RBNZ COVID 19 Stress Tests

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tony – From the Outside

Australian banking – “Unquestionably Strong” gets a bit more complicated

Students of the dark art of bank capital adequacy measurement were excited this week by the release of some proposed revisions to APRA’s “Prudential Standard APS 111 Capital Adequacy” (APS 111); i.e. the one which sets out the detailed criteria for measuring an ADI’s Regulatory Capital.

Is anyone still reading? Possibly not, but there is something I think worth noting here if you want to understand what may be happening with Australian bank capital. This is of course only a consultation at this stage but I would be very surprised if the key proposal discussed below is not adopted.

The Short Version

The consultation paper has a number of changes but the one that I want to focus on is the proposal to apply stricter constraints on the amount of equity an ADI invests in banking and insurance subsidiaries.

In order to understand how this impacts the banks, I have to throw in two more pieces of Australian bank capital jargon, specifically Level 1 and Level 2 capital.

  • 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 the 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.”

You can be forgiven for not being familiar with this distinction but the capital ratios typically quoted in any discussion of Australian bank capital strength are the Level 2 measures. The Unquestionably Strong benchmark that dominates the discussion is a Level 2 measure. The changes proposed in this consultation however operate at the Level 1 measurement (the ones that virtually no one currently pays any attention to) and not the Level 2 headline rate.

This has the potential to impact the “Unquestionably Strong” benchmark and I don’t recollect seeing this covered in the consultation paper or any public commentary on the proposal that I have seen to date.

APRA has been quite open about the extent to which these changes are a response to the RBNZ proposal to substantially increase equity requirements for NZ banks.

“This review was prompted in part by recent proposals by the Reserve Bank of New Zealand (RBNZ) to materially increase capital requirements in New Zealand. The RBNZ’s proposals and APRA’s processes are a natural by-product of both regulators working to protect their respective communities from the costs of financial instability and the regulators continue to support each other as these reforms are developed.”

The changes have however been calibrated to maintain the status quo based on the amounts of capital the Australian majors currently have invested in their NZ subsidiaries.

“APRA has calibrated the proposed capital requirements so they are broadly consistent with … the current capital position of the four major Australian banks, in respect of these exposures (i.e. preserving most of the existing capital uplift).”

It follows that any material increase in the capital the majors are required to invest in their NZ subsidiaries (in response to the RBNZ’s proposed requirement) will in turn require that they have to hold commensurately more common equity on a 1:1 basis in the Level 1 ADI to maintain the existing Level 1 capital ratios.

So far as I can see, the Level 2 measure does not require that this extra capital invested in banking subsidiaries be subject to the increased CET1 deductions applied at Level 1. It follows that the Level 2 CET1 ratio will increase but the extent to which a creditor benefits from that added strength will depend on which part of the banking group they sit.

I am not saying this a problem in itself. The RBNZ has the authority to set the capital requirements it deems necessary, Australian bank shareholders can make their own commercial decisions on whether the diluted return on equity meets their requirements and APRA has to respond to protect the interests of the Australian banking system.

I am saying that measuring relative capital adequacy is getting more complicated so you need to pay attention to the detail if this matters to you. In particular, I am drawing attention to the potential for the Level 2 CET1 ratios of the Australian majors to increase in ways that the existing “Unquestionably Strong” benchmark is not calibrated to. I don’t think this matters much for Australian bank depositors who have a very safe super senior position in the Australian loss hierarchy. It probably does matter for creditors who are closer to the sharp end of the loss hierarchy including senior and subordinated bondholders.

To date, the Level 2 capital adequacy ratios have been sufficient to provide a measure of relative capital strength; a higher CET1 ratio equals greater capital strength and that was probably all you needed to know. Going forward, I think you will need to pay closer attention to what is happening at the Level 1 measure to gain a more complete understanding of relative capital strength. The Level 2 measure by itself may not tell you the full story.

The detail

As a rule, APRA’s general capital treatment of equity exposures is to require that they be 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 rule when 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 is comfortable with that outcome based on current exposure levels.

The RBNZ’s (near certain) move towards higher CET1 requirements however threatens to undermine this status quo and potentially see 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 is proposing 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 is proposing 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.

