Tag: RWA consistency

ECB Targeted Review of Internal Models

The European Central Bank recently (April 2021) released a report documenting what had been identified in a “Targeted Review of Internal Models”(TRIM). The TRIM Report has lots of interesting information for subject matter experts working on risk models.

It also has one item of broader interest for anyone interested in understanding what it means for an Australian Authorised Deposit Taking Institution (ADI) to be “Unquestionably Strong” per the recommendation handed down by the Australian Financial System Inquiry in 2014 and progressively being enshrined in capital regulation by the Australian Prudential Regulation Authority (APRA).

The Report disclosed that the TRIM has resulted in 253 supervisory decisions that are expected to result in a 12% increase in the aggregate RWAs of the models covered by the review. European banks may not be especially interested in the capital adequacy of their Australian peers but international peer comparisons have become one of the core lens through which Australian capital adequacy is assessed as a result of the FSI recommendation.

There are various ways in which the Unquestionably Strong benchmark is interpreted but one is the requirement that the Australian ADIs maintain a CET1 ratio that lies in the top quartile of international peer banks. A chart showing how Australian ADIs compare to their international peer group is a regular feature of the capital adequacy data they disclose. The changes being implemented by the ECB in response to the TRIM are likely (all other things being equal) to make the Australian ADIs look even better in relative terms in the future.

More detail …

The ECB report documents work that was initiated in 2016 covering 200 on-site model investigations (credit, market and counterparty credit risk) across 65 Significant Institutions (SI) supervised by ECB under what is known as the Single Supervisory Mechanism and extends to 129 pages. I must confess I have only read the Executive Summary (7 pages) thus far but I think students of the dark art of bank capital adequacy will find some useful nuggets of information.

Firstly, the Report confirms that there has been, as suspected, areas in which the outputs of the Internal Models used by these SI varied due to inconsistent interpretations of the BCBS and ECB guidance on how the models should be used to generate consistent and comparable risk measures. This was not however simply due to evil banks seeking to game the system. The ECB identified a variety of areas in which their requirements were not well specified or where national authorities had pursued inconsistent interpretations of the BCBS/ECB requirements. So one of the key outcomes of the TRIM is enhanced guidance from the ECB which it believes will reduce the instances of variation in RWA due to differences in interpretation of what is required.

Secondly the ECB also identified instances in which the models were likely to be unreliable due to a lack of data. As you would expect, this was an issue for Low Default Portfolios in general and Loss Given Default models in particular. As a result, the ECB is applying “limitations” on some models to ensure that the outputs are sufficient to cover the risk of the relevant portfolios.

Thirdly the Report disclosed that the TRIM has resulted in 253 supervisory decisions that are expected to result in a 12% increase in the aggregate RWAs of the models covered by the review.

As a follow-up to the TRIM investigations, 253 supervisory decisions have been issued or are in the process of being issued. Out of this total, 74% contain at least one limitation and 30% contain an approval of a material model change. It is estimated that the aggregated impact of TRIM limitations and model changes approved as part of TRIM investigations will lead to a 12% increase in the aggregated RWA covered by the models assessed in the respective TRIM investigations. This corresponds to an overall absolute increase in RWA of about €275 billion as a consequence of TRIM and to a median impact of -51 basis points and an average impact of -71 basis points on the CET1 ratios of the in-scope institutions.

European Central Bank, “Targeted Review of Internal Models – Project Report”, April 2021, (page 7)
Summing up

Interest in this report is obviously likely to be confined for the most part to the technical experts that labour in the bowels of the risk management machines operated by the large sophisticated banks that are accredited to measure their capital requirements using internal models. There is however one item of general interest to an Australian audience and that is the news that the RWA of their European peer banks is likely to increase by a material amount due to modelling changes.

It might not be obvious why that is so for readers located outside Australia. The reason lies in the requirement that our banks (or Authorised Deposit-Taking Institutions to use the Australian jargon) be capitalised to an “Unquestionably Strong” level.

There are various ways in which this benchmark is interpreted but one is the requirement that the Australian ADIs maintain a CET1 ratio that lies in the top quartile of international peer banks. A chart showing how Australian ADIs compare to this international peer group is a regular feature of the capital adequacy data disclosed by the ADIs and the changes being implemented by the ECB are likely (all other things being equal) to make the Australian ADIs look even better in relative terms in the future.

Tony – From the Outside

Australian bank capital adequacy – “a more flexible and resilient capital framework”

This post looks at a Discussion Paper published by APRA in late 2020 titled “A more flexible and resilient capital framework for ADIs” setting out how it proposes to wrap up a number of prior consultations on a variety of aspects of ADI (authorised deposit-taking institution) capital reform in Australia. The next step in the roll out of the revised framework is to conduct a quantitive impact study (QIS) with selected ADIs to ensure that the proposed final standards are appropriately calibrated.

Key elements of the revised framework (effective 1 January 2023) include:
  • More risk-sensitive risk weights (mostly for residential mortgages but also SME lending) that are expected to reduce average risk weights by approximately 10% for Internal Ratings Based (IRB) banks and 7% for banks operating under the Standardised Approach (SA) to capital adequacy,
  • Support for enhanced competition between the big and small ADIs via a series of initiatives intended to limit the differences between the IRB and SA, approaches (though APRA also offers evidence that the existing differences are not as great as some claim),
  • Improved transparency and comparability both with international peer banks and between the big IRB banks and the smaller SA banks
  • Improved flexibility in capital requirements via an increase in the size of regulatory capital buffers.
Improved risk sensitivity (lower risk weights)

Improved risk sensitivity is obviously a two edged sword (capital requirements could increase) but APRA estimates that the overall impact of the proposed revisions will be to reduce average risk weights for IRB ADIs by 10% and by 7% for Standardised ADIs. I have published a couple of posts already on the proposed changes to residential mortgage risk weights (see here and here) so I don’t intend to cover that in any detail in this post.

