Capital Adequacy – Page 6 – From the outside

“Between Debt and the Devil: Money, Credit and Fixing Global Finance” by Adair Turner (2015)

This book is worth reading, if only because it challenges a number of preconceptions that bankers may have about the value of what they do. The book also benefits from the fact that author was the head of the UK Financial Services Authority during the GFC and thus had a unique inside perspective from which to observe what was wrong with the system. Since leaving the FSA, Turner has reflected deeply on the relationship between money, credit and the real economy and argues that, notwithstanding the scale of change flowing from Basel III, more fundamental change is required to avoid a repeat of the cycle of financial crises.

Overview of the book’s main arguments and conclusions

Turner’s core argument is that increasing financial intensity, represented by credit growing faster than nominal GDP, is a recipe for recurring bouts of financial instability.

Turner builds his argument by first considering the conventional wisdom guiding much of bank prudential regulation prior to GFC, which he summarises as follows:

Increasing financial activity, innovation and “financial deepening” were beneficial forces to be encouraged
More compete and liquid markets were believed to ensure more efficient allocation of capital thereby fostering higher productivity
Financial innovations made it easier to provide credit to households and companies thereby enabling more rapid economic growth
More sophisticated risk measurement and control meanwhile ensured that the increased complexity of the financial system was not achieved at the expense of stability
New systems of originating and distributing credit, rather than holding it on bank balance sheets, were believed to disperse risks into the hands of those best placed to price and manage it

Some elements of Turner’s account of why this conventional wisdom was wrong do not add much to previous analysis of the GFC. He notes, for example, the conflation of the concepts of risk and uncertainty that weakened the risk measurement models the system relied on and concludes that risk based capital requirements should be foregone in favour of a very high leverage ratio requirement. However, in contrast to other commentators who attribute much of the blame to the moral failings of bankers, Turner argues that this is a distraction. While problems with the way that bankers are paid need to be addressed, Turner argues that the fundamental problem is that:

modern financial systems left to themselves inevitably create debt in excessive quantities,
in particular, the system tends to create debt that does not fund new capital investment but rather the purchase of already existing assets, above all real estate.

Turner argues that the expansion of debt funding the purchase or trading of existing assets drives financial booms and busts, while the debt overhang left over by the boom explains why financial recovery from a financial crisis is typically anaemic and protracted. Much of this analysis seems to be similar to ideas developed by Hyman Minsky while the slow pace of recovery in the aftermath of the GFC reflects a theme that Reinhart and Rogoff have observed in their book titled “This time is different” which analyses financial crises over many centuries.

The answer, Turner argues, is to build a less credit intensive growth model. In pursuing this goal, Turner argues that we also need to understand and respond to the implications of three underlying drivers of increasing credit intensity;

the increasing importance of real estate in modern economies,
increasing inequality, and
global current account imbalances.

Turner covers a lot of ground, and I do not necessarily agree with everything in his book, but I do believe his analysis of what is wrong with the system is worth reading.

Let me start with an argument I do not find compelling; i.e. that risk based capital requirements are unreliable because they are based on a fundamental misunderstanding of the difference between risk (which can be measured) and uncertainty (which cannot):

Distinguishing between risk and uncertainty is clearly a fundamental part of understanding risk and Turner is not alone in emphasising its importance
I believe that means that we should treat risk based capital requirements with a healthy degree of scepticism and a clear sense of their limitations but that does not render them entirely unreliable especially when we are using them to understand relative differences in risk and to calibrate capital buffers
The obvious problem with non-risk based capital requirements is that they create incentives for banks to take higher risk that may eventually offset the supposed increase in soundness attached to the higher capital
It may be that Turner discounts this concern because he envisages a lower credit growth/intensity economy delivering less overall systemic risk or because he envisages a more active role for the public sector in what kinds of assets banks lend against; i.e. his support for higher capital may stem mostly from the fact that this reduces the capacity of private banks to generate credit growth

While advocating much higher capital, Turner does seem to part company with M&M purists by expressing doubt that equity investors will be willing to accept deleveraged returns. His reasoning is that returns to equity investments need a certain threshold return to be “equity like” while massively deleveraged ROE still contains downside risks that are unacceptable to debt investors.

