Adam Tooze wants everyone to read “The Currency of Politics” by Stefan Eich

I have only just started reading the book myself but the outline that Adam Tooze offers suggests to me that it has a lot to say on an important topic.

At this stage I will have to quote the author for a sense of what this book is about ..

The Currency of Politics is about the layers of past monetary crises that continue to shape our idea of what money is and what it can do politically. Grappling with past crises helped previous theorists to escape the blindspots of their own time. We must do the same today.

This seems like a pretty worthwhile endeavour to me so I thought it was worth sharing for anyone else engaged in trying to make sense of the role that money (and banking) does and should play in our society.

Tony – From the Outside

Bank capital buffers – room for improvement

I recently flagged a speech by Sam Woods (a senior official at the UK Prudential Regulation Authority) which floated some interesting ideas for what he describes as a “radically simpler, radically usable” version of the multi-layered capital buffers currently specified by the BCBS capital accord. At the time I was relying on a short summary of the speech published in the Bank Policy Institute’s “Insights” newsletter. Having now had a chance to read the speech in full I would say that there is a lot to like in what he proposes but also some ideas that I am not so sure about.

Mr Woods starts in the right place with the acknowledgment that “… the capital regime is fiendishly complex”. Complexity is rarely (if ever?) desirable so the obvious question is to identify the elements which can be removed or simplified without compromising the capacity to achieve the underlying economic objectives of the regime.

While the capital regime is fiendishly complex, its underlying economic goals are fairly simple: ensure that the banking sector has enough capital to absorb losses, preserve financial stability and support the economy through stresses.

… my guiding principle has been: any element of the framework that isn’t actually necessary to achieve those underlying goals should be removed. …

With that mind, my simple framework revolves around a single, releasable buffer of common equity, sitting above a low minimum requirement. This would be radically different from the current regime: no Pillar 2 buffers; no CCoBs, CCyBs, O-SII buffer and G-SiB buffers; no more AT1.

In practice, Mr Woods translates this simple design principle into 7 elements:

1. A single capital buffer, calibrated to reflect both microprudential and macroprudential risks.

2. A low minimum capital requirement, to maximise the size of the buffer.

3. A ‘ladder of intervention’ based on judgement for firms who enter their buffer – no mechanical triggers and thresholds.

4. The entire buffer potentially releasable in a stress.

5. All requirements met with common equity.

6. A mix of risk-weighted and leverage-based requirements.

7. Stress testing at the centre of how we set capital levels.

The design elements that appeal to me:
  • The emphasis on the higher capital requirements of Basel III being implemented via buffers rather than via higher minimum ratio thresholds
  • The concept of a “ladder of intervention” with more room for judgment and less reliance on mechanical triggers
  • The role of stress testing in calibrating both the capital buffer but also the risk appetite of the firm
I am not so sure about:
  • relying solely on common equity and “no more AT1” (Additional Tier 1)
  • the extent to which all of the components of the existing buffer framework are wrapped into one buffer and that “entire buffer” is potentially usable in a stress

No more Additional Tier 1?

There is little debate that common equity should be the foundation of any capital requirement. As Mr Woods puts it

Common equity is the quintessential loss-absorbing instrument and is easy to understand.

The problem with Additional Tier 1, he argues, is that these instruments …

… introduce complexity, uncertainty and additional “trigger points” in a stress and so have no place in our stripped-down concept …

I am a huge fan of simplifying things but I think it would be a retrograde step to remove Additional Tier 1 and other “bail-in” style instruments from the capital adequacy framework. This is partly because the “skin in the game” argument for common equity is not as strong or universal as its proponents seem to believe.

The “skin in the game” argument is on solid foundations where an organisation has too little capital and shareholders confronted with a material risk of failure, but limited downside (because they have only a small amount of capital invested), have an incentive to take large risks with uncertain payoffs. That is clearly undesirable but it is not a fair description of the risk reward payoff confronting bank shareholders who have already committed substantial increased common equity in response to the new benchmarks of what it takes to be deemed a strong bank.

I am not sure that any amount of capital will change the kinds of human behaviour that see banks mistakenly take on outsize, failure inducing, risk exposures because they think that they have found some unique new insight into risk or have simply forgotten the lessons of the past. The value add of Additional Tier 1 and similar “bail-in” instruments is that they enable the bank to be recapitalised with a material injection of common equity while imposing a material cost (via dilution) on the shareholders that allowed the failure of risk management to metastasise. The application of this ex post cost as the price of failure is I think likely to be a far more powerful force of market discipline than applying the same amount of capital before the fact to banks both good and bad.