The main points to note regarding residential mortgages are:

  • Standardised ADIs get
  • IRB ADIs see
    • the higher than Basel “correlation adjustment” currently used to narrow the difference between IRB and SA risk weights replaced by a simple “scalar” adjustment,
    • the existing 20% LGD floor reduced to 10% for approved LGD models and
    • recognition of the risk reduction value of Lenders’ Mortgage Insurance (LMI) in line with the SA.

I have not looked closely at the changes impacting the other RWA exposures but list them here for completeness:

  • SME lending
    • Standardised ADIs – RW applied under the SA will recognise the value of commercial property security while RW for loans not secured by property will be reduced from 100% to 75% for loans less than $1.5m and 85% otherwise
    • IRB ADIs – the thresholds for applying the Retail SME approach and the Corporate SME approach will be increased
  • Other credit portfolios
    • Standardised ADIs see no real change (existing RW are already largely aligned with the Basel framework)
    • IRB ADIs will see the overall credit scalar in the IRB RW formula increased from 1.06x to 1.1x, risk estimates will be more closely aligned to those of overseas peers (but still higher than those peers) and models will be permitted for the calculation of capital requirements for commercial property exposures
  • New Zealand based exposures
    • RWA determined under RBNZ requirements will be used for group capital requirements
Enhanced competition, increased transparency and comparability

The main points to note here are:

  • The risk weight initiatives listed above should address a long standing complaint from the Standardised ADIs that the higher risk weights they are subject to place them at a competitive disadvantage relative to IRB ADIs
  • Note however that APRA has also provided evidence that the difference in capital requirements is not as large as is often claimed and can be justified by differences in the risk of the loan portfolios that different types of ADIs typically hold
  • The extent of any competitive disadvantage due to capital requirements will be further clarified by the requirement that IRB ADIs also publish capital ratios under the Standardised Approach
  • The extent of the differences between the capital requirements applied by APRA and those used to calculate the ratios reported by international peer banks will also be reduced thereby enhancing the transparency of the Australian ADI capital strength versus the international peer groups. This will make the “top quartile” test employed to determine the “unquestionably strong” benchmark simpler and more transparent.
Increased resilience via larger more flexible capital buffers

We noted above that RWA are expected to reduce by around 10 per cent on average for IRB banks and 7 per cent on average for standardised banks. All other things being equal this will translate into a very visible increase in reported capital ratios which requires a recalibration of the balance between minimum requirements and capital buffers:

  • The minimum Prudential Capital Requirement (PCR) remains unchanged in percentage terms (4.5%), as does the minimum threshold for Point of Non-Viability (PONV) conversion (5.125%), but these requirements fall in dollar terms due to the decline in average RWA
  • The Capital Conservation Buffer (CCB) – will be increased by 150 basis points (but only for IRB ADIs)
  • The default Countercyclical Capital Buffer (CCyB) – will be set at 100 basis points (versus zero under the current approach)

Minimum capital requirements

At face value, a reduction in minimum capital requirements sounds like a cause for concern. In theory you can argue that there is a slightly lower amount of CET1 capital available in a scenario in which a bank has breached the PONV threshold that triggers the conversion of Additional Tier 1 and any other layers of loss absorbing capital. In practice, however, this theoretical risk is more than offset by the increase in the CCB and the CCyB. APRA is at pains to emphasise that, all other things being equal, the dollar value of capital that ADI’s currently hold consistent with the Unquestionably Strong benchmarks introduced in 2017 does not change under the revised framework.

With amendments across a number of dimensions, reported capital ratios will inevitably change … However, APRA remains committed to its previous position that an ADI that currently meets the ‘unquestionably strong’ benchmarks under the current framework should have sufficient capital to meet any new requirements. Changing the presentation of capital ratios will not impact overall capital strength or the quantum of capital required to be considered ‘unquestionably strong’; but instead improves comparability, supervisory flexibility and international alignment.

“A more flexible and resilient capital framework for ADIs, APRA Discussion Paper, 8 December 2020 (page 5)

In addition to the increased base levels of CET1, the systemically important ADI are holding increasing amounts of “Additional Loss Absorbing Capital” that can be bailed-in to create CET1 capital in the event that a bank is at risk of breaching the PONV threshold. There are differences of opinion on whether APRA would be willing to pull the trigger to convert these instruments. We won’t know for sure until the time comes, but my colours are nailed to the assumption that APRA will much prefer to see shareholders get diluted rather than having to use government funds to bail-out a bank.

Capital Conservation Buffer

The 150bp expansion in the CCB only applies to IRB ADIs. APRA attributes this to the need to respond to “the greater level of risk sensitivity inherent in the IRB approach” (page 16 of the Discussion Paper). They don’t actually use the term but I think of this as a means of absorbing some of the pro-cyclicality that is inherent in any risk sensitive capital adequacy measure.

A simple way to think about this change is to link the 150bp increase to the roughly equivalent benefit of the 10% decline in RWA expected to flow from RWA changes set out in the paper. We note however that SA gets 7% decline due to improved risk sensitivity but no equivalent increase in CCB. So we get enhanced risk sensitivity in the IRB approach via the revised risk weights without exacerbating the concern about the difference in capital requirements.