Summing up

What APRA is proposing to do makes sense to me. We can debate the necessity for the RBNZ to insist on virtually 100% CET1 capital (for the record, I continue to believe that a mix of CET1 and contingent convertible debt is likely to be a more effective source of market discipline). However, once it became clear that the RBNZ was committed to its revised capital requirements, APRA was I think left with no choice but to respond.

What will be interesting from here is to see whether investments of CET1 in NZ banking subsidiaries increase in response to the RBNZ requirement or whether the Australian majors choose to reduce the size of their NZ operations.

If the former (i.e. the majors are required to increase the capital committed to NZ subsidiaries) then we need to keep an eye on how this impacts the Level 2 capital ratios and what happens to the “Unquestionably Strong” CET1 benchmark that currently anchors the capital the Australian majors maintain.

This is a pretty technical area of bank capital so it is possible I am missing something; if so please let me know what it is. Otherwise keep an eye on how the capital adequacy targets of the Australian majors respond to these developments.

Tony (From the Outside)

The “skin in the game” argument for more common equity

One of the traditional arguments for higher common equity requirements is that it increases the shareholders’ “skin in the game” and thereby creates an incentive to be more diligent and conservative in managing risk.

This principle is true up to a point but I believe more common equity mostly generates this desirable risk management incentive when the extra skin in the game (aka capital) is addressing a problem of too little capital. It is much less obvious that more capital promotes more conservative risk appetite for a bank that already has a strong capital position.

In the “too little” capital scenarios, 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.

The European Systemic Risk Board published some interesting research on this question in a paper titled “Has regulatory capital made banks safer? Skin in the game vs moral hazard” . I have copied the abstract below which summarises the key conclusions.

Abstract: The paper evaluates the impact of macroprudential capital regulation on bank capital, risk taking behaviour, and solvency. The identification relies on the policy change in bank-level capital requirements across systemically important banks in Europe. A one percentage point hike in capital requirements leads to an average CET1 capital increase of 13 percent and no evidence of reduction in assets. The increase in capital comes at a cost. The paper documents robust evidence on the existence of substitution effects toward riskier assets. The risk taking behavior is predominantly driven by large and less profitable banks: large wholesale funded banks show less risk taking, and large banks relying on internal ratings based approach successfully disguise their risk taking. In terms of overall impact on solvency, the higher risk taking crowds-out the positive effect of increased capital.

I have only skimmed the paper thus far and have reservations regarding how they measure increased risk. As I understand it, the increased riskiness the analysis measures is based on increases in average risk weights. It was not clear how the analysis distinguished changes in portfolio riskiness from changes in the risk weight measure. That said, the overall conclusions seem intuitively right.

Tony

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

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

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

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

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

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

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

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

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

It is less clear however that:

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

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

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

How does leverage affect the cost of bank financing?

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

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

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

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

Banker’sNew Clothes (p101)

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

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

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

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

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

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

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

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

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

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

How much capital is (more than) enough?

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

Why are banks different?

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

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

Flawed risk models

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

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

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

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

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

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

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

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

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

What should count as capital?

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

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

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

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

What is the minimum return an equity investor requires?

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

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

Summary

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

I see more potential in pursuing a capital structure based on

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

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

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

Tony

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

How much capital is enough? – The NZ perspective

The RBNZ has delivered the 4th instalment in a Capital Review process that was initiated in March 2017 and has a way to run yet. The latest consultation paper addresses the question “How much capital is enough?”.  The banking industry has until 29 March 2019 to respond with their views but the RBNZ proposed answer is:

  • A Tier 1 capital requirement of 16% of RWA for systemically important banks and 15% of RWA for all other banks
  • The Tier 1 minimum requirement to remain unchanged at 6% (with AT1 capital continuing to be eligible to contribute a maximum of 1.5 percentage points)
  • The proposed increased capital requirement to be implemented via an overall prudential capital buffer of 9-10% of RWA comprised entirely of CET1 capital;
    • Capital Conservation Buffer 7.5% (currently 2.5%)
    • D-SIB Buffer 1.0% (no change)
    • Counter-cyclical buffer 1.5% (currently 0%)

The increase in the capital ratio requirement is proposed to be supplemented with a series of initiatives that will increase the RWA of IRB banks:

  • The RBNZ proposes to 1) remove the option to apply IRB RW to sovereign and bank exposures,  2) increase the IRB scalar (from 1.06 to 1.20) and 3) to introduce an output floor set at 85% of the Standardised RWA on an aggregate portfolio basis
  • As at March 2018, RWA’s produced by the IRB approach averaged 76% of the Standardised Approach and the RBNZ estimate that the overall impact will be to increase the aggregate RWA to 90% of the outcome generated by the Standardised approach (i.e. the IRB changes, not the output floor, drive the increase in RWA)
  • Aggregate RWA across the four IRB banks therefore increases by approximately 16%, or $39bn, compared to March 2018 but the exact impact will depend on how IRB banks respond to the higher capital requirements

The RBNZ has also posed the question whether a Tier 2 capital requirement continues to be relevant given the substantial increase in Tier 1 capital.

Some preliminary thoughts …

There is a lot to unpack in this paper so this post will only scratch the surface of the issues it raises …

  • The overall number that the RBNZ proposes (16%) is not surprising.It looks to be at the lower end of what other prudential regulators are proposing in nominal terms
  • But is in the same ball park once you allow for the substantial increase in IRB RWA and the fact that it is pretty much entirely CET1 capital
  • What is really interesting is the fundamentally different approach that the RBNZ has adopted to Tier 2 capital and bail-in versus what APRA (and arguably the rest of the world) has adopted
    • The RBNZ proposal that the increased capital requirement take the form of CET1 capital reflects its belief that “contingent convertible instruments” should be excluded from what counts as capital
    • Exactly why the RBNZ has adopted this position is a complex post in itself (their paper on the topic can be found here) but the short version (as I understand it) is that they think bail-in capital instruments triggered by non-viability are too complex and probably won’t work anyway.
    • Their suggestion that Tier 2 probably does not have a role in the capital structure they have proposed is logical if you accept their premise that Point of Non-Viability (PONV) triggers and bail-in do not work.
  • The RBNZ highlight a significantly enhanced role for prudential capital buffersI am generally in favour of bigger, more dynamic, capital buffers rather than higher fixed minimum requirements and I have argued previously in favour of the base rate for the counter-cyclical being a positive value (the RBNZ propose 1.5%)
    • But the overall size of the total CET1 capital buffer requirement requires some more considered thought about 1) the role of bail-in  structures and PONV triggers in the capital regulation toolkit (as noted above) and 2) whether the impacts of the higher common equity requirement will be as benign as the RBNZ analysis suggests
  • I am also not sure that the indicative capital conservation responses they have outlined (i.e. discretionary distributions limited to 60% of net earnings in the first 250bp of the buffer, falling to 30% in the next 250bp and no distributions thereafter) make sense in practice.
    • This is because I doubt there will be any net earnings to distribute if losses are sufficient to reduce CET1 capital by 250bp so the increasing capital conservation requirement is irrelevant.
  • Last, but possibly most importantly, we need to consider the impact on the Australian parents of the NZ D-SIB banks and how APRA responds. The increase in CET1 capital proposed for the NZ subsidiaries implies that, for any given amount of CET1 capital held by the Level 2 Banking Group, the increased strength of the NZ subsidiaries will be achieved at the expense of the Australian banking entities
    • Note however that the impact of the higher capital requirement in NZ will tend to be masked by the technicalities of how bank capital ratios are calculated.
      • It probably won’t impact the Level 2 capital ratios at all since these are a consolidated view of the combined banking group operations of the Group as a whole
      • The Level 1 capital ratios for the Australian banks also treat investments in bank subsidiaries relatively generously (capital invested in unlisted subsidiaries is treated as a 400% risk weighted asset rather than a capital deduction).

Conclusion

Overall, I believe that the RBNZ is well within its rights to expect the banks it supervises to maintain a total level of loss absorbing capital of 16% or more. The enhanced role for capital buffers is also a welcome move.

The issue is whether relying almost entirely on CET1 capital is the right way to achieve this objective. This is however an issue that has been debated for many decades with no clear resolution. It will take some time to fully unpack the RBNZ argument and figure out how best to articulate why I disagree. In the interim, any feedback on the issues I have outlined above would be most welcome.

Tony

Stress Testing – Do (really) bad things happen to good banks?