In addition to the potential role AT1 play when banks get into trouble, AT1 investors also have a much greater incentive to monitor (and constrain) excessive risk taking than the common equity holders do because they don’t get any upside from this kind of business activity. AT1 investors obviously do not get the kinds of voting rights that common shareholders do but they do have the power to refuse to provide the funds that banks need to meet their bail-in capital requirements. This veto power is I think vastly underappreciated in the current design of the capital framework.

Keep AT1 but make it simpler

Any efforts at simplification could be more usefully directed to the AT1 instruments themselves. I suspect that some of the complexity can be attributed to efforts to make the instruments look and act like common equity. Far better I think to clearly define their role as one of providing “bail-in” capital to be used only in rare circumstances and for material amounts and define their terms and conditions to meet that simple objective.

There seems, for example, to be an inordinate amount of prudential concern applied to the need to ensure that distributions on these instruments are subject to the same restrictions as common equity when the reality is that the amounts have a relatively immaterial impact on the capital of the bank and that the real value of the instruments lie in the capacity to convert their principal into common equity. For anyone unfamiliar with the way that these instruments facilitate and assign loss absorption under bail-in I had a go at a deeper dive on the topic here.

One buffer to rule them all

I am not an expert on the Bank of England’s application of the Basel capital accord but I for one have always found their Pillar 2B methodology a bit confusing (and I like to think that I do mostly understand capital adequacy). The problem for me is that Pillar 2B seems to be trying to answer much the same question as a well constructed stress testing model applied to calibration of the capital buffer. So eliminating the Pillar 2B element seems like a step towards a simpler, more transparent approach with less potential for duplication and confusion.

I am less convinced that a “single capital buffer” is a good idea but this is not a vote for the status quo. The basic structure of a …

  • base Capital Conservation Buffer (CCB),
  • augmented where necessary to provide an added level of safety for systemically important institutions (either global or domestic), and
  • capped with a variable component designed to absorb the “normal” or “expected” rise and fall of losses associated with the business cycle

seems sound and intuitive to me.

What I would change is the way that the Countercyclical Capital Conservation Buffer (CCyB) is calibrated. This part of the prudential capital buffer framework has been used too little to date and has tended to be applied in an overly mechanistic fashion. This is where I would embrace Mr Woods’ proposal that stress testing become much more central to the calibration of the CCyB and more explicitly tied to the risk appetite of the entity conducting the process.

I wrote a long post back in 2019 where I set out my thoughts on why every bank needs a cyclical capital buffer. I argued then that using stress testing to calibrate the cyclical component of the target capital structure offered an intuitive way of translating the risk appetite reflected in all the various risk limits into a capital adequacy counterpart. Perhaps more importantly,

  • it offered a way to more clearly define the point where the losses being experienced by the bank transition from expected to unexpected,
  • focussed risk modelling on the parts of the loss distribution that more squarely lay within their “zone of validity”, and
  • potentially allowed the Capital Conservation Buffer (CCB) to more explicitly deal with “unexpected losses” that threatened the viability of the bank.

I have also seen a suggestion by Douglas Elliott (Oliver Wyman) that a portion of the existing CCB be transferred into a larger CCyB which I think is worth considering if we ever get the chance to revisit the way the overall prudential buffers are designed. This makes more sense to me than fiddling with the minimum capital requirement.

As part of this process I would also be inclined to revisit the design of the Capital Conservation Ratio (CCR) applied as CET1 capital falls below specified quartiles of the Capital Conservation Buffer. This is another element of the Basel Capital Accord that is well intentioned (banks should respond to declining capital by retaining an increasing share of their profits) that in practice tends to be much more complicated in practice than it needs to be.

Sadly, explaining exactly why the CCR is problematic as currently implemented would double the word count of this post (and probably still be unintelligible to anyone who has not had to translate the rules into a spreadsheet) so I will leave that question alone for today.

Summing up

Mr Woods has done us all a service by raising the question of whether the capital buffer framework delivered by the Basel Capital Accord could be simplified while improving its capacity to achieve its primary prudential and economic objectives. I don’t agree with all of the elements of the alternative he puts up for discussion but that is not really the point. The important point is to realise that the capital buffer framework we have today is not as useful as it could be and that really matters for helping ensure (as best we can) that we do not find ourselves back in a situation where government finds that bailing out the banks is its least worst option.

I have offered my thoughts on things we could do better but the ball really sits with the Basel Committee to reopen the discussion on this area of the capital adequacy framework. That will not happen until a broader understanding of the problems discussed above emerges so all credit to Mr Woods for attempting to restart that discussion.