However the increased risk sensitivity of the IRB approach also manifests in heightened sensitivity to an economic downturn. All other things being equal both Standardised and IRB ADIs should face similar increases in loan loss charges. The impact on IRB ADI capital ratios is however amplified by the increase in average RWs under stress. I don’t have any hard data to refer to but would not be surprised if the RWA inflation effect contributed another 150bp to the decline in capital ratios we see quoted in stress testing results under this new framework.

Viewed from this perspective the expanded CCB not only neutralises the benefit of lower IRB risk weights, it also helps absorb the increased sensitivity to declines in capital ratios that IRB ADIs can be expected to experience under a stress scenario.

Counter-cyclical Capital Buffer

The CCyB has, for me at least, always been a sound idea badly executed. It 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 Basel Committee 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 whatever that might be) 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 pro-actively responding to excess credit growth has been a core part of the rationale underpinning its development.

The idea of having a buffer that can be released in response to a downturn makes perfect sense but the analytical structure the Basel Committee developed to guide its deployment seems unnecessarily complex. The simple non-zero default level that APRA proposes to adopt is arguably a better (if not the best) approach and one that other countries are already pursuing (see here, here and here).

None of this pro-cyclicality benefit is spelled out in the material APRA released so I may be reading too much into the material. If I am analysing it correctly if is a subtle but still useful benefit of the package of changes that APRA is pursuing.

Conclusion

Broadly speaking, I think there is a lot to like in the revised framework that APRA is pursuing

  • Risk weights that are both more risk sensitive but also more closely aligned under the two approaches to capital adequacy measurement (IRB and Standardised)
  • An increased share of the capital requirement allocated to buffers that can be used rather than minimum requirements that can’t
  • A better approach to setting the CCyB

My primary concern is that the amplified pro-cyclicality in capital ratios that is seemingly inherent in any risk sensitive capital framework seems likely to increase but there is very little discussion of this factor . There are tools to manage the impact but one of the key lessons I have taken away from four decades in this game is that the markets hate surprises. Far better to quantify the extent of any amplified pro-cyclicality in capital ratios prior to the next crisis than to try to explain the impacts when capital ratios start to decline more quickly than expected during the next downturn/crisis.

Let me know what I am missing …

Tony – From the Outside

Some of the backstory

The idea that Australian banks needed to be “Unquestionably Strong” has dominated the local capital adequacy discussion for the past few years. The idea originated in a recommendation of the Australian Financial System Inquiry (2014) based on the rationale that Australian banks should both be and, equally importantly, be perceived to be more resilient than the international peers with which they compete for funding in the international capital markets.In July 2017, APRA translated the FSI recommendation into practical guidance in an announcement supported by a longer information paper.

For most people, this all condensed into a very simple message, the systemically important Australian banks needed to maintain a Common Equity Tier 1 ratio of at least 10.5%. The smaller banks have their own Unquestionably Strong benchmark but most of the public scrutiny seems to have focussed on the larger banks.

In the background, an equally important discussion has been playing out regarding the extent to which the Unquestionably Strong framework should take account of the “comparability” and “transparency” of that measure of strength and the ways in which “flexibility” and “resilience” could be added to the mix. This discussion kicked off in earnest with a March 2018 discussion paper (covered in more detail here) and has come to a conclusion with the December 2020 release of the APRA Discussion Paper explored in the post above.

The dark art of measuring residential mortgage risk

Residential mortgages are one of the seemingly more plain vanilla forms of bank lending. Notwithstanding, comparing capital requirements applied to this category of lending across different types of banks can be surprisingly complicated and is much misunderstood. I have touched on different aspects of this challenge in a number of mortgage risk weight “fact check” posts (see here and here), focussing for the most part on the comparison of “standardised” capital requirements compared to those applied to banks operating under the “internal rating based” (IRB) approach.

A discussion paper (“A more flexible and resilient capital framework for ADIs”, 8 December 2020) released by the Australian Prudential Regulation Authority (APRA) offers a good summary (see p27 “Box 2”) of the differences in capital requirements not captured by simplistic comparisons of risk weights. However, one of the surprises in the discussion paper was that APRA chose not to address one of these differences by aligning the credit conversion factors applied to off-balance sheet (non-revolving) residential mortgage exposures.

Understanding why APRA chose to maintain a different treatment of CCFs across the two approaches offers some insights into differences in the way that the two approaches recognise and measure the underlying risks.

Before proceeding we need to include a short primer on “off-balance exposures” and “CCFs”. Feel free to skip ahead if you already understand these concepts.

  • Off-balance sheet exposures are the difference between the maximum amount a bank has agreed to lend and the actual amount borrowed at any point in time.
  • The CCF is the bank’s estimate of how much of these undrawn limits will in fact have been called on (converted to an on balance sheet exposure) in the event a borrower defaults.
  • In the case of “non-revolving” residential mortgages, these off-balance sheet exposures typically arise because borrowers have got ahead of (“pre-paid”) their contractual loan repayments.

APRA noted that the credit conversion factor (CCF) currently applied to off-balance sheet exposures was much higher for IRB banks than for standardised, thereby partially offsetting the lower risk weights applied under the IRB approach. It had been expected that APRA would address this inconsistency by applying a 100% CCF under both approaches.

Contrary to this expectation, APRA has proposed to revise the CCFs applying to (non-revolving) off-balance sheet residential mortgage exposures as follows:

Current

Standardised 0-50%

IRB 100%

Proposed

40%

100% (unchanged)

The interesting nuance here is that APRA is not saying that standardised banks are likely to experience a lower percentage drawdown of credit limits in the event a borrower defaults. In the “Response to Submissions” that accompanied the Discussion Paper, APRA noted that “Borrowers do not typically enter default until they have fully drawn down on their available limit, including any prepayments ahead of their scheduled balance.”

