Cost of Equity – From the outside

Banks may be asked to absorb more than their contractual share of the economic fallout of the Coronavirus

We have already seen signs that the Australian banks recognise that they need to absorb some of the fallout from the economic impact of the Coronavirus. This commentator writing out of the UK makes an interesting argument on how much extra cost banks and landlords should volunteer to absorb.

Richard Murphy on tax, accounting and political economy
— Read on www.taxresearch.org.uk/Blog/2020/03/04/banks-and-landlords-have-to-pick-up-the-costs-of-the-epidemic-to-come-if-the-the-economy-is-to-have-a-chance-of-surviving/

I am not saying banks should not do this but two themes to reflect on:

1) This can be seen as part of the price of rebuilding trust with the community

2) it reinforces the cyclicality of the risk that bank shareholders are required to absorb which then speaks to what is a fair “Through the Cycle” ROE for that risk

I have long struggled with the “banks are a simple utility ” argument and this reinforces my belief that you need a higher ROE to compensate for this risk

Tony

Thinking aloud about Australian bank ROE

I have been wanting to put something down on the question of Australian major bank ROE for a while. The issue generates a lot of heat but the public discussion I have observed has been truncated, in my opinion, by misconceptions.

I think we can agree that banks need to be profitable to be healthy and a healthy banking system underpins the health of the economy as a whole. Excessive profitability however is clearly bad for consumers, business and for the economy as a whole. The problem is determining what level of profitability is excessive. This post is unlikely to be the final word on this topic but hopefully it introduces a couple of considerations that seem to me to be largely missing from the public debate.

Most of what I read on this topic seems to treat the ROE of the Australian majors as self evidently excessive and focuses on what to do about it. Exhibit A is the reported ROE which in the 2019 half year updates varied from 10.05% to 14.10%. This is much less than it was but still substantially better than what is being achieved by most banks outside Australia and by the smaller local banks. Exhibit B is the fact that the Australian banking system is an oligopoly which almost by definition earn excess profits.

Reported ROE exceeds COE – case closed

Any discussion of ROE must be anchored by the estimated Cost of Equity (COE), the minimum return that investors require to hold equity risk. There are a variety of ways of calculating this but all of them generate a number that is much less than the ROE the majors currently earn. So case closed.

There is no question that the Australian majors cover their cost of equity, but it is less clear to me that the margin of excess profitability is as excessive as claimed.

Corporate finance 101 teaches us that we can derive a company’s cost of equity using the Capital Asset Pricing Model (CAPM) which holds that the required return is equal to the Risk Free Return plus the Equity Risk Premium (ERP) multiplied by the extent to which the return the individual stock is correlated with the market as a whole. The general idea of being paid a premium for taking on equity risk makes sense but there are a bunch of issues with the CAPM once you get into the detail. One of the more topical being what do you do when the risk free rate approaches zero.

I don’t want to get into the detail of those issues here but will assume for the purposes of this post that a rate of return in the order of 8-10% can be defended as a minimum acceptable return. I recognise that some of the more mechanical applications of the CAPM might generate a figure lower than this if they simply apply a fixed ERP to the current risk free rate.

Two reasons why a simple comparison of ROE and COE may be misleading

Banking is an inherently cyclical business and long term investors require a return that compensates them for accepting this volatility in returns.
Book value does not define market value

Banking is a highly cyclical business – who knew?

It is often asserted that banking is a low risk, “utility” style business and hence that shareholders should expect commensurately low returns. The commentators making these assertions tend to focus on the fact that the GFC demonstrated that it is difficult (arguably impossible) to allow large banks to fail without imposing significant collateral damage on the rest of the economy. Banks receive public sector support to varying degrees that reduces their risk of failure and hence the risk to shareholders. A variation of this argument is that higher bank capital requirements post the GFC have reduced the risk of investing in a bank by reducing the risk of insolvency.

There is no question that banks do occupy a privileged space in the economy due to the central bank liquidity support that is not available to other companies. This privilege (sometimes referred to as a “social licence”) is I think an argument for tempering the kinds of ROE targeted by the banks but it does not necessarily make them a true utility style investment whose earnings are largely unaffected by cyclical downturns.

The reality is that bank ROE will vary materially depending on the state of the credit cycle and this inherent cyclicality is probably accentuated by accounting for loan losses and prudential capital requirements. Loan losses for Australian banks are currently (October 2019) close to their cyclical low points and can be expected to increase markedly when the economy eventually moves into a downturn or outright recession. Exactly how much downside in ROE we can expect is open to debate but history suggests that loan losses could easily be 5 times higher than what we observe under normal economic conditions.