As always let me know what I am missing …

Tony – From the Outside

Australian bank capital adequacy – Roadmap to 2023

I have posted a couple of times on the revisions of the Australian bank capital adequacy framework that APRA initiated in December 2020 – most recently here where I laid out some problems I was having in understanding exactly what it will mean for an Australian ADI to be “Unquestionably Strong once the revised framework is operational. A letter to ADIs posted on APRA’s website today (2 June 2021) does not provide any answers to the questions I posed but it does give a “roadmap” outlining the steps to be undertaken to calibrate and implement the revised framework.

APRA has included a detailed indicative timeline in an attachment to the letter covering key policy releases, reporting requirements, industry workshops and the process for capital model approvals associated with the revised framework

Next steps

To provide a clear roadmap for consultation and industry engagement, APRA has set out an indicative timeline in Attachment A. The timeline covers key policy releases, reporting requirements, industry workshops and the process for capital model approvals. Over the course of 2021, APRA intends to:

• Conduct a targeted data study, to assess potential changes to the calibration of the prudential standards;

• Initiate regular workshops with industry as the standards and guidance are finalised, to provide a forum for updates and FAQs; and

• Release final prudential standards, draft prudential practice guides (PPGs) and initial details of reporting requirements by the end of the year.

Over the course of 2022, APRA intends to finalise the PPGs and reporting requirements. There are a number of related policy revisions that will also be progressed next year, including the fundamental review of the trading book and public disclosure requirements. APRA intends to conduct a parallel run of capital reporting on the new framework in late 2022.

APRA Letter to ADIs “ADI Capital Reforms: Roadmap to 2023”, 2 June 2021

Two key dates are

  • July 2021 – “Targeted Quantitative Impact Study” (due for completion August 2021)
  • November 2021 – Release of final Prudential Standards

It is not clear what, if any, information APRA will be releasing publicly between now and November 2021 when the Prudential Standards are published. I am hopeful however that the November release will be accompanied by some form of Information Paper setting out what APRA learned from the QIS and the industry workshops that it will be conducting along the way.

Exciting times for a bank capital tragic

Tony – From the Outside

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 – building out the Unquestionably Strong framework

In this post, I lay out some problems that I have encountered in attempting to reconcile what it will mean for a D-SIB ADI to be “Unquestionably Strong” under the proposed new framework that APRA outlined in its December 2020 Discussion Paper (“A more flexible and resilient capital framework for ADIs”). Spoiler alert – I think the capital buffers adding up to a 10.5% CET1 prudential requirement may need to be recalibrated once all of the proposed changes to risk weights are tied down. I also include some questions regarding the impact of the RBNZ’s requirement for substantially higher capital requirements for NZ domiciled banks.

The backstory

The idea that Australian Authorised Deposit Taking Institutions (“ADIs” but more commonly referred to as “banks”) needed to be “Unquestionably Strong” originated in a recommendation of the Australian Financial System Inquiry (2014) based on the rationale that Australian ADIs should both be and, equally importantly, be perceived to be more resilient than the international peers with which they compete for funding in the international capital markets.In July 2017, APRA translated the FSI recommendation into practical guidance in an announcementsupported by a longer information paper.

For most people, this all condensed into a very simple message, the systemically important Australian ADIs needed to maintain a Common Equity Tier 1 (CET1) ratio of at least 10.5%. The smaller ADIs have their own Unquestionably Strong benchmark but most of the public scrutiny seems to have focussed on the larger systemically important ADIs.

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

December 2020 – “Unquestionably Strong” meets “A more flexible and resilient capital framework for ADIs”

I have written a couple of posts on APRA’s December 2020 Discussion Paper but have thus far focussed on the details of the proposed changes to risk weights and capital buffers (here, here and here). This was partly because there was a lot to digest in these proposals but also because I simply found the discussion of how the proposed new framework reconciled to the Unquestionably Strong benchmark to be a bit confusing.

What follows is my current understanding of what the DP says and where we are headed.

On one level, the answer is quite simple – Exhibit A from the Discussion Paper (page 17) …

APRA DP “A more flexible and resilient capital framework for ADIs” page 17
  • For systemically important ADI (D-SIB ADIs), the Unquestionably Strong 10.5% CET1 benchmark will be enshrined in a series of expanded capital buffers that will come into force on 1 January 2023 and add up to 10.5%.
  • However, we also know that APRA has at the same time outlined a range of enhancements to risk weights that are expected to have the effect of reducing aggregate Risk Weighted Assets and thereby result in higher capital adequacy ratios.
  • APRA has also emphasised that the net impact of the changes is intended to be capital neutral; i.e. any D-SIB ADI that meets the Unquestionably Strong benchmark now (i.e. that had a CET1 ratio of at least 10.5% under the current framework) will be Unquestionably Strong under the new framework
  • However this implies that the expected increase in reported CET1 under the new framework will not represent surplus capital so it looks like Unquestionably Strong will require a CET1 ratio higher than 10.5% once the new framework comes into place.