However, APRA also noted that loans with material levels of prepayment are also likely to be lower risk based on the demonstrated greater capacity to service and repay the loan.

Under the IRB approach, the greater capacity to repay the loan is generally recognised through a lower PD estimate which the IRB formula translates into lower risk weights reflecting the lower risk. In the absence of some equivalent risk recognition mechanism in the standardised approach, APRA is proposing to use a concessional CCF treatment to reflect the lower risk of loans with material levels of prepayment. It notes that the concessional CCF treatment will also contribute to ensuring the difference in residential mortgage capital requirements between the standardised and IRB approaches remains appropriate.

Summing up:

  • Looked at in isolation, 100% is arguably the “right” value for the CCF to apply to off-balance sheet exposures for a non-revolving residential mortgage irrespective of whether it is being measured under the standardised or IRB approach
  • But a “concessional” CCF is a mechanism (fudge?) that allows the standardised approach to reflect the lower risk associated with loans with material levels of prepayment

Tony – From the Outside

Low Risk Residential Mortgage Risk Weights

I have posted a number of times on the question of residential mortgage risk weights, either on the general topic of the comparison of the risk weights applied to the standardised and IRB ADIs (see here) or the reasons why risk weights for IRB ADIs can be so low (see here).

On the question of relative risk weights, I have argued that the real difference between the standardised and IRB risk weights is overstated when framed in terms of simplistic comparisons of nominal risk weights that you typically read in the news media discussion of this question. I stand by that general assessment but have conceded that I have paid insufficient attention to the disparity in risk weights at the higher quality end of the mortgage risk spectrum.

A Discussion Paper released by APRA offers a useful discussion of this low risk weight question as part of a broader set of proposals intended to improve the transparency, flexibility and resilience of the Australian capital adequacy framework.

In section 4.2.1 of the paper, APRA notes the concern raised by standardised ADIs…

A specific concern raised by standardised ADIs in prior rounds of consultation has been the difference in capital requirements for lending at low LVRs. Stakeholders have noted that the lowest risk weight under the standardised approach would be 20 per cent under the proposed framework, but this appears to be significantly lower for the IRB approach. In response to this feedback, APRA has undertaken further analysis at a more detailed level, noting the difference in capital requirements that need to be taken into account when comparing capital outcomes under the standardised and IRB approaches (see Box 2 above).

But APRA’s assessment is that the difference is not material when you look beyond the simplistic comparison of risk weights and consider the overall difference in capital requirements

APRA does not consider that there is a material capital difference between the standardised and IRB approaches at the lower LVR level. For loans with an LVR less than 60 per cent, APRA has estimated that the pricing differential that could be reasonably attributed to differences in the capital requirements between the two approaches would be lower than the differential at the average portfolio outcome.

In explaining the reasons for this conclusion, APRA addresses some misconceptions about the IRB approach to low LVR lending compared to the standardised approach

In understanding the reasons for this outcome, it is important to understand the differences in how the standardised and IRB approaches operate. In particular, there are misconceptions around the capital requirement that would apply to low LVR lending under the IRB approach. For example, it would not be appropriate to solely equate the lowest risk weight reported by IRB ADIs in market disclosures with low LVR loans. The IRB approach considers a more complex range of variable interactions compared to the standardised approach. Under the standardised approach, a low risk weight is assigned to a loan with a low LVR at origination.

One of the key points APRA makes is that IRB ADIs do not get to originate loans at the ultra low risk weights that have been the focus of much of the concern raised by standardised ADIs.

In particular, IRB estimates are more dynamic through the life of the loan, for example, they are more responsive to a change in borrower circumstances or movements in the credit cycle. Standardised risk weights generally do not change over the life of a loan. For an IRB ADI, the lowest risk weight is generally applied to loans that have significantly prepaid ahead of schedule. A low LVR loan on the standardised approach is not necessarily assigned the lowest risk weight under the IRB approach at origination.

APRA states that it is not appropriate to introduce “dynamic”factors into the standardised risk weight framework.

APRA is not proposing to include dynamic factors in determining risk weights under the standardised approach for the following reasons:

– the standardised approach is intended to be simple and aligned with Basel III. For the standardised approach, APRA considers it more appropriate to focus on origination rather than behavioural variables as this has more influence on the quality of the portfolio and leads to less procyclical capital requirements; and

– the average difference between standardised and IRB capital outcomes is much narrower at the point of origination, which is the key point for competition. While the difference between standardised and IRB capital outcomes could widen over the life of the loan, APRA has ensured that the difference in average portfolio outcomes remains appropriate

But that it does intend to introduce a 5 per cent risk weight floor into the IRB approach to act as a backstop.

That said, APRA is proposing to implement a 5 per cent risk-weight floor for residential mortgage exposures under the IRB approach, to act as a simple backstop in ensuring capital outcomes do not widen at the lower risk segment of the portfolio. This is consistent with the approach taken by other jurisdictions and will limit the difference in capital outcomes between the standardised and IRB approaches for lower risk exposures. This risk-weight floor is in addition to other factors that will reduce the difference in capital outcomes between standardised and IRB ADIs, such as the higher CCB for IRB ADIs and lower CCF estimates for standardised ADIs.

As always, it remains possible that I am missing something. The explanation offered by APRA however gives me confidence that my broad argument about the overstatement of the difference has been broadly correct. Equally importantly, the changes to residential mortgage risk weights proposed in the Discussion Paper will further reduce the gap that does exist.