Turning to the arguments which I think raise very valid concerns and deserve serious attention.

Notwithstanding my skepticism regarding a leverage ratio as the solution, the arguments he makes about the dangers of excessive credit growth resonate very strongly with what I learned during my banking career. Turner is particularly focussed on the downsides of applying excessive debt to the financing of existing assets, real estate in particular. The argument seems to be similar to (if not based on) the work of Hyman Minsky.

Turner’s description of the amount of money that banks can create as being “infinitely elastic” seems an overstatement to me (especially in the Australian context with the Net Stable Funding Ratio (NSFR) weighing on the capacity to grow the balance sheet) but the general point he is making about the way that credit fuelled demand for a relatively inelastic supply of desirable residential property tends to result in inflated property values with no real social value rings true.

What banks can do about this remains an open question given that resolving the problem with inelastic supply of property is outside their direct control but it is obviously important to understand the dynamics of the market underpinning their largest asset class and it may help them engage more constructively with public policy debates that seek to address the problem.

Turner’s analysis of the downsides of easy monetary policy (the standard response to economic instability) also rings true. He identifies the fact that lower interest rates tend to result in inflated asset values (residential property in particular given its perceived value as a safe asset) which do not address the fundamental problem of over-indebtedness and may serve to increase economic inequality. His discussion of the impact of monetary policy and easy credit on economic inequality is also interesting. The banks providing the credit in the easy money environment may not necessarily be taking undue risk and prudential supervisors have tools to ensure sound lending standards are maintained if they do believe there is a problem with asset quality. What may happen however is that the wealthier segments of society benefit the most under easy money because they have the surplus cash flow to buy property at inflated values while first homebuyers become squeezed out of the market. Again their capacity to address the problem may be limited but Turner’s analysis prompted me to reflect on what increasing economic inequality might mean for bank business models.

In addition to much higher bank capital requirements, Turner’s specific recommendations for moving towards a less credit intensive economy include:

Government policies related to urban development and the taxation of real estate
Changing tax regimes to reduce the current bias in favour of debt over equity financing (note that Australia is one of the few countries with a dividend imputation system that does reduce the bias to debt over equity)
Broader macro prudential powers for central banks, including the power to impose much larger countercyclical capital requirements
Tough constraints on the ability of the shadow banking system to create credit and money equivalents
Using public policy to produce different allocations of capital than would result from purely market based decisions; in particular, deliberately leaning against the market signal based bias towards real estate and instead favouring other “potentially more socially valuable forms of credit allocation”
Recognising that the traditional easy monetary policy response to an economic downturn (or ultra-easy in the case of a financial crisis such as the GFC) is better than doing nothing but comes at a cost of reigniting the growth in private credit that generated the initial problem, creating incentives for risky financial engineering and exacerbating economic inequality via inflating asset prices.

For those who want to dig deeper, I have gone into a bit more detail here on what Turner has to say about the following topics:

The way in which inefficient and irrational markets leave the financial system prone to booms and busts
The dangers of debt contracts sets out how certain features of these contracts increase the risk of instability and hamper the recovery
Too much of the wrong sort of debt describes features of the real estate market that make it different from other asset classes
Liberalisation, innovation and the credit cycle on steroids recaps on the philosophy that drove the deregulation of financial markets and what Turner believes to be the fundamental flaws with that approach. In particular his conclusion that the amount of credit created and its allocation is “… too important to be left to bankers…”
Private credit and money creation offers an outline of how bank deposits evolved to play an increasing role (the key point being that it was a process of evolution rather than overt public policy design choices)
Credit financed speculation discusses the ways in which credit in modern economies tends to be used to finance the purchase of existing assets, in particular real estate, and the issues that flow from this.
Inequality, credit and more inequality sets out some ways in which the extension of credit can contribute to increasing economic inequality
Capital requirements sets out why Turner believes capital requirements should be significantly increased and why capital requirements (i.e. risk weights) for some asset classes (e.g. real estate) should be be calibrated to reflect the social risk of the activity and not just private risks captured by bank risk models
Turner defence against the argument that his proposals are anti-markets and anti-growth.

