The Level 2 capital measure tells us nothing about this question. In theory this is where the Level 1 capital adequacy measure comes into play but I have always found the Level 1 measure a bit counter-intuitive.
My intuitive expectation is that the Level 1 measure for an Australian ADI should include the capital actually available in Australia and the risk exposures that capital has to underwrite.
What actually happens is that the dollar value of the Level 1 capital can be virtually the same as the Level 2 measure even though capital has been deployed in an offshore banking subsidiary (retained earnings in the subsidiary do not count but that can be addressed by paying a divided to the parent and then investing an equivalent amount of capital back in the subsidiary).
Level 1 risk weighted assets of the parent only incorporate an allowance for the risk weighted value of the equity invested in the banking subsidiary
This adjustment to the Level 1 risk weighted assets will of course be substantially less than the risk weighted assets the subsidiary is supporting with that equity that are excluded from the Level 1 parent capital ratio.
As a result, it is mathematically possible for the Level 1 CET1 ratio of the parent entity to be higher than the Level 2 Group ratio even though capital has been deployed outside the parent entity – that seems counter intuitive to me.
The changes that APRA has proposed to introduce will force the Australian banks to hold more capital to offset the impact of the CET1 deduction created when the investment in the banking subsidiary exceeds the (10%) threshold. As I understand it, this deduction only applies to the Level 1 measure so Level 2 capital will, all other things being equal, be higher as a result of responding to the combined impact of the RBNZ and APRA requirements. At face value that looks like stronger capital, which it is for the Group on average (i.e. Level 2), but the Australian parts of the banking Group do not benefit from the increase and it is important to understand that when evaluating the extent to which the Australian part of the banking group continues to be Unquestionably Strong.
APRA’s proposed change addresses the immediate issue created by the RBNZ requirement but I must confess that I still find the Level 1 capital adequacy measure a touch confusing. Level 1 capital ratios calculated on the basis I have set out above do not appear (to me at least) to offer an intuitively logical view of the relative capital strength of the various parts of the banking group.
As always, it is entirely possible that I am missing something here but understanding the technical issues outlined above is I think useful when making sense of the issues that Westpac (and other Australian ADIs) will be considering as they weigh their options in New Zealand. Relying on your intuition expectations of how the two requirements interact may be an unreliable guide if you are not familiar with the technical detail.
Westpac today (24 March 2021) announced that it is “… assessing the appropriate structure for its New Zealand business and whether a demerger would be in the best interests of shareholders. Westpac is in the very early stage of this assessment and no decisions have been made.”
There are obviously a lot of moving parts here but one important consideration is the interaction between the substantial increase in capital requirements mandated by the RBNZ and APRA’s proposed change in the way that these investments must be funded by the Australian parent.
The rest of this post offers a short summary of how these investments are currently treated under the Australian capital adequacy standard (APS 111) and APRA’s proposed changes.
As a rule, APRA’s general capital treatment of equity exposures requires that they be fully deducted from CET1 Capital in order to avoid double counting of capital. The existing rules (APS 111) however provides a long-standing variation to this general rulewhen measuring Level 1 capital adequacy. This variation allows an ADI at Level 1 to risk weight (after first deducting any intangibles component) its equity investments in banking and insurance subsidiaries. The risk weight is 300 percent if the subsidiary is listed or 400 per cent if it is unlisted.
APRA recognises that this improves the L1 ratios by around 100bp versus what would be the case if a full CET1 deduction were applied but was comfortable with that outcome based on exposure levels that preceded the RBNZ change in policy.
The RBNZ’s move towards higher CET1 requirements however undermines this status quo and potentially sees a greater share of the overall pool of equity in the group migrate from Australia to NZ. APRA recognises of course that the RBNZ can do whatever it deems best for NZ depositors but APRA equally has to ensure that the NZ benefits do not come at the expense of Australian depositors (and other creditors).
To address this issue, APRA has proposed to amend APS 111 to limit the extent to which an ADI may use debt to fund investments in banking and insurance subsidiaries.
ADIs, at Level 1, will be required to deduct these equity investments from CET1 Capital, but only to the extent the investment in the subsidiary is in excess of 10 per cent of CET1 Capital.
An ADI may risk weight the investment, after deduction of any intangibles component, at 250 per cent to the extent the investment is below this 10 per cent threshold.
The amount of the exposure that is risk weighted would be included as part of the related party limits detailed in the recently finalised APS 222.
As APRA is more concerned about large concentrated exposures, it proposed to limit the amount of the exposure to an individual subsidiary that can be leveraged to 10 per cent of an ADI’s CET1 Capital. This means capital requirements are increasing for large concentrated exposures, as amounts over the 10 per cent threshold would be required to be met dollar-for-dollar by the ADI parent company.
You can find my original post here which offers more background and may be useful if you are not familiar with the technicalities of Level 1 and Level 2 capital adequacy. At the time the change was proposed, APRA indicated that it would release more detail during 2020 with the aim of implementing the change on 1 January 2021. Covid 19 obviously derailed that original timeline but I assume APRA will provide an update sometime soon.
Some interesting research via a Bank of England Staff Working Paper that explores the value of using multiple regulatory constraints to measure the risk of failure in banks.
Not surprisingly, they find superior utility in a portfolio of measures (risk weighted capital ratio, leverage ratio and Net Stable Funding Ratio) versus relying on a single measure of risk. This is not just due to better predictions of potential for failure but also because this is achieved at lower threshold ratios than would be the case if any of the measures was the sole basis for indicating heightened risk of failure
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):
Corporate, IPCRE, Business Lending
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 take away. 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.
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:
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
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.