Tony – From the Outside

Financing the Danish home

There is a surprising (to me at least) variety of ways that countries address the common problem of financing the purchase of residential property. To date, I have mostly approached the question from the perspective of trying to understand differences in mortgage risk weights across different banks in Australia (see here). The topic also has implications for cross border comparisons of capital adequacy ratios (see here and here).

Marc Rubinstein wrote a great piece looking at the mysteries of the the 30-year fixed-rate fully prepayable mortgage that finances the majority of home purchases in America. Marc noted in passing that Denmark is the only other country that offers a comparable form of mortgage financing. That is broadly true but I think the Danish mortgage financing system has some distinct and intriguing features of its own. A paper published by the New York Fed in 2018 comparing the US and Danish mortgage systems has been especially useful in gaining some deeper insights into the different ways that countries solve the residential property finance challenge.

This extract from the New York Fed paper gives you a flavour of the history and main features of the Danish system

In Denmark, mortgage lending has long been dominated by specialized mortgage banks. Denmark’s first mortgage bank was established in 1797, and Nykredit, the country’s largest mortgage bank today, traces its origins to 1851 (Møller and Nielsen 1997). Originally, these firms were set up as mutual mortgage credit associations with a local focus. But several waves of mergers—some encouraged or even prescribed by their then-regulator—led to the formation of the handful of large mortgage banks that today dominate mortgage lending in Denmark.


Because the original mortgage credit associations were founded by borrowers, lending terms were to a large extent designed to reflect borrowers’ objectives and interests. At the same time, the associations needed to build trust among the investors in covered bonds, and this led to a business model aimed at balancing borrower and investor interests (Møller and Nielsen 1997).

Key aspects of this business model included:

# Mortgage lenders could not call for early redemption of a loan unless the borrower became delinquent.

# Investors could not call the covered bonds.

# Homeowners had a right to prepay the mortgage loan at par on any payment day without penalty.

# Homeowners were personally liable for the mortgage debt.

# Homeowners were jointly and severally liable for the covered bonds issued by the mortgage credit association.

# Mortgage margins could be increased for the entire stock of mortgage loans—for example, if needed in order to increase capitalization or cover loan losses.

# Strict lending guidelines were instituted that were regulated by law (maximum LTV ratio, maximum maturity, and so forth).

With the exception of joint and several liability, these principles still apply to mortgage banks today.

Berg J, Baekmand Nielsen M, and Vickery J, “Peas in a Pod? Comparing the U.S. and Danish Mortgage Financing Systems”, Federal Reserve Bank of New York Economic Policy Review 24, no. 3, December 2018

The paper summarises the comparison between the two systems as follows

The U.S. and Danish mortgage finance models both rely heavily on capital markets to fund residential mortgages, transferring interest rate and prepayment risk, but not credit risk, to investors. But in Denmark, homeowners can buy back their mortgages or transfer them in a property sale, avoiding the “lock-in” effects present in the U.S. system, and easier refinancing reduces defaults and speeds the transmission of lower interest rates in a downturn. Denmark’s tighter underwriting standards and strong creditor protections help limit credit losses, while its higher capital requirements make lenders more stable.

Worth reading.

Tony – From the Outside

Capital adequacy reform – what we have learned from the crisis

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tony – From the Outside

The case for low mortgage risk weights

I have touched on residential mortgage risk weights a couple of times in this blog, most recently in a post on the Dutch proposal to increase residential mortgage RW. This post explores the question of why residential mortgage RW under the Internal Rating Based (IRB) approach can be so low. More importantly, can we trust these very low risk weights (and the banks generating them) or is this yet more evidence that the IRB approach is an unreliable foundation for measuring bank capital requirements? It also touches on some of the issues we encounter in cross border comparisons of capital strength.

It has to be said at this point that IRB modelling is not an area where I claim deep expertise and I would welcome comments and input from people who do have this subject matter expertise. However, it is an important issue given the role that residential mortgage lending plays both in the economy as a whole. If nothing else, the post will at least help me get my thoughts on these questions into some kind of order and potentially invite comments that set me straight if I have got anything wrong. Notwithstanding the importance of the issue, this post is pretty technical so likely only of interest if you want to dig into the detailed mechanics of the IRB approach.

Recapping on the Dutch proposal to increase mortgage risk weights

First a recap on what the Dutch bank supervisor proposes to do. Residential mortgage RW in the Netherlands are amongst the lowest observed in Europe

DNB:Financial Stability Report Autumn 2019


The Dutch banks can of course cite reasons why this is justified but, in order to improve the resilience of the banking system, the Dutch banking supervisor proposes to introduce a floor set at 12% on how low the RW can be. The 12% floor applies to loans with a dynamic Loan to Value (LTV) of 55% or lower. The RW floor increases progressively as the LTV increases reaching a maximum of 45% for loans with a LTV of 100% or more. DNB expects the application of the measure to increase the average risk weights of Dutch IRB banks by 3-4 percentage points (from 11% to 14%-15%).

What drives the low end of the IRB Mortgage RW?

None of the discussion set out below is in any way intended to challenge bank supervisors seeking to apply limits to the low mortgage risk weights we observe being generated by the internal models developed by IRB banks. That is a whole separate discussion but the move to higher RW on these exposures broadly makes sense to me, not only for reasons of systemic resilience, but also with regard to the way that it reduces the disparity between IRB RW and those the standardised banks are required to operate against. It is however useful to understand what is driving the model outcomes before citing them as evidence of banks gaming the system.

This extract from Westpac’s September 2019 Pillar 3 Report shows a weighted average RW of 24% with individual segments ranging from 6% to 137%. The CBA Pillar 3 shows a similar pattern (RW range from 4.4% to 173.5%). I won’t get too much into the technical detail here but the effective IRB RW is higher when you factor in Regulatory Expected Loss. The impact on the RW in the table below is roughly 16% on average (I divide REL by .08 to translate it to an RWA equivalent and then divide by RWA) but this effect only becomes material for the 26% and higher RW bands).