The only way I can reconcile this is to assume that APRA will be revisiting the calibration of the proposed increased capital buffers once it gets a better handle on how much capital ratios will increase in response to the changes it makes to bring Australian capital ratios closer to those calculated by international peers under the Basel minimum requirements. If this was spelled out in the Discussion Paper I missed it.

What about the impact of RBNZ requiring more capital to be held in New Zealand?

Running alongside the big picture issues summarised above (Unquestionably Strong, Transparency, Comparability, Flexibility, Resilience”, APRA has also been looking at how it should respond to the issues posed by the RBNZ policy applying substantial increases to the capital requirements for banks operating in NZ. I wrote two post on this issue (see here and here) that make the following points

  • To understand what is going on here you need to understand the difference between “Level 1” and Level 2” Capital Adequacy (part of the price of entry to this discussion is understanding more APRA jargon)
  • The increased share of the group capital resources required to be maintained in NZ will not have any impact on the Level 2 capital adequacy ratios that are the ones most commonly cited when discussing Australian ADI capital strength
  • In theory, maintaining the status quo share of group capital resources maintained in Australia would require some increase in the Level 2 CET1 ratio (i.e. the one that is used to express the Unquestionably Strong benchmark)
  • In practice, the extent to which the Level 2 benchmark is impacted depends on the maternity of the NZ business so it may be that there is nothing to see here
  • It is hard to tell however partly because there is not a lot of disclosure on the details of the Level 1 capital adequacy ratios (at least not a lot that I could find) and partly because the Level 1 capital measure is (to my mind) not an especially reliable (or indeed intuitive) measure of the capital strength
Summing up
  • There is I think a general consensus that the Australian D-SIB ADIs all currently exceed the requirements of what it means to be Unquestionably Strong under the current capital adequacy framework
  • This implies that they have surplus capital that may potentially be returned to shareholders
  • APRA has laid out what I believe to be pretty sensible and useful enhancements to that framework (the expanded and explicitly more flexible capital buffers in particular)
  • These changes have however (for me at least) made it less clear what it will mean for an ADI to be Unquestionably Strong post 1 January 2023 when the proposed changes to Risk Weighted Assets come into effect

Any and all contributions to reducing my ignorance and confusion will be gratefully accepted – let me know what I am missing

Tony – From the Outside

Capital adequacy is not always intuitive

I did a short post yesterday scratching the surface of the issues associated with Westpac’s announcement that it is reviewing its options in New Zealand. In this post I will offer a little more background and comment focussed on the impact of Australian capital adequacy requirements.

The backstory thus far is that:

These combined changes obviously impact the economics of an Australian ADI owning a NZ regulated banks but to have any hope of understanding what is going on I believe we first need to define two pieces of Australian ADI capital jargon, Level 1 and Level 2

Level 1 is the ADI itself on a stand alone basis (note that is a simplification but close enough to the truth for the purposes of this post).

Level 2 is defined in APRA’s consultation paper as “The consolidation of the ADI and all its subsidiaries other than non-consolidated subsidiaries; or if the ADI is a subsidiary of a non-operating holding company (NOHC), the consolidation of the immediate parent NOHC and all the immediate parent NOHC’s subsidiaries (including any ADIs and their subsidiaries) other than non-consolidated subsidiaries.”

For completeness I should probably also define “ADI” which is an Authorised Deposit Taking Institution (more colloquially referred to as a bank).

You can be forgiven for not being familiar with the Level 1 – Level 2 distinction but the capital ratios typically quoted in any discussion of Australian ADI capital strength are the Level 2 measures. The Unquestionably Strong benchmark that dominates the discussion is a Level 2 measure. 

Part of the problem with the RBNZ initiative is that the increase in capital required to be held in the NZ part of the Group has no impact on the Level 2 capital ratio that is used to define the “Unquestionably Strong” benchmark the Australian ADI are expected to meet. The RBNZ is of course within its rights to set what ever capital requirement it deems appropriate but APRA then has to ensure that the increase in NZ based capital does not come at the expense of Australian stakeholders.

The Level 2 capital measure tells us nothing about this question. In theory this is where the Level 1 capital adequacy measure comes into play but I have always found the Level 1 measure a bit counter-intuitive.