This post will focus on stress testing in response to some recent papers the RBNZ released (July 2018) describing both its approach to stress testing and the outcomes from the 2017 stress test of the major banks and a speech by Wayne Byres (APRA) which offered some detail of the Australian side of the joint stress testing undertaken by APRA and the RBNZ. I intend to make some observations related to this specific stress testing exercise but also some broader points about the ways that stress testing is currently conducted. The overriding point is that the cyclical scenarios employed to calibrate capital buffers seem to focus on “what” happened with less consideration given to “why” the historical episodes of financial stress the scenarios mimic were so severe.

There will be technical detail in this post but the question, simply put, is to what extent do really bad things happen to good banking systems? Paraphrased in more technical language, are we calibrating for scenarios based on the impact of some random exogenous shock on a sound banking system, or does the scenario implicitly assume some systemic endogenous factors at play that made the financial system less resilient in the lead up to the shock? Endogenous factors may be embedded in the balance sheets of the banks (e.g. poor credit quality amplified by excessive credit growth) or perhaps they are a feature of the economic system (e.g. a fixed exchange rate regime such as confronted many European economies during the GFC) that may or may not be universally relevant. I am focusing on the RBNZ stress test to explore these points mostly because they offered the most detail but I believe their approach is very similar to APRA’s and the observations apply generally to macro economic stress testing.

No prizes for guessing that I will be arguing that the kinds of really severe downturns typically used to calibrate capital buffers are usually associated with conditions where endogenous forces within the banking system are a key element in explaining the extent of the asset price declines and weak recoveries and that the severity of some historical scenarios was arguably exacerbated by unhelpful exchange rate, monetary or fiscal policy settings. This is not to say that we should not be using very severe downturns to calibrate the resilience of capital buffers. My argument is simply that recognising this factor will help make more sense of how to reconcile the supervisory approach with internal stress testing and how best to respond to the consequences of such scenarios.

The RBNZ approach to stress testing

The RBNZ characterises its approach to be at the less intensive end of the spectrum of supervisory practice so “stress tests are used to provide insights into the adequacy of bank capital buffers and can highlight vulnerabilities at the bank wide level or in its various loan portfolios” but “… the use of individual bank results in setting capital buffers and promoting market discipline is relatively limited“. The RBNZ stress tests fall into three categories 1)  cyclical scenarios, 2) exploratory stress tests and 3) targeted tests.

This post will focus on the cyclical scenario which was the focus of the RBNZ’s 2017 stress test and the place where the question of what happened and why it happened is most at risk of getting lost amongst the desire to make the test tough, coupled with the often daunting task of just running the test and getting some results.

The RBNZ states that the aim of a cyclical scenario is to help “… understand the resilience of participating banks to a macroeconomic downturn” so these scenarios “… mimic some of the worst downturns in advanced economies since World War 2, and typically feature sharp declines in economic activity and property prices, and stressed funding markets”. The repetition of the benchmark cyclical downturn scenario over time also allows the RBNZ “to track the resilience of the financial system over time (although the scenario will 

It is hard to argue with calibrating the resilience of the banking system to a very high standard of safety. That said, the concern I have with cyclical scenarios drawn from worst case historical events is that the approach tends to skip over the question of why the downturn of such severity occurred.

The RBNZ commentary does recognise the “… need to take account of the nature of the specific stress scenario” and for the cyclical scenario to “evolve based on new research and insights, such as the extent of over-valuation evident in property markets” and the possibility that “domestic monetary policy and a falling exchange rate would provide a significant buffer … that was unavailable during many of these stress episodes in countries without floating exchange rates“. “Exploratory” and “Targeted” stress testing may also be focussed on the endogenous risks embedded in the banking system without explicitly using that terminology.

So if the RBNZ, and APRA, are implicitly aware of the endogenous/exogenous risk distinction, then maybe I am just being pedantic but I would argue that greater clarity on this aspect of stress testing helps in a number of areas:

  • It can help to explain why there is often a gap between:The severity of outcomes modelled internally (where the bank will probably assume their portfolios has robust credit quality and none of the systemic weaknesses that were responsible for past episodes of severe financial weakness implicit in the downturn scenario adopted by the supervisors), andThe severity the regulator expects (possibly based on a skeptical view of the extent to which bank management has balanced risk and return with the reward of higher growth and market share).
  • The types of recovery actions that can be deployed and the amounts of capital they contribute to the rebuilding process are also very much shaped by the nature of the scenario (scenarios shaped by endogenous factors embedded in the banks’ balance sheets or business models require much more substantial responses that are more costly though the cost can be a secondary issue when the scale of the challenge is so large).
  • Supervisors rightly focus on the need for banks to maintain the supply of credit to the economy but endogenous scenarios may actually require that some customers de-gear themselves and become less reliant on bank credit.