Source: Westpac Pillar 3 Report – Sep 2019

I am very happy to stand corrected on the facts but my understanding is that the 6% and 14% RW bands in the table above capture “seasoned” portions of the loan portfolio where the Loan to Valuation (LVR) ratio has declined substantially from the circa 80% plus typically observed in newly originated loans. The declining LVR is of course a natural outcome for Principal and Interest loans which is the kind traditional prudent banking prefers.

What at face value looks like an incredibly thin capital requirement starts to make more sense when you consider the fact that the borrowers in these segments have demonstrated their capacity to service their loans and, perhaps more importantly, have built up a substantial pool of their own equity in the property that will absorb very substantial declines in property prices before the bank is likely to face a loss.

Australian owner occupied borrowers have an incentive to repay as fast as possible because their interest is not tax deductible (making the mortgage repayment one of the best applications of surplus cash) and they typically borrow on a floating rate basis. The natural amortisation of loan principal is also likely to have been accelerated by the progressive decline in interest rates in recent years which has seen a large share of borrowers apply the interest saving to higher principal repayments.

Comparing Dutch and Australian Mortgage Risk Weights

Looking at the Dutch RW provides some perspective on the mortgage RW of the Australian IRB banks and the initiatives APRA has implemented to increase them. I will only scratch the surface of this topic but it is interesting none the less to compare the 14-15% average RW the Dutch IRB banks will be required to hold with the 25% average RW that Australian IRB banks must hold.

The Dutch banks cite a favourable legal system that supports low LGD by allowing them to quickly realise their security on defaulted loans. That is a sound argument when you are comparing to a jurisdiction where it can take up to 3 years for a bank to gain access to the security underpinning a defaulted loan. That said, the Australian banks can make a similar argument so that does not look like a definitive factor in favour of lower Dutch RW.

The Australian LTV is based on the amortised value of the loan compared to the value of the property at the time the loan was originated. The Dutch LTV as I understand it seem to includes the updated value of the property as the loan ages. Again I don’t see anything in the Dutch system that renders their residential mortgage lending fundamentally less risky than the Australian residential mortgage.

The other positive factor cited by the Dutch banks is the tax deductibility of mortgage interest which applies even where the property is owner occupied. In Australia, interest on loans for owner occupied property is not tax deductible. The Dutch banks argue that the tax deduction on interest enhances the capacity of the borrower to service a loan but my guess is that this advantage is highly likely to be translated into higher borrowing capacity and hence higher property prices so it is not clear that there is a net improvement in the capacity to repay the loan.

I obviously only have a very rudimentary understanding of Dutch tax rules but my understanding is that tax deductibility of interest expense in some European jurisdictions is quid pro quo for including the implied value of rental on the property in the owner’s taxable income. If that is the case then it looks like tax deductibility of interest is a zero sum game from the lending bank perspective. Qualified by the caveats above, I will provisionally take the side of the Australian mortgage in this comparison. It seems equally likely to me that the the absence of a tax deduction creates an incentive for Australian borrowers to repay their loan as quickly as possible and hence for a greater proportion of loans outstanding to move into the low LVR bands that insulate the bank from the risk of loss. There does not seem to be the same incentive in the Dutch system, especially where the loans are fixed rate.

Summing up

The purpose of this post was mostly to help me think through the questions posed in the introduction. If you are still reading at this point then I fear you (like I) take bank capital questions way too seriously.

There are two main points I have attempted to explore and stake out a position on:

  • What at face value looks like an incredibly thin capital requirement for some parts of the residential mortgage portfolio start to make more sense when you consider the fact that the borrowers in these segments have demonstrated their capacity to service their loans and have built up a substantial pool of their own equity in the property that will absorb very substantial declines in property prices before the bank is likely to face a loss.
  • Cross border comparisons of capital are complicated but mortgages are a big part of the Australian bank risk profile and I still feel like they stack up relatively well in comparison to other jurisdictions that cite structural reasons why theirs are low risk.

If you have some evidence that contradicts what I have outlined above then by all means please let me know what I am missing.

Tony

Mortgage Risk Weights – revisited

I post on a range of topics in banking but residential mortgage risk weights is one that seems to generate the most attention. I first posted on the topic back in Sep 2018 and have revisited the topic a few times (Dec 2018, June 2019#1, June 2019#2, and Nov 2019) .

The posts have tended to generate a reasonable number of views but limited direct engagement with the arguments I have advanced. Persistence pays off however because the last post did get some specific and very useful feedback on the points I had raised to argue that the difference in capital requirements between IRB and Standardised Banks was not as big as it was claimed to be.

My posts were a response to the discussion of this topic I observed in the financial press which just focussed on the nominal difference in the risk weights (i.e. 25% versus 39%) without any of the qualifications. I identified 5 problems with the simplistic comparison cited in the popular press and by some regulators:

  • Problem 1 – Capital adequacy ratios differ
  • Problem 2 – You have to include capital deductions
  • Problem 3 – The standardised risk weights for residential mortgages seems set to change
  • Problem 4 – The risk of a mortgage depends on the portfolio not the individual loan
  • Problem 5 – You have to include the capital required for Interest Rate Risk in the Banking Book

With the benefit of hindsight and the feedback I have received, I would concede that I have probably paid insufficient attention to the disparity between risk weights (RW) at the higher quality end of the mortgage risk spectrum. IRB banks can be seen to writing a substantial share of their loan book at very low RWs (circa 6%) whereas the best case scenario for standardised banks is a 20% RW. The IRB banks are constrained by the requirement that their average RW should be at least 25% and I thought that this RW Floor was sufficient to just focus on the comparison of average RW. I also thought that the revisions to the standardised approach that introduced the 20% RW might make more of a difference. Now I am not so sure. I need to do a bit more work to resolve the question so for the moment I just want to go on record with this being an issue that needs more thought than I have given it to date.