  • My intuitive expectation is that the Level 1 measure for an Australian ADI should include the capital actually available in Australia and the risk exposures that capital has to underwrite.
  • What actually happens is that the dollar value of the Level 1 capital can be virtually the same as the Level 2 measure even though capital has been deployed in an offshore banking subsidiary (retained earnings in the subsidiary do not count but that can be addressed by paying a divided to the parent and then investing an equivalent amount of capital back in the subsidiary).
  • Level 1 risk weighted assets of the parent only incorporate an allowance for the risk weighted value of the equity invested in the banking subsidiary
  • This adjustment to the Level 1 risk weighted assets will of course be substantially less than the risk weighted assets the subsidiary is supporting with that equity that are excluded from the Level 1 parent capital ratio.
  • As a result, it is mathematically possible for the Level 1 CET1 ratio of the parent entity to be higher than the Level 2 Group ratio even though capital has been deployed outside the parent entity – that seems counter intuitive to me.

The changes that APRA has proposed to introduce will force the Australian banks to hold more capital to offset the impact of the CET1 deduction created when the investment in the banking subsidiary exceeds the (10%) threshold. As I understand it, this deduction only applies to the Level 1 measure so Level 2 capital will, all other things being equal, be higher as a result of responding to the combined impact of the RBNZ and APRA requirements. At face value that looks like stronger capital, which it is for the Group on average (i.e. Level 2), but the Australian parts of the banking Group do not benefit from the increase and it is important to understand that when evaluating the extent to which the Australian part of the banking group continues to be Unquestionably Strong.

APRA’s proposed change addresses the immediate issue created by the RBNZ requirement but I must confess that I still find the Level 1 capital adequacy measure a touch confusing. Level 1 capital ratios calculated on the basis I have set out above do not appear (to me at least) to offer an intuitively logical view of the relative capital strength of the various parts of the banking group.

As always, it is entirely possible that I am missing something here but understanding the technical issues outlined above is I think useful when making sense of the issues that Westpac (and other Australian ADIs) will be considering as they weigh their options in New Zealand. Relying on your intuition expectations of how the two requirements interact may be an unreliable guide if you are not familiar with the technical detail.

Tony – From the Outside

Capital adequacy – looking past the headline ratios

Comparing capital adequacy ratios is full of traps for the unwary. I recently flagged a speech by Wayne Byres (Chairman of APRA) that indicated APRA will be releasing a package of capital adequacy changes that will be more aligned with the international minimum standards and result in higher reported capital ratios.

While waiting for this package to be released, I thought it might be useful to revisit the mechanics of the S&P Risk Adjusted Capital (RAC) ratio which is another lens under which Australian bank capital strength is viewed. In particular I want to highlight the way in which the S&P RAC ratio is influenced by S&P’s assessment of the economic risks facing banks in the countries in which the banks operate.

The simplest way to see how this works is to look at an example from 2019 when S&P announced an upgrade of the hybrid (Tier 1 and Tier 2) issues of the Australian major banks. The senior debt ratings were left unchanged but the hybrid issues were all upgraded by 1 notch. Basel III compliant Tier 2 ratings were raised to “BBB+” (from “BBB”) and Tier 1 were raised to “BBB-” (from “BB+”).

S&P explained that the upgrade was driven by a revision in S&P’s assessment of the economic risks facing the Australian banks; in particular the “orderly decline in house prices following a period of rapid growth”. As a consequence of the revised assessment of the economic risk environment,

  • S&P now apply lower risk weights in their capital analysis,
  • This in turn resulted in stronger risk-adjusted capital ratios which now exceed the 10% threshold where S&P deem capital to be “strong” as opposed to “adequate”,
  • Which resulted in the Stand-Alone Credit Profile (SACP) of the Australian majors improving by one-notch and hence the upgrades of the hybrids.

Looking past the happy news for the holders of major bank hybrid issues, what was interesting was how much impact the revised assessment of the economic outlook has on the S&P risk weights. The S&P assessment of the economic outlook is codified in the BICRA score (short for the Banking Industry Country Risk Assessment) which assigns a numeric value from 1 (lowest risk) to 10 (highest risk). This BICRA score in turn determines the risk weights used in the S&P Risk Adjusted Capital ratio.

As a result of S&P revising its BICRA score for Australia from 4 to 3, the risk weights are materially lower with a commensurate benefit to the S&P assessment of capital adequacy (see some selected risk weights in the table below):

BICRA
Residential MortgagesBankCorporate, IPCRE, Business LendingCredit Cards
3302375105
4373387118
% Change
18.9%30.3%13.8%11.0%

The changes were fairly material across the board but the impact on residential mortgages (close to 20% reduction in the risk weight) is particulate noteworthy given the fact that this class of lending dominates the balance sheets of the Australian majors. It is also important to remember that, what the S&P process gives, it can also take away. This substantial improvement in the RAC ratio could very quickly reverse if S&P revised its economic outlook score or industry rating.