The Countercyclical Capital Buffer

This post uses a recent BCBS working paper as a stepping off point for a broader examination of how the countercyclical capital buffer (CCyB) can help make the banking system more resilient.

This post uses a recent BCBS working paper as a stepping off point for a broader examination of how the countercyclical capital buffer (CCyB) can help make the banking system more resilient. The BCBS paper is titled “Towards a sectoral application of the countercyclical capital buffer: A literature review – March 2018” (BCBS Review) and its stated aim is to draw relevant insights from the existing literature and use these to shed light on whether a sectoral application of the CCyB would be a useful extension of the existing Basel III framework under which the CCyB is applied at an aggregate country level credit measure. The views expressed in Working Papers like this one are those of their authors and do not represent the official views of the Basel Committee but they do still offer some useful insights into what prudential supervisors are thinking about.

Key points

I very much agree with the observation in the BCBS Review that the standard form of the CCyB is a blunt instrument by virtue of being tied to an aggregate measure of credit growth
And that a sectoral application of the CCyB (operating in conjunction with other sector focussed macro prudential tools) would be an improvement
But the CCyB strategy that has been developed by the Bank of England looks to be a much better path to pursue
Firstly, because it directly addresses the problem of failing to detect/predict when the CCyB should be deployed and secondly because I believe that it results in a much more “usable” capital buffer
The CCyB would be 1% if APRA adopted the Bank of England strategy (the CCyB required by APRA is currently 0%) but adopting this strategy does not necessarily require Australian banks to hold more capital at this stage of the financial cycle
One option would be to align one or more elements of APRA’s approach with the internationally harmonised measure of capital adequacy and to “reinvest” the increased capital in a 1% CCyB.

First a recap on the Countercyclical Capital Buffer (aka CCyB).

The CCyB became part of the international macro prudential toolkit in 2016 and is intended to ensure that, under adverse conditions, the banking sector in aggregate has sufficient surplus capital on hand required to maintain the flow of credit in the economy without compromising its compliance with prudential requirements.

A key feature in the original BCBS design specification is that the buffer is intended to be deployed in response to high levels of aggregate credit growth (i.e high relative to the sustainable long term trend rates) which their research has identified as an indicator of heightened systemic risk. That does not preclude bank supervisors from deploying the buffer at other times as they see fit, but responding to excess credit growth has been a core part of the rationale underpinning its development.

The BCBS Review

The BCBS Review notes that the CCyB works in theory but concedes there is, as yet, virtually no empirical evidence that it will work in practice. This is not surprising given that it has only been in place for a very short period of time but still important to remember. The BCBS Review also repeatedly emphasises the point that the CCyB may help to mitigate the credit cycle but that is a potential side benefit, not the main objective. Its primary objective is to ensure that banks have sufficient surplus capital to be able to continue lending during adverse economic conditions where losses will be consuming capital.

The Review argues that the CCyB is a useful addition to the supervisor’s tool kit but is a blunt instrument that impacts all sectors of the economy indiscriminately rather than just targeting the sectors which are the source of systemic concern. It concludes that applying the CCyB at a sectoral level might be more effective for three reasons

more direct impact on the area of concern,
stronger signalling power, and
smaller effects on the wider economy than the Basel III CCyB.