Regarding the other 4 issues that I identified in my first post, I stand by them for the most part. That does not mean I am right of course but I will briefly recap on my arguments, some of the push back that I have received and areas where we may have to just agree to disagree.

Target capital adequacy ratios differ materially. The big IRB banks are targeting CET1 ratios based on the 10.5% Unquestionably Strong Benchmark and will typically have a bit of a buffer over that threshold. Smaller banks like Bendigo and Suncorp appear to operate with much lower CET1 targets (8.5 to 9.0%). This does not completely offset the nominal RW difference (25 versus 39%) but it is material (circa 20% difference) in my opinion so it seem fair to me that the discussion include this fact. I have to say that not all of my correspondents accepted this argument so it seems that we will have to agree to disagree.

You have to include capital deductions. In particular, the IRB banks are required to hold CET1 capital for the shortfall between their loan loss provision and a regulatory capital value called “Regulatory Expected Loss”. There did not appear to be a great awareness of this requirement and a tendency to dismiss it but my understanding is that it can increase the effective capital requirement by 10-12% which corresponds to an effective IRB RW closer to 28% than 25%.

The risk of a mortgage depends on the overall portfolio not the individual loan. My point here has been that small banks will typically be less diversified than big banks and so that justifies a difference in the capital requirements. I have come to recognise that the difference in portfolio risk may be accentuated to the extent that capital requirements applied to standardised banks impede their ability to capture a fair share of the higher quality end of the residential mortgage book. So I think my core point stands but there is more work to do here to fully understand this aspect of the residential mortgage capital requirements. In particular, I would love get more insight into how APRA thought about this issue when it was calibrating the IRB and standardised capital requirements. If they have spelled out their position somewhere, I have not been able to locate it.

You have to include the capital required for Interest Rate Risk in the Banking Book (IRRBB). I did not attempt to quantify how significant this was but simply argued that it was a requirement that IRB banks faced that standardised banks did not and hence it did reduce the benefit of lower RW. The push back I received was that the IRRBB capital requirement was solely a function of IRB banks “punting” their capital and hence completely unrelated to their residential mortgage loans. I doubt that I will resolve this question here and I do concede that the way in which banks choose to invest their capital has an impact on the size of the IRRBB capital requirement. That said, a bank has to hold capital to underwrite the risk in its residential mortgage book and, all other thinks being equal, an IRB bank has to hold more capital for the IRRBB requirement flowing from the capital that it invests on behalf of the residential mortgage book. So it still seems intuitively reasonable to me to make the connection. Other people clearly disagree so we may have to agree to disagree on this aspect.

Summing up, I had never intended to say that there was no difference in capital requirements. My point was simply that the difference is not as big as is claimed and I was yet to see any analysis that considered all of the issues relevant to properly understand what the net difference in capital requirements is. The issue of how to achieve a more level playing field between IRB and Standardised Banks is of course about much more than differences in capital requirements but it is an important question and one that should be based on a firmer set of facts that a simplistic comparison of the 39% standardised versus 25% IRB RW that is regularly thrown around in the discussion of this question.

I hope I have given a fair representation here of the counter arguments people have raised against my original thesis but apologies in advance if I have not. My understanding of the issues has definitely been improved by the challenges posted on the blog so thanks to everyone who took the time to engage.

Tony

Mortgage risk weights fact check revisited – again

The somewhat arcane topic of mortgage risk weights is back in the news. It gets popular attention to the extent they impact the ability of small banks subject to standardised risk weights to compete with bigger banks which are endorsed to use the more risk sensitive version based on the Internal Ratings Based (IRB) approach. APRA released a Discussion Paper (DP) in February 2018 titled “Revisions to the capital framework for authorised deposit-taking institutions”. There are reports that APRA is close to finalising these revisions and that this will address the competitive disadvantage that small banks suffer under the current regulation.

This sounds like a pretty simple good news story – a victory for borrowers and the smaller banks – and my response to the discussion paper when it was released was that there was a lot to like in what APRA proposed to do. I suspect however that it is a bit more complicated than the story you read in the press.

The difference in capital requirements is overstated

Let’s start with the claimed extent of the competitive disadvantage under current rules. The ACCC’s Final Report on its “Residential Mortgage Price Inquiry” described the challenge with APRA’s current regulatory capital requirements as follows:

“For otherwise identical ADIs, the advantage of a 25% average risk weight (APRA’s minimum for IRB banks) compared to the 39% average risk weight of standardised ADIs is a reduction of approximately 0.14 percentage points in the cost of funding the loan portfolio. This difference translates into an annual funding cost advantage of almost $750 on a residential mortgage of $500 000, or about $15 000 over the 30 year life of a residential mortgage (assuming an average interest rate of 7% over that period).”

You could be forgiven for concluding that this differential (small banks apparently required to hold 56% more capital for the same risk) is outrageous and unfair.

Just comparing risk weights is less than half the story

I am very much in favour of a level playing field and, as stated above, I am mostly in favour of the changes to mortgage risk weights APRA outlined in its discussion paper but I also like fact based debates.

While the risk weights for big banks are certainly lower on average than those required of small banks, the difference in capital requirements is not as large as the comparison of risk weights suggests. To understand why the simple comparison of risk weights is misleading, it will be helpful to start with a quick primer on bank capital requirements.