The other aspect of this process that is worth noting is the way in which the risk weights are anchored to S&P defined downturn scenarios and an 8% capital ratio. In the wake of the Royal Commission into Australian Banking, there has been a lot of focus on the idea of large banks being “Unquestionably Strong”. APRA subsequently determined that a 10.5% CET1 benchmark for capital strength was sufficient for a bank to be deemed to meet this test.

In that context, the S&P assessment that an 8-10% RAC ratio is “adequate” sounds a bit underwhelming. However, my understanding is the S&P risk weights are calibrated to an “A” or “substantial” stress scenario which is defined by the following Key Economic Indicators (KEI)

  • GDP decline of up to 6%
  • Unemployment of up to 15%
  • Stock market decline of ups to 60%

The loss rates expected in response to this level of stress are translated into equivalent risk weights using a 8% RAC ratio. The capital required by an 8% RAC ratio may only be “adequate” in S&P terms, but starts to look a lot more robust when you understand the severity of the scenario driving the risk weights that drive that requirement.

Summing up

I am not suggesting that there is anything fundamentally wrong with the S&P process, my purpose is simply to offer some observations regarding how the ratios in the capital adequacy assessment should be interpreted:

  1. Firstly to recognise that the process is by design anchored to an 8% capital ratio and risk weights that are calibrated to a very severe (“Substantial” is the term S&P uses) stress scenario, and
  2. Secondly, that the process is very sensitive to the BICRA score

This is not an area in which I will claim deep expertise so it is entirely possible that I am missing something. There are people who understand the S&P rating process far better than I do and I am very happy to stand corrected if I have mis-understood or mis-represented anything above.

Tony – From the Outside

Bank capital adequacy – APRA chooses Option 2

APRA released a discussion paper in August 2018 titled “Improving the transparency, comparability and flexibility of the ADI capital framework” which offered two alternative paths.

  • One (“Consistent Disclosure”) under which the status quo would be largely preserved but where APRA would get involved in the comparability process by adding its imprimatur to the “international harmonised ratios” that the large ADIs use to make the case for their strength compared to their international peers, and
  • A second (“Capital Ratio Adjustments”) under which APRA would align its formal capital adequacy measure more closely with the internationally harmonised approach.

I covered those proposals in some detail here and came out in favour of the second option. I don’t imagine APRA pay much attention to my blog but in a speech delivered to the AFR Banking and Wealth Summit Wayne Byres flagged that APRA do in fact intend to pursue the second option.

The speech does not get into too much detail but it listed the following features the proposed new capital regime will exhibit:

– more risk-based – by adjusting risk weights in a range of areas, some up (e.g. for higher risk housing) and some down (e.g. for small business);
 – more flexible – by changing the mix between minimum requirement and buffers, utilising more of the latter;
 – more transparent – by better aligning with international minimum standards, and making the underlying strength of the Australian framework more visible;
 – more comparable – by, in particular, making sure all banks disclose a capital ratio under the common, standardised approach; and
 – more proportionate – by providing a simpler framework suitable for small banks with simple business models.

while also making clear that

… probably the most fundamental change flowing from the proposals is that bank capital adequacy ratios will change. Specifically, they will tend to be higher. That is because the changes we are proposing will, in aggregate, reduce risk-weighted assets for the banking system. Given the amount of capital banks have will be unchanged, lower risk-weighted assets will produce higher capital ratios.

However, that does not mean banks will be able to hold less capital overall. I noted earlier that a key objective is to not increase capital requirements beyond the amount needed to meet the ‘unquestionably strong’ benchmarks. Nor is it our intention to reduce that amount. The balance will be maintained by requiring banks to hold larger buffers over their minimum requirements.

One observation at this stage …

It is hard to say too much at this stage given the level of detail released but I do want to make one observation. Wayne Byres listed four reasons for the changes proposed;

  1. To improve risk sensitivity
  2. To make the framework more flexible, especially in times of stress
  3. To make clearer the fundamental strength of our banking system vis-a-vis international peers
  4. To ensure that the unquestionably strong capital built up prior to the pandemic remains a lasting feature of the Australian banking system.

Pro-cyclicality remains an issue

With respect to increasing flexibility, Wayne Byres went on to state that “Holding a larger proportion of capital requirements in the form of capital buffers main that there is more buffer available to be utilised in times of crisis” (emphasis added).

It is true that the capital buffer will be larger in basis points terms by virtue of the RWA (denominator in the capital ratio) being reduced. However, it is also likely that the capital ratio will be much more sensitive to the impacts of a stress/crisis event.