The Review also discusses the potential to combine a sectoral CCyB with other macro prudential instruments; in particular the capacity for the two approaches to complement each other;

Quote “Generally, macroprudential instruments that operate through different channels are likely to complement each other. The literature reviewed indicates that a sectoral CCyB could indeed be a useful complement to alternative sectoral macroprudential measures, including borrower-based measures such as LTV, LTI and D(S)TI limits. To the extent that a sectoral CCyB is more effective in increasing banks’ resilience and borrower-based measures are more successful in leaning against the sectoral credit cycle, both objectives could be attained more effectively and efficiently by combining the two types of instruments. Furthermore, there is some evidence that suggests that a sectoral CCyB could have important signalling effects and may therefore act as a substitute for borrower-based measures.”

A Sectoral CCyB makes sense

Notwithstanding repeated emphasis that the main point of the CCyB is to ensure banks can and will continue to support credit growth under adverse conditions, the Review notes that there is not much, if any, hard empirical evidence on how effective a release of the CCyB might be in achieving this. The policy instrument’s place in the macro prudential tool kit seems to depend on the intuition that it should help, backed by some modelling that demonstrates how it would work and a pinch of hope. The details of the modelling are not covered in the Review but I am guessing it adopts a “homo economicus” approach in which the agents act rationally. The relatively thin conceptual foundations underpinning the BCBS version of the CCyB are worth keeping in mind.

The idea of applying the CCyB at a sectoral level seems to make sense. The more targeted approach advocated in the Review should in theory allow regulators to respond to sectoral areas of concern more quickly and precisely than would be the case when the activation trigger is tied to aggregate credit growth. That said, I think the narrow focus of the Review (i.e. should we substitute a sectoral CCyB for the current approach) means that it misses the broader question of how the CCyB might be improved. One alternative approach that I believe has a lot of promise is the CCyB strategy adopted by the Bank of England’s Financial Policy Committee (FPC).

The Bank of England Approach to the CCyB (is better)

The FPC published a policy statement in April 2016 explaining that its approach to setting the countercyclical capital buffer is based on five core principles. Many of these are pretty much the same as the standard BCBS policy rationale discussed above but the distinguishing feature is that it “… intends to set the CCyB above zero before the level of risk becomes elevated. In particular, it expects to set a CCyB in the region of 1% when risks are judged to be neither subdued nor elevated.”

This contrasts with the generic CCyB, as originally designed by the BCBS, which sets the default position of the buffer at 0% and only increases it in response to evidence that aggregate credit growth is excessive. This might seem like a small point but I think it is a material improvement on the BCBS’s original concept for two reasons.

Firstly, it directly addresses the problem of failing to detect/predict when systemic risk in the banking system requires prudential intervention. A lot of progress has been made in dealing with this challenge, not the least of which has been to dispense with the idea that central banks had tamed the business cycle. The financial system however retains its capacity to surprise even its most expert and informed observers so I believe it is better to have the foundations of a usable countercyclical capital buffer in place as soon as possible after the post crisis repair phase is concluded rather than trying to predict when it might be required.

The FPC still monitors a range of core indicators for the CCyB grouped into three categories.

The first category includes measures of ‘non-bank balance sheet stretch’, capturing leverage in the broader economy and in the private non-financial (ie household and corporate) sector specifically.
The second category includes measures of ‘conditions and terms in markets’, which capture borrowing terms on new lending and investor risk appetite more broadly.
The third category includes measures of ‘bank balance sheet stretch’, which capture leverage and maturity/liquidity transformation in the banking system.

However the FPC implicitly accepts that it can’t predict the future so it substitutes a simple, pragmatic and error resilient strategy (put the default CCyB buffer in place ASAP) for the harder problem of trying to predict when it will be needed. This strategy retains the option of increasing the CCyB, is simpler to administer and less prone to error than the BCBS approach. The FPC might still miss the turning point but it has a head start on the problem if it does.

The FPC also integrates its CCyB strategy with its approach to stress testing. Each year the stress tests include a scenario:

“intended to assess the risks to the banking system emanating from the financial cycle – the “annual cyclical scenario”

The severity of this scenario will increase as risks build and decrease after those risks crystallise or abate. The scenario might therefore be most severe during a period of exuberance — for example, when credit and asset prices are growing rapidly and risk premia are compressed. That might well be the point when markets and financial institutions consider risks to be lowest. And severity will be lower when exuberance has corrected — often the time at which markets assess risks to be largest. In leaning against these tendencies, the stress-testing framework will lean against the cyclicality of risk taking: it will be countercyclical.”