There is also the issue of how often this can be expected to happen. Again using history as a guide for the base rate, it seems that downturns might be expected every 7-10 years on average and long periods without a downturn seem to be associated with increased risk of more severe and prolonged periods of reduced economic activity.

What kind of risk premium does an investor require for this cyclicality? The question may be academic for shareholders who seek to trade in and out of bank stocks based on their view of the state of the cycle but I will assume that banks seek to cater to the concerns and interests of long term shareholders. The answer for these shareholders obviously depends on how frequent and how severe you expect the downturns to be, but back of the envelope calculations suggest to me that you would want ROE during the benign part of the credit cycle to be at least 200bp over the COE and maybe 300bp to compensate for the cyclical risk.

Good risk management capabilities can mitigate this inherent volatility but not eliminate it; banks are inherently cyclical investments on the front line of the business cycle. Conversely, poor risk management or an aggressive growth strategy can have a disproportionately negative impact. It follows that investors will be inclined to pay a premium to book value for banks they believe have good risk management credentials. I will explore this point further in the discussion of book value versus market value.

Book Value versus Market Value

Apart from the cyclical factors discussed above, the simple fact that ROE is higher than COE is frequently cited as “proof” that ROE is excessive. It is important however to examine the unstated assumption that the market value of a bank should be determined by the book value of its equity. To the best of my knowledge, there is no empirical or conceptual basis for this assumption. There are a number of reasons why a company’s share price might trade at a premium or a discount to its book value as prescribed by the relevant accounting standards.

The market may be ascribing value to assets that are not recognised by the accounting standards.The money spent on financial control and risk management, for example, is largely expensed and hence not reflected in the book value of equity. That value however becomes apparent when the bank is under stress. These “investments” cannot eliminate the inherent cyclicality discussed above but they do mitigate those risk.

A culture built on sound risk management and financial control capabilities is difficult to value and won’t be reflected in book value except to the extent it results in conservative valuation and provisioning outcomes. It is however worth something. Investors will pay a premium for the banks they believe have these intangible strengths while discounting or avoiding altogether the shares of banks they believe do not.

Summing up …

This post is in no way an exhaustive treatment of the topic. Its more modest objective was simply to offer a couple of issues to consider before jumping to the conclusion that the ROE earned by the large Australian banks is excessive based on simplistic comparisons of point in time ROE versus mechanical derivations of the theoretical COE.

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

Tony

“The rate of return on everything”

This is the focus of a paper titled “The Rate of Return on Everything, 1870-2015 that seeks to address some fundamental questions that underpin, not only economic theory, but also investment strategy.

To quote the abstract:

This paper answers fundamental questions that have preoccupied modern economic thought since the 18th century. What is the aggregate real rate of return in the economy? Is it higher than the growth rate of the economy and, if so, by how much? Is there a tendency for returns to fall in the long-run? Which particular assets have the highest long-run returns? We answer these questions on the basis of a new and comprehensive dataset for all major asset classes, including—for the first time—total returns to the largest, but oft ignored, component of household wealth, housing. The annual data on total returns for equity, housing, bonds, and bills cover 16 advanced economies from1870 to 2015, and our new evidence reveals many new insights and puzzles.ets.
“The Rate of Return on Everything” Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, Alan M. Taylor – December 2017

The paper is roughly 50 pages long (excluding appendices) but the 5 page introduction summarises the four main findings which I have further summarised below:

Risky Returns: The study finds that “… residential real estate and equities have shown very similar and high real total gains, on average about 7% per year. Housing outperformed equity before WW2. Since WW2, equities have outperformed housing on average, but only at the cost of much higher volatility and higher synchronicity with the business cycle”.
Safe Returns: The study finds that “Safe returns have been low on average, falling in the 1%–3% range for most countries and peacetime periods“. However, “the real safe asset return has been very volatile over the long-run, more so than one might expect, and oftentimes even more volatile than real risky returns.” This offers a long-run perspective on the current low level of the safe returns with the authors observing that “… it may be fair to characterize the real safe rate as normally fluctuating around the levels that we see today, so that today’s level is not so unusual. Which begs the question “… why was the safe rate so high in the mid-1980s rather than why has it declined ever since.”
The Risk Premium: The study finds that the risk premium has been very volatile over the long run. The risk premium has tended to revert to about 4%-5% but there have been periods in which it has been higher. The study finds that the increases in the risk premium “… were mostly a phenomenon of collapsing safe rates rather than dramatic spikes in risky rates. In fact, the risky rate has often been smoother and more stable than safe rates, averaging about 6%–8% across all eras” . This for me was one of the more interesting pieces of data to emerge from the study and has implications for the question of what should be happening to target return on equity in a low interest rate environment such as we are currently experiencing. In the Authors’ words “Whether due to shifts in risk aversion or other phenomena, the fact that safe rates seem to absorb almost all of these adjustments seems like a puzzle in need of further exploration and explanation“
On Returns Minus Growth: This is the question that Thomas Piketty explored in his book “Capital in the Twenty-First Century”. Piketty argued that, if the return to capital exceeded the rate of economic growth, rentiers would accumulate wealth at a faster rate and thus worsen wealth inequality. The study finds that, “for more countries and more years, the rate of return on risk assets does in fact materially exceed the rate of growth in GDP… In fact, the only exceptions to that rule happen in very special periods: the years in or right around wartime. In peacetime, r has always been much greater than g. In the pre-WW2 period, this gap was on average 5% per annum (excluding WW1). As of today, this gap is still quite large, in the range of 3%–4%, and it narrowed to 2% during the 1970s oil crises before widening in the years leading up to the Global Financial Crisis.