This is mostly simple math.

  1. I assume that loan losses eating into capital are unchanged.
  2. It is less clear what happens to capital deductions (such as the CET1 deduction for Regulatory Expected Loss) but it is not obvious that they will be reduced.
  3. Risk Weights we are told will be lower and more risk sensitive.
  4. The lower starting value for RWA in any adverse scenario means that the losses (we assume unchanged) will translate into a larger decline in the capital ratio for any given level of stress.
  5. There is also the potential for the decline in capital ratios under stress to be accentuated (or amplified) to the extent the average risk weights increase in percentage terms more than they would under the current regime.

None of this is intended to suggest that APRA has made the wrong choice but I do believe that the statement that “more buffer” will be available is open to question. The glass is however most definitely half full. I am mostly flagging the fact that pro-cyclicality is a feature of any risk sensitive capital adequacy measure and I am unclear on whether the proposed regime will do anything to address this.

The direction that APRA has indicated it intends to take is the right one (I believe) but I think there is an opportunity to also address the problem of pro-cyclicality. I remain hopeful that the consultation paper to be released in a few weeks will shed more light on these issues.

Tony – From the Outside

p.s. the following posts on my blog touch on some of the issues that may need to be covered in the consultation

  1. The case for lower risk weights
  2. A non zero default for the counter cyclical capital buffer
  3. The interplay of proposed revisions to APS 111 and the RBNZ requirement that banks in NZ hold more CET1 capital
  4. Does expected loss loan provisioning reduce pro-cyclicality
  5. My thoughts on a cyclical capital buffer

Bank deposits – turning unsecured loans to highly leveraged companies into (mostly) risk free assets – an Australian perspective

The ability to raise funding via “deposits” is one of the things that makes banks different from other types of companies. As a rule bank deposits benefit from a variety of protections that transform what is effectively an unsecured loan to a highly leveraged company into an (arguably) risk free asset.

This rule is not universal however. The NZ banking system, for example, had (at the time this post was written) a distinctly different approach to bank deposits that not only eschews the protections Australian depositors take for granted but also has the power, via its Open Banking Resolution regime, to write down the value of bank deposits if required to ensure the solvency and viability of a bank. But some form of protection is common.

I previously had a go at the question of “why” bank deposits should be protected here.

This post focuses on the mechanics of “how” AUD denominated deposits held with APRA authorised deposit-taking institutions incorporated in Australia (“Australian ADIs” or “Australian banks”) are protected. In particular, I attempt to rank the relative importance of the various protections built into the Australian system. You may not necessarily agree with my ranking and that is OK – I would welcome feedback on what I may be missing.

Multiple layers of protection

Australian bank deposits benefit from multiple layers of protection:

  1. The risk taking activities of the banks are subject to a high level of supervision and regulation (that is true to varying degrees for most banking systems but Australian standards do seem to be at the more conservative end of the spectrum where Basel Committee standards offer a choice),
  2. The target level of Common Equity Tier 1 (CET1) capital required to support that risk must meet the standard of being “Unquestionably Strong”,
  3. This core capital requirement is supported by a series of supplementary layers of loss absorbing capital that can be converted into equity if the viability of the bank as a going concern comes into doubt,
  4. The deposits themselves have a priority super senior claim on the Australian assets of the bank should it fail, and
  5. The timely repayments of AUD deposits up to $250,000 per person per bank is guaranteed by the Australian Government.

Deposit preference rules …

The government guarantee might seem like the obvious candidate for the layer of protection that counts for the most, but I am not so sure. All the layers of protection obviously contribute but my vote goes to deposit preference. The capacity to bail-in the supplementary capital gets an honourable mention. These seem to me to be the two elements that ultimately underwrite the safety of the majority of bank deposits (by value) in Australia.

The other elements are also important but …

Intensive supervision clearly helps ensure that banks are well managed and not taking excessive risks but experience demonstrates that it does not guarantee that banks will not make mistakes. The Unquestionably Strong benchmark for CET1 capital developed in response to one of the recommendations of the 2014 Financial System Inquiry also helps but again does not guarantee that banks will not find some new (or not so new) way to blow themselves up.

At face value, the government guarantee seems like it would be all you need to know about the safety of bank deposits (provided you are not dealing with the high quality problem of having more than AUD250,000 in your bank account). When you look at the detail though, the role the government guarantee plays in underwriting the safety of bank deposits seems pretty limited, especially if you hold you deposit account with one of the larger ADIs. The first point to note is that the guarantee will only come into play if a series of conditions are met including that APRA consider that the ADI is insolvent and that the Treasurer determines that it is necessary.