The RBNZ discussion of the 2017 stress test of the major banks focussed on the Phase 2 results and noted that:

  • The four participating banks started the stress test with an aggregate CET1 ratio of 10.3% and an aggregate buffer ratio of 5.4%
  • The impact of the combined macro economic downturn and the operational risk event saw the aggregate CET1 ratio decline by 3.4 percentage points to 6.9% in the third year; driven in order of importance by:
    • Credit losses (including the large counter party loss) – 6.6 ppts
    • Growth in RWA – 1.4 ppts
    • Dividends and other capital deductions – 1.4 ppts
    • The operational risk event for misconduct risk – 0.7 ppts
    • Underlying profits which offset the gross decline in the CET1 ratio by 6.7 ppts to arrive at the net decline of 3.4 ppts
  • Mitigating actions improved the aggregate CET1 ratio by 1.1 ppts by year three to 8%; these actions included 1) reductions in lending, 2) additional interest rate repricing and 3) operating expense reductions.

There is not a lot of detail on individual bank outcomes. In the combined scenario, individual bank CET1 ratios declined to between 6.4% to 7.4% versus the 6.9% aggregate result. The individual buffer ratios fell to between 1.2 and 1.4% at their low points (no aggregate minimum buffer was reported).

Some observations on the outcomes of the RBNZ 2017 stress test

The fact that the major banks can maintain significant buffers above minimum capital requirements during quite severe stress scenarios offers a degree of comfort, especially when you factor in the absence of mitigating responses. Minor quibble here, but it is worth noting that the aggregate data the RBNZ uses to discuss the stress testing results does not map neatly to the minimum requirements and capital buffers applied at the individual bank level. A 5.4 ppt buffer over the 4.5% CET1 buffer equates to 9.9%, not 10.3%. Looking at Figure 1 in the “outcomes” paper also shows that there was a narrower range in the CCB at its low point than there was for the CET1 ratio so part of the CCB decline observed in the stress test may be attributable to shortfalls at either the Tier 1 or Total Capital Ratio levels rather than CET1. Small point, but it does matter when interpreting what the results mean for the target capital structure and how to respond.

The RBNZ is clearly correct to question the reliability of mitigating actions and the potential for some actions, such as tightening of lending standards, to generate negative feedback effects on asset prices and economic activity. However, it is equally open to question whether the market confidence that banks rely on to fund themselves and otherwise conduct business would remain resilient in the face of a three-year continuous decline in capital ratios. So I do not think we can take too much confidence in the pre mitigation outcomes alone; the mitigating responses matter just as much.

I have always thought of the capital buffer as simply “buying time” for management to recognise the problem and craft a response that addresses the core problems in the business while creating positive momentum in capital formation. The critical question in stress testing is how much time will the markets grant before they start to hold back from dealing with your bank. Markets do not necessarily expect a magic bullet, but they do expect to see positive momentum and a coherent narrative.  It would also be useful to distinguish between a core set of actions that could reasonably be relied on and other actions that are less reliable or come at a higher cost to the business.

It is hard to comment on the specific mitigating actions since the paper only reports an aggregate benefit of 1.1 ppts over the 3 years but I can make the following general observations:

  • Reductions in lending: The potential for reduced lending to generate negative feedback effects on asset prices and economic activity is a very valid concern but I do struggle to reconcile a 35% decline in house prices with a scenario in which the loans the banking system has outstanding to this sector do not appear to have declined.
    • I can’t see any specific numbers in the RBNZ paper but that is the inference I draw if the overall loan book has not declined, which seems to be implied by the statement that the 20% RWA growth over the first three years of the scenario was primarily due to higher risk weights.
    • Loan principal is progressively being repaid on performing loans but this balance sheet shrinkage is amplified in the scenario by elevated defaults, while the rate of new lending which would otherwise be the driver of growth in outstanding must be slowing if house prices are falling by such a large amount. In addition, the reduced volume of new loans being written are I assume for lower amounts than was the case prior to the decline in house prices.
    • I am very happy to be set straight on this part of the modelling but the numbers don’t quite add up for me. If I am right then a loan book that is stable or even declining in value may be what is implied by the scenario rather than something that adds further to the stress on capital ratios. At the very least, winding back loan growth assumptions relative to the benign base case seems a reasonable response.
  • Repricing: I can’t tell from the RBNZ paper how significant this factor was in contributing to the 1.1 percentage point 3 year improvement in CET1 but I am guessing it was reasonably material. Materiality therefore requires that the numbers be subject to a higher level of scrutiny.
    • History does offer a reasonable body of evidence that Australian and NZ banks have had the capacity to reprice loans under stress and in response to higher funding costs. The question is whether the collapse in trust in big banks has undermined the value of the repricing option they have traditionally benefited from.
    • I do believe that some of the critiques of bank repricing are not well founded but that does not change the real politic of the likely public and government push back should banks attempt to do so.
    • So the answer here is probably yes; the benefits of this particular mitigating action are likely not as reliable as they have been in the past. At the very least, there is likely to be a higher cost to using them.
  • The contribution of RWA growth to the decline in the capital ratio noted in the RBNZ paper is also worth calling out. There is not a lot of detail in the paper but it does appear that the 20% increase in RWA over the first three years of the scenario was driven primarily by an increase in the average credit RW from 45% to 54%.
    • This seems to imply that there was a significant cycle driven increase in capital requirements over the course of the scenario that was not driven by an increase in loans outstanding.
    • I believe that this kind of capital measurement driven impact on capital ratios is fundamentally different from the impact of actual losses and higher new lending but it is treated as equivalent for the purposes of the analysis. This looks to me like a category error; a decline in a capital ratio due to higher risk weights is not the same thing for the purposes of solvency as a loss due to a loan defaulting.
    • The solution probably lies in a better designed approach to counter cyclical buffers (see my post here and here for background) and the regulatory treatment of expected loss, but the stress testing analysis suffers by simply noting the outcome without going behind what that component of the decline in capital ratio actually represents.

Deposit growth under a stress scenario

I also struggled with the statement in Section 5 of the RBNZ paper that “Banks expected strong growth in retail deposits, in line with their experience during the Global Financial Crisis.

  • This statement seems to reflect the intuitive view that bank deposits increase under adverse conditions as people sell risky assets and put their money in banks. But we also know that selling a risky asset requires someone else to buy it, so the increase in cash in the account of the seller is offset by the decrease in the account of the buyer. There was an increase in bank deposits during the GFC but the simple sell risky assets and put your money in the bank does not seem to explain why it happened.
  • So what do we know about the GFC? Firstly, big banks continued to grow their loan book and we know that bank credit creation leads to deposit creation. The GFC was also a scenario where the collapse of securitisation markets saw lending for residential mortgages migrate back to big bank balance sheets. I think this also creates a net increase in deposits. Banks were also paying down foreign borrowings which I think is also positive for deposit creation via the balance of payments though this channel is murkier. We also observed money migrating from equities to property lending. The selling of the risky assets is net square for deposits by itself but the deposit creation comes as the cash in the hands of the seller gets leveraged up to support new credit creation via the increased property loans which are typically geared much more highly than other types of risk assets. The shift from equity to property also seems to be driven by the typical monetary policy strategy of reducing interest rates.
  • So it is not clear to me that the pool of deposits grows under the conditions of the RBNZ scenario. We do have the likelihood that people are selling risky assets but we seem to be missing a number of the elements specific to the GFC that saw new deposits get created in the banking system. The only deposit formation positive I can see is maybe via the balance of payments but, as noted above this, channel is very murky and hard to understand.
  • The other interesting question is whether bank deposits continue to be a safe haven for New Zealanders in future crises given that the RBNZ has implemented an Open Banking Resolution regime that exposes bank deposits to the risk of being bailed-in on a pari passu basis with other unsecured bank creditors. This is a unique feature of the NZ financial system which even eschews the limited guarantees of bank deposits that many other systems see as essential to maintaining the confidence of depositors under stress.

I may well be missing something here so I am very happy to hear the other side to any of the observations I have offered above. I am big believer in the value of stress testing which is why I think it is so important to get it right.

Tony