The topic can be hugely complex but, reduced to its essence, there are three elements that drive the amount of capital a bank holds:

  1. The risk weights applied to its assets
  2. The target capital ratio applied to those risk weighted assets
  3. Any capital deductions required when calculating the capital ratio

I have looked at this question a couple of times (most recently here) and identified a number of problems with the story that the higher risk weights applied to residential mortgages originated by small bank places them at a severe competitive disadvantage:

Target capital ratios – The target capital adequacy ratios applied to their higher standardised risk weighted assets are in some cases lower than the IRB banks and higher in others (i.e. risk weights alone do not determine how much capital a bank is required to hold).

Portfolio risk – The risk of a mortgage depends on the portfolio not the individual loan. The statement that a loan is the same risk irrespective of whether it is written by a big bank or small bank sounds intuitively logical but is not correct. The risk of a loan can only be understood when it is considered as part of the portfolio the bank holds. All other things being equal, small banks will typically be less diversified and hence riskier than a big bank.

Capital deductions – You also have to include capital deductions and the big banks are required to hold capital for a capital deduction linked to the difference between their loan loss provisions and a regulatory capital value called “Regulatory Expected Loss”. The exact amount varies from bank to bank but I believe it increases the effective capital requirement by 10-12% (i.e. an effective RW closer to 28% for the IRB banks).

IRRBB capital requirement – IRB banks must hold capital for Interest Rate Risk in the Banking Book (IRRBB) while the small standardised banks do not face an explicit requirement for this risk. I don’t have sufficient data to assess how significant this is, but intuitively I would expect that the capital that the major banks are required to hold for IRRBB will further narrow the effective difference between the risk weights applied to residential mortgages.

How much does reducing the risk weight differential impact competition in the residential mortgage market?

None of the above is meant to suggest that the small banks operating under the standardised approach don’t have a case for getting a lower risk weight for their higher quality lower risk loans. If the news reports are right then it seems that this is being addressed and that the gap will be narrower. However, it is important to remember that:

  • The capital requirement that the IRB banks are required to maintain is materially higher than a simplistic application of the 25% average risk weight (i.e. the IRB bank advantage is not as large as it is claimed to be).
  • The standardised risk weight does not seem to be the binding constraint so reducing it may not help the small banks much if the market looks through the change in regulatory risk measurement and concludes that nothing has changed in substance.

One way to change the portfolio quality status quo is for small banks to increase their share of low LVR loans with a 20% RW. Residential mortgages do not, for the most part, get originated at LVR of sub 50% but there is an opportunity for small banks to try to refinance seasoned loans where the dynamic LVR has declined. This brings us to the argument that IRB banks are taking the “cream” of the high quality low risk lending opportunities.

The “cream skimming” argument

A report commissioned by COBA argued that:

“While average risk weights for the major banks initially rose following the imposition of average risk weight on IRB banks by APRA, two of the major banks have since dramatically reduced their risk weights on residential mortgages with the lowest risk of default. The average risk weights on such loans is now currently on average less than 6 per cent across the major banks.”

“Despite the imposition of an average risk weight on residential home loans, it appears some of the major banks have decided to engage in cream skimming by targeting home loans with the lowest risk of default. Cream skimming occurs when the competitive pressure focuses on the high-demand customers (the cream) and not on low- demand ones (the skimmed milk) (Laffont & Tirole, 1990, p. 1042). Cream skimming has adverse consequences as it skews the level of risk in house lending away from the major banks and towards other ADIs who have to deal with an adversely selected and far riskier group of home loan applicants.”

“Reconciling Prudential Regulation with Competition” prepared by Pegasus Economics May 2019 (page 43)

It is entirely possible that I am missing something here but, from a pure capital requirement perspective, it is not clear that IRB banks have a material advantage in writing these low risk loans relative to the small bank competition. The overall IRB portfolio must still meet the 25% risk weight floor so any loans with 6% risk weights must be offset by risk weights (and hence riskier loans) that are materially higher than the 25% average requirement. I suspect that the focus on higher quality low risk borrowers by the IRB banks was more a response to the constraints on capacity to lend than something that was driven by the low risk weights themselves.

Under the proposed revised requirements, small banks in fact will probably have the advantage in writing sub 50% LVR loans given that they can do this at a 20% risk weight without the 25% floor on their average risk weights and without the additional capital requirements the IRB banks face.

I recognise there are not many loans originated at this LVR band but there is an opportunity in refinancing seasoned loans where the combined impact of principal reduction and increased property value reduces the LVR. In practice the capacity of small banks to do this profitably will be constrained by their relative expense and funding cost disadvantage. That looks to me to be a bigger issue impacting the ability of small banks to compete but that lies outside the domain of regulatory capital requirements.

Maybe this potential arbitrage does not matter in practice but APRA could quite reasonably impose a similar minimum average RW on Standardised Banks if the level playing field argument works both ways. This should be at least 25% but arguably higher once you factor in the fact that the small banks do not face the other capital requirements that IRB banks do. Even if APRA did not do this, I would expect the market to start looking more closely at the target CET1 for any small bank that accumulated a material share of these lower risk weight loans.

Implications

Nothing in this post is meant to suggest that increasing the risk sensitivity of the standardised risk weights is a bad idea. It seems doubtful however that this change alone will see small banks aggressively under cutting large bank competition. It is possible that small bank shareholders may benefit from improved returns on equity but even that depends on the extent to which the wholesale markets do not simply look through the change and require smaller banks to maintain the status quo capital commitment to residential mortgage lending.

What am I missing …

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