The Bank of England’s approach to stress testing the UK banking system – October 2015 (page 5)

The second reason I favour the FPC strategy is because I believe it is likely to result in a more “usable” buffer once risk crystallizes (not just systemic risk) and losses start to escalate. I must admit I have struggled to clearly articulate why this would be so but I think the answer lies partly in the way that the FPC links the CCyB to a four stage model that can be interpreted as a stylised description of the business cycle. The attraction for me in the FPC’s four stage model is that it offers a coherent narrative that helps all the stakeholders understand what is happening, why it is happening, what will happen next and when it will happen.

The BCBS Review talks about the importance of communication and the FPC strategy offers a good model of how the communication strategy can be anchored to a coherent and intuitive narrative that reflects the essentially cyclical nature of the banking industry. The four stages are summarised below together with some extracts setting out the FPC rationale.

Stage 1: The post-crisis repair phase in which risks are subdued – the FPC would expect to set a CCyB rate of 0%

FPC rationale: “Risks facing the financial system will normally be subdued in a post-crisis repair and recovery phase when the financial system and borrowers are repairing balance sheets. As such, balance sheets are not overextended. Asset and property prices tend to be low relative to assessed equilibrium levels. Credit supply is generally tight and the risk appetite of borrowers and lenders tends to be low. The probability of banks coming under renewed stress is lower than average.”

Stage 2: Risks in the financial system re-emerge but are not elevated – the FPC intends to set a positive CCyB rate in the region of 1% after the economy moves into this phase.

FPC rationale: ‘In this risk environment, borrowers will not tend to be unusually extended or fragile, asset prices are unlikely to show consistent signs of over, or under, valuation, and measures of risk appetite are likely to be in line with historical averages”. As such, it could be argued that no buffer is required but the FPC view is that a pre-emptive strategy is more “robust to the inherent uncertainty associated with measuring risks to financial stability”. It also allows subsequent adjustments to be more graduated than would be possible if the CCyB was zero.

Stage 3: Risks in the financial system become elevated: stressed conditions become more likely – the FPC would expect to increase the CCyB rate beyond the region of 1%. There is no upper bound on the rate that can be set by the FPC.

FPC rationale: “As risks in the financial system become elevated, borrowers are likely to be stretching their ability to repay loans, underwriting standards will generally be lax, and asset prices and risk appetite tend to be high. Often risks are assumed by investors to be low at the very point they are actually high. The distribution of risks to banks’ capital at this stage of the financial cycle might have a ‘fatter tail’ [and] stressed outcomes are more likely.”

Stage 4: Risks in the financial system crystallise – the FPC may cut the CCyB rate, including where appropriate to 0%.

FPC rationale: “Reducing the CCyB rate pre-emptively before losses have crystallised may reduce banks’ perceived need to hoard capital and restrict lending, with consequent negative impacts for the real economy. And if losses have crystallised, reducing the CCyB allows banks to recognise those losses without having to restrict lending to meet capital requirements. This will help to ensure that capital accumulated when risks were building up can be used, thus enhancing the ability of the banking system to continue to support the economy in times of stress.”

The March 2018 meeting of the FPC advised that the CCyB applying to UK exposures would remain unchanged at the 1% default level reflecting its judgement that the UK banking system was operating under Stage 2 conditions.

Calibrating the size of the CCyB

The FPC’s approach to calibrating the size of the CCyB also offers some interesting insights. The FPC’s initial (April 2016) policy statement explained that a “CCyB rate in the region of 1%, combined with other elements of the capital framework, provides UK banks with sufficient capital to withstand a severe stress. Given current balance sheets, the FPC judges that, at this level of the CCyB, banks would have sufficient loss-absorbing capacity to weather a macroeconomic downturn of greater magnitude than those observed on average in post-war recessions in the United Kingdom — although such estimates are inherently uncertain.”