So why does this matter?

There is a lot to think about in this paper depending on your particular areas of interest.

The finding that the long run return on residential housing is on par with equity but lower volatility is intriguing though I must confess that I want to have a closer look at the data and methodology before I take the conclusion as a fact. In particular, I think it is worth paying close attention to the way that the study deals with taxation. Fortunately, the paper offers a great deal of detail on the way that residential property is taxed (Appendix M in the December 2017 version of the paper) in different countries which is useful in its own right. I have been looking for a source that collates this information for some time and this is the best I have seen so far.

For me at least, the data on how the Equity Risk Premium (ERP) expands and contracts to offset changes in the return unsafe assets was especially interesting. This observation about the relationship is not new of itself but it was useful to find more data in support of it. I have been thinking a lot about Cost of Equity in a low interest rate environment and this seems to support the thesis that the target Return on Equity (ROE) should not necessarily be based on simply adding a fixed measure of the ERP (say 4%-5%) to whatever the current long run risk free rate is. It is at least worth having the question in mind when considering the question of whether Australian bank ROE is excessive at this point of the cycle.

If you are interested in the issues covered above then it is also worth having a look at an RBA Research Discussion Paper titled “A History of Australian Equities” by Thomas Matthews that was published this month.

From The Outside

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.

Why this blog?

making sense of what I have learned about banks with a focus on bank capital management.

Late in 2017 I decided to take some time out from work (the paid kind to be precise). My banking career has spanned a variety of roles working in a large Australian bank but the unifying theme for much of that time was a focus on bank capital management. This is a surprisingly rich topic (yes honestly) and one that I am not done with yet. Accordingly, I want to devote some of my time out to an attempt to make sense of what I have learned and apply that knowledge to topical banking issues. It was suggested that I write a book but I have opted for a blog format in part because it will hopefully allow for a two way dialogue with like minded bank capital tragics.

An alternative title for this blog was “The education of a banker; a work in progress” which sought to convey the idea that I believe I have learned quite a lot about banking over the past four decades but the plan is to keep learning. Some of the perspectives I offer are to, the best of my knowledge, based on very firm foundations while others are ones which reasonable people can disagree upon or outright speculative. To the best of my ability, all of the views expressed will be “lightly held” in the sense that I am just as interested in identifying reasons why they might be wrong as I am in affirmation.

I settled on “From the Outside” based on an informal survey of a group of like minded people with who I have already devoted many emails and coffee catchups debating the issues I intend to explore. The title highlights that I bring a perspective forged working inside a bank over many years but now looking at the questions from the outside. Each reader will need decide for themselves whether I achieve a balanced view or have become irredeemably institutionalised. I will seek to correct what I believe to be unfounded criticisms of banks (for the record, I don’t think the current ROE major Australian banks are targeting is excessive) while at the same time there are other areas where I believe Australian banks need to do better (engaging with long time customers in a way that recognises their loyalty would be a great place to start).

The focus of the blog will no doubt evolve over time (and hopefully in response to feedback) but the initial plan is to explore a sequence of big picture themes in parallel with topical issues that arise from time to time. I also plan to share my thoughts on books and papers I have read that I think readers might find worth following up.

The big picture themes will likely encompass questions like the ways in which banks are different from other companies and the implications this has for thinking about questions like their cost of equity, optimal capital structure, risk appetite, risk culture, prudential regulation etc. Topical issues would encompass discussion papers, academic research, opinion pieces, prudential regulation and anything else that intersected with banking, finance and economics.

I am currently working my way through APRA’s Feb 2018 discussion paper on Revisions to the capital framework for ADI’s. I think there is a lot to like in the proposals APRA has set out but also some gaps and possible unintended consequences that are worth exploring.

… and so it begins

Tony

Continue reading “Why this blog?”