In practice, recourse to the guarantee might be required for a small ADI heavily reliant on deposit funding but I suspect that this chain of events is extremely unlikely to play out for one of the bigger banks. That is partly because the risk of insolvency has been substantially reduced by higher CET1 requirements (for the larger ADI in particular) but also because the government now has a range of tools that allow it to bail-in rather than bail-out certain bank creditors that rank below depositors in the loss hierarchy. There are no great choices when dealing with troubled banks but my guess is that the authorities will choose bail-in over liquidation any time they are dealing with one of the larger ADIs.

If deposit preference rules, why doesn’t everyone do it?

Banking systems often seem to evolve in response to specific issues of the day rather than being the result of some grand design. So far as I can tell, it seems that the countries that have chosen not to pursue deposit preference have done so on the grounds that making deposits too safe dilutes market discipline and in the worst case invites moral hazard. That is very clearly the case in the choices that New Zealand has made (see above) and the resources they devote to the disclosure of information regarding the relative risk and strength of their banks.

I understand the theory being applied here and completely agree that market discipline should be encouraged while moral hazard is something to be avoided at all costs. That said, it does not seem reasonable to me to expect that the average bank deposit account holder is capable of making the risk assessments the theory requires, nor the capacity to bear the consequences of getting it wrong.

Bank deposits also function as one of the primary forms of money in most developed economies but need to be insulated from risk if they are to perform this role. Deposit preference not only helps to insulate this component of our money supply from risk, it also tends to transfer the risk to investors (debt and equity) who do have the skills and the capacity to assess and absorb it, thereby encouraging market discipline.

The point I am making here is very similar to the arguments that Grant Turner listed in favour of deposit protection in a paper published in the RBA Bulletin.

There are a number of reasons why authorities may seek to provide greater protection to depositors than to other creditors of banks. First, deposits are a critical part of the financial system because they facilitate economic transactions in a way that wholesale debt does not. Second, they are a primary form of saving for many individuals, losses on which may result in significant adversity for depositors who are unable to protect against this risk. These two characteristics also mean that deposits are typically the main source of funding for banks, especially for smaller institutions with limited access to wholesale funding markets. Third, non-deposit creditors are generally better placed than most depositors to assess and manage risk. Providing equivalent protection arrangements for non-deposit creditors would weaken market discipline and increase moral hazard.

Depositor Protection in Australia, Grant Turner, RBA Bulletin December Quarter 2011 (p45)

For a more technical discussion of these arguments I can recommend a paper by Gary Gorton and George Pennacchi titled “Financial Intermediation and Liquidity Creation” that I wrote about in this post.

Deposit preference potentially strengthens market discipline

I argued above that deposit preference potentially strengthens market discipline by transferring risk to debt and equity investors who have the skills to assess the risk, are paid a risk premium for doing so and, equally as importantly, the capacity to absorb the downside should a bank get into trouble. I recognise of course that this argument is strongest for the larger ADIs which have substantial layers of senior and subordinated debt that help ensure that deposits are materially insulated from bank risk. The capacity to bail-in a layer of this funding, independent of the conventional liquidation process, further adds to the protection of depositors while concentrating the role of market discipline where it belongs.

This market discipline role is one of the chief reasons I think “bail-in” adds to the resilience of the system in ways that higher equity requirements do not. The “skin in the game” these investors have is every bit as real as that the equity investors do, but they have less incentive to tolerate excessive or undisciplined risk taking.

The market discipline argument is less strong for the smaller ADIs which rely on deposits for a greater share of their funding but these entities account for a smaller share of bank deposits and can be liquidated if required with less disruption with the assistance of the government guarantee. The government guarantee seems to be more valuable for these ADIs than it is for the larger ADIs which are subject to a greater level of self-insurance.

Deposit preference plus ex ante funding of the deposit guarantee favours the smaller ADI

Interestingly, the ex ante nature of the funding of the government guarantee means that the ADIs for which it is least valuable (the survivors in general and the larger ADI’s in particular) are also the ones that will be called upon to pay the levy to make good any shortfalls not covered by deposit preference. That is at odds with the principle of risk based pricing that features in the literature about deposit guarantees but arguably a reasonable subsidy that assists the smaller ADIs to compete with larger ADI that have the benefit of risk diversification and economies of scale.

Summing up

If you want to dig deeper into this question, I have summarised the technical detail of the Australian deposit protection arrangements here. It is a little dated now but I can also recommend the article by Grant Turner published in the RBA Bulletin (December 2011) titled “Depositor Protection in Australia” which I quoted from above.

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

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