The first point to note is that the FPC has chosen to anchor their 1% default setting to a severity greater than the typical post war UK recession but not necessarily a GFC style event. There is a school of thought that maintains that more capital is always better but the FPC seems to be charting a different course. This is a subtle area in bank capital management but I like the the FPC’s implied defence of subtlety.

What is sometimes lost in the quest for a failure proof banking system is a recognition of the potential for unintended consequence. All other things being equal, more capital makes a bank less at risk of insolvency but all other things are almost never equal in the real world. Banks come under pressure to find ways to offset the ROE dilution associated with more capital. I know that theory says that a bank’s cost of equity should decline as a result of holding more capital so there is no need to offset the dilution but I disagree (see this post for the first in a proposed series where I have started to set out my reasons why). Attempts to offset ROE dilution also have a tendency to result in banks taking more risk in ways that are not immediately obvious. Supervisors can of course intervene to stop this happening but their already difficult job is made harder when banks come under pressure to lift returns. This is not to challenge the “unquestionably strong” benchmark adopted by APRA but simply to note that more is not always better.

Another problem with just adding more capital is that the capital has to be usable in the sense that the capital ratio needs to be able to decline as capital is consumed by elevated losses without the bank coming under pressure to immediately restore the level of capital it is expected to hold. The FPC strategy of setting out how it expects capital ratios to increase or decrease depending on the state of the financial cycle helps create an environment in which this can happen.

Mapping the BOE approach to Australia

APRA has set the CCyB at 0% whereas the BOE approach would suggest a value of at least 1% and possibly more given that APRA has felt the need to step in to cool the market down. It is important to note that transitioning to a FPC style CCyB does not necessarily require that Australian banks need to hold more capital. One option would be to harmonise one or more elements of APRA’s approach to capital measurement (thereby increasing the reported capital ratio) and to “reinvest” the surplus capital in a CCyB. The overall quantum of capital required to be unquestionably strong would not change but the form of the capital would be more usable to the extent that it could temporarily decline and banks had more time to rebuild the buffer during the recovery phase.

Summing up

A capital adequacy framework that includes a CCyB that is varied in a semi predictable manner over the course of the financial cycle would be far more resilient than the one we currently have that offers less flexibility and is more exposed to the risk of being too late or missing the escalation of systemic risk all together.

Tell me what I am missing …

APRA’s proposed revisions to capital requirements for residential mortgages

… there is a lot to like in what APRA have proposed but also some issues that would benefit from further thought

Many readers will be aware that APRA released a Discussion Paper (DP) last week titled “Revisions to the capital framework for authorised deposit-taking institutions”. The paper sets out APRA’s proposed changes to ADI capital requirements defined by the Internal Ratings Based Approach (IRB) and Standardised Approach to Credit Risk, Interest Rate Risk in the Banking Book (IRRBB) and Operational Risk. The focus of this post will be the proposals impacting credit risk capital requirements for residential mortgage lending. This post presupposes that the reader is familiar with the detail of what APRA has proposed. For those of you who have not yet got around to reading the whole paper I have added a short summary of the proposals below (see “APRA’s proposals – in more detail”).

My gut reaction is that there is a lot to like in what APRA have proposed but there are also issues that deserve further consideration in order to address the risk of unintended consequence and to better deliver on the objectives of consistency, transparency and competitive neutrality.

Proposals which make sense to me:

The increased risk sensitivity of the proposed standardised RWs for residential mortgages is, I believe, a material enhancement of the capital adequacy framework
There are arguments (and indeed evidence) for why investor property loans can be as low risk as owner occupier loans (most of the time) but APRA’s desire to address the systemic tail risk of this form of lending is I think an understandable policy objective for a prudential regulator to pursue
Continuing to pursue higher IRB RW via changes to the correlation factor also looks to be a better approach than the 20% floor on LGD currently applied and thankfully also up for revision
Applying a higher correlation factor to low PD loans also makes intuitive sense, especially if your primary concern is the systemic risk associated with the residential mortgage lending that dominates the balance sheets of your banking system
In addition, the potential for the correlation adjustment to reduce the sensitivity of residential mortgage RWA to the economic cycle (and hence reduce the risk of pro-cyclical stress on capital ratios) is particularly welcome though I believe there is much more to do on this general issue
The support for Lender’s Mortgage Insurance (LMI) is also welcome

Areas where I believe the proposed revised capital framework could be improved (or at least benefit from some more thought):

The discussion of relative standardised and IRB RW does not address the fact IRB banks are required to hold additional capital to cover any shortfall between loan loss provisions and Regulatory Expected Loss (REL)
Residential mortgage portfolios subject to the standardised approach should be subject to a minimum average RW in the same way that IRB portfolios are currently constrained by the 25% floor
Applying a fixed scalar to Credit RWA can be problematic as the composition of the loan portfolio continues to evolve

The discussion of comparative IRB and Standardised RW you typically encounter seems to assume that the two approaches are identical in every aspect bar the RW but people working at the coal face know that the nominal RW advantage the IRB banks have has been partly offset by a higher exposure measure the RW are applied to. It appears that APRA’s proposed revisions will partly address this inconsistency by requiring banks using the Standardised Approach to apply a 100% Credit Conversion Factor (CCF) to undrawn loan limits. IRB banks are also required to take a Common Equity Tier 1 deductions for the shortfall between their loan loss provisions and REL. The proposed revisions do nothing to address this area of inconsistency and in fact the Discussion Paper does not even acknowledge the issue.

Residential mortgage portfolios subject to the standardised approach should be subject to a minimum average RW in the same way that IRB portfolios are constrained. The majority of new residential mortgages are originated at relatively high LVR (most at 70% plus and a significant share at 80% plus), but the average LVR will be much lower as principal is repaid (and even more so if you allow for the appreciation of property values). The introduction of a 20% RW bucket for standardised banks poses the question whether these banks will have an advantage in targeting the refinancing of seasoned loans with low LVR’s. The IRB banks would seek to retain these customers but they will still be constrained by the 25% average RW mandated by the FSI while the standardised banks face no comparable constraint.

This is unlikely to be an issue in the short term but one of the enduring lessons learned during my time “on the inside” is that banks (not just the big ones) are very good at identifying arbitrages and responding to incentives. It is widely recognised that housing loans have become the largest asset on Australian bank balance sheets (The Royal Commission issued a background paper that cited 42% of assets as at September 2017) but the share was significantly less when I started in banking. There has been a collection of complex drivers at play here (a topic for another post) but the relatively low RW has not harmed the growth of this kind of lending. Consequently, it is dangerous to assume that the status quo will persist if incentives exist to drive a different outcome.

This competitive imbalance could be addressed quite simply if the standardised banks were also subject to a requirement that their average RW was also no lower than 25% (or some alternative floor ratio that adjusted for the differences in exposure and REL noted above).

Another lesson learned “on the inside” is that fixed scalars look simple but are often not. They work fine when the portfolio of assets they are scaling up is stable but will gradually generate a different outcome to what was intended as the composition of the loan book evolves over time. I don’t have an easy solution to this problem but, if you must use them, it helps to recognise the potential for unintended consequence at the start.

Read on below if you have not read the Discussion Paper or want more detail on the revisions APRA has proposed and how these changes are proposed to be reconciled with the FSI recommendation. This is my first real post so feedback would be much appreciated.

Above all, tell me what I am missing …

Tony

Note: The original version of this post published 22 February 2018 stated that inconsistent measurement of the exposures at default between the standardised and IRB approaches was not addressed by APRA’s proposed revisions. I believe now that the proposed application of a 100% CCF in the Standardised Approach would in fact address one of the areas of inconsistency. The treatment of Regulatory Expected Loss remains an issue however. The post was revised on 24 February to clarify these points.

APRA’s proposals – in more detail

Good quality loans fully secured by mortgages on occupied residential property (either rented or occupied by the borrower) have been assigned concessionary risk weights (RW) ever since risk weighted capital adequacy ratios were introduced under Basel I (1988). The most concessionary risk weight was initially set at 50% and reduced to 35% in the Basel II Standardised Approach (2006).

APRA currently applies the concessionary 35% RW to standard eligible mortgages with Loan Valuation Ratios (LVR) of 80% or better (or up to 90% LVR if covered by Lender’s Mortgage Insurance) while the best case scenario for a non-standard mortgage is a 50% RW. Progressively higher RW (50/75/100) are applied for higher risk residential mortgages.

Under the Standardised Approach, APRA proposes:

The classification of a Standard Eligible Mortgage will distinguish between lowest risk “Owner-occupied P&I” and a higher risk “Other residential mortgages” category which is intended to be conceptually similar to the “material dependence” concept employed by Basel III to distinguish loans where repayment depends materially on the cash flows generated by the property securing the loan
6 RW bands for each of these two types of residential mortgage (compared to 5 bands currently)
Standard Eligible Mortgages with lower LVR loans to be assigned lower RW but these loans must also meet defined serviceability, marketability and valuation criteria to qualify for the concessionary RW
The higher RW applied to “Other residential mortgages” may take the form of a fixed risk-weight schedule (per the indicative RW in Table 3 of the Discussion Paper) but might also be implemented via a multiplier, applied to the RW for owner-occupied P&I loans, which might vary over time “… depending on prevailing prudential or financial stability objectives or concerns”
Relatively lower capital requirements to continue to apply where loans are covered by LMI but its preferred approach is to apply a RW loading to loans with LVR in excess of 80% that are not insured (i.e. the indicative RW in Table 3 assume that LMI covers the high LVR loans)
Non-Standard residential mortgages should no longer benefit from any RW concession and be assigned a flat 100% RW irrespective of LVR and LMI

While the IRB requirements impacting residential mortgages are largely unchanged under Basel III, APRA proposes the following changes to the Australian IRB Approach to reflect local requirements and conditions:

Increased capital requirements for investment and interest-only exposures; to be implemented via a higher correlation factor for these loans
The (currently fixed) correlation factor applied to residential mortgages to be amended to depend on probability of default (PD); reflecting empirical evidence that “… the default risk of lower PD exposures is more dependent on the economic cycle and can consequently increase at a relatively higher rate in a downturn”
A reduction in the minimum Loss Given Default (LGD) from 20% to 10% (subject to APRA approval of the LGD model); in order to facilitate “… better alignment of LGD estimates to key drivers of loss such as LVR and LMI”
Capital requirements for non-standard mortgages use the standardised approach; increasing consistency between the IRB an standardised approaches

APRA’s proposals seek to strike a balance between risk sensitivity and simplicity but must also take account of the FSI recommendations that ADI capital levels be unquestionably strong while also narrowing the difference between standardised and IRB RWs for residential mortgages. APRA is undertaking a Quantitative Impact Study (QIS) to better understand the impact of its proposals but the DP flagged that APRA does not expect the changes to correlation factors to meet its objectives for increased capital for residential mortgage exposures.

APRA could just further ramp up the correlation factor to generate the target IRB RW (which I assume continues to be 25%) but the DP notes that this would create undesirable inconsistencies with the correlation factors applied to other asset classes. Consequently, the DP indicates that the target increase in IRB RWA will likely be pursued via

A fixed multiplier (scalar) applied to total Credit RWA (i.e. althoughBasel III removes the 1.06 Credit RWA scalar, APRA is considering retaining a scalar with a value yet to be determined); and
If necessary, by applying additional specific RWA scalars for residential (and commercial) property.

These scalars will be subject to consultation with the industry and APRA has committed to review the 10.5% CET1 benchmark for unquestionably strong capital should the net result of the proposed revisions result in an overall increase in RWA’s relative to current methodologies.