Why More Capital Won’t Fix Banking

In the recent results round, the need to raise more capital in response to regulatory change was used as one of the pretexts for the need to lift mortgage rates. Given we, on an international comparison basis, still have more ground to make up to reach “unquestionably strong” we can expect this to continue, and APRA says it will be further lifting capital requirements soon. Wayne Byers said recently:

We have been doing quite a bit of thinking on this issue, but had held off taking action until the international work in Basel on the bank capital regime had been completed. Unfortunately, the timetable for that Basel work now seems less certain, so it would be remiss of us to wait any longer.

We estimate the banks will need to raise another $20-25bn to cover likely rises in the next year or two. Whilst this is manageable, lending costs will rise further. Internationally, Basel III finalisation is in question.

Shareholder returns are under pressure in the current environment, with some able to maintain payouts whilst others are trimming. CBA’s return on equity was 16% as last reported down from 19.5% in 2011. The weighted cost of capital is lower than this but the higher capital demands is still taking its toll.

The drive to hold more capital is primarily to ensure financial stability in a time of crisis, and to protect tax payers from a direct bail-out during a crisis as happened for example in the UK in 2007.  However, recent research has shown that higher capital requirements may encourage some banks to take MORE risk.

But, lifting capital does nothing to fix the root cause issues which lurk in the shadows, and which costs Australia Inc. dear. Some of the banks appear to be mounting a charm offensive where they demonstrate their contribution to society via the salaries they pay staff, the tax they pay, and returms which flow to shareholders (many of whom are institutional investors, and some offshore). But this effort sounds false to many.

The profitability of our banks sits at the top end of international lists, not because our management are especially talented, but because of the level of competition in the industry which allows higher margins to mask relative inefficiencies.  ANZ’s recent trading update showed that when a bank tries hard, they can drive costs down and efficiency up, but not all players have this same focus.  And this is hard to do.

The cultural norms where for all the lip service towards serving customers better, many customers do not feel the love; where capital costs are passed on to consumers and small business and where the litany of scandals and poor customer experiences continue to surface; are the real issues that need to be addressed.

But let us be clear, there is no necessary trade-off between good customer outcomes and profitability. Indeed, I would argue that superior long term returns will be achieved by those players who are really driving their business from a point of customer centricity. But this is hard, and requires a different set of cultural norms to those displayed in many financial services companies today. If they were to ban sales incentives, price products fairly, and put processes to train their staff to deal with errors effectively, this would lead to better outcomes all round. Such cultural changes cannot be legislated or regulated though, it requires management leadership to make this happen.

At the moment, there is a gap between (to use an old cheque processing phrase) “words and figures differ”. This is the gap between all the talk and real action. And more capital is not a replacement for the cultural change which is required.




APRA fiddles on bank risk while Rome burns

From The Conversation.

Australian Prudential Regulation Authority (APRA) chairman Wayne Byers has made it clear the bank regulator will be cracking down on bank capital levels this year.

Bank capital reserves are a loss-absorber, designed to protect creditors if banks suffer significant losses. That protection, in turn, will – ostensibly – prevent panicked withdrawals by depositors, thereby preventing financial contagion and financial crises.

[DFA notes, its the Council of Financial Regulators that is the coordinating body for Australia’s main financial regulatory agencies. Its membership comprises the Reserve Bank of Australia (RBA), which chairs the CFR; the Australian Prudential Regulation Authority (APRA); the Australian Securities and Investments Commission (ASIC); and The Treasury — so APRA is just part of the problem!]

Byers has decided that Australian banks’ capital levels must be “unquestionably strong” in keeping with the findings of the Financial System Inquiry. But how much capital equals “unquestionably strong”? We don’t know.

What we do know is that the inquiry handed down that finding in November 2014. More than two years have passed and only now is APRA getting a wriggle on.

The problem is that, according to the IMF, when it comes to Tier 1 bank capital, this time last year Australia was ranked 91st in the world. That puts us close to the bottom of the G20, the OECD and the G8. Our position has fluctuated, but at no time during the preceding four quarters have we risen above 60th.

Ranked above Australia were Swaziland, Afghanistan and even Greece. That sounds like, at best, unquestionably ordinary. Maybe even unquestionably weak. But definitely not “unquestionably strong”.

The global financial crisis could’ve led to change

Some argue, determinedly and erroneously, that when functioning correctly bank capital levels are almost magical things. As former US Federal Reserve chair Alan Greenspan once said:

The reason I raise the capital issue so often is that … it solves every problem.

Greenspan, as Fed chair, was ultimately responsible for the health of the US financial system. Having touted capital levels, his tenure ended just before the sub-prime disaster turned into the global financial crisis. This earned Greenspan Time Magazine’s moniker as one of the 25 people most to blame for the crisis.

However, bank capital levels were in place before the crisis hit. The Basel Committee – a sort-of UN for Reserve Bank governors and bank regulators – introduced global standards for bank capital as far back as 1988.

Back then, it set the capital level at 8%. In other words, for every $100 in liabilities, banks had to retain $8 in cash (or close to cash). But this level was simply a reflection of the average of the day.

Codifying the average into a global standard was an excellent trick. No-one was made to feel left out, or inadequate.

Then came the global financial crisis. It resulted in an output loss of somewhere between US$6 trillion and US$14 trillion in the US alone.

The Basel Committee said it was going to raise bank capital levels in response to the crisis. This meant it was going to do more of the thing (bolster capital levels) that had been meant to prevent such a crisis from occurring in the first place, but had failed.

What now?

The Basel Committee’s latest attempt to take action on capital levels involves curbing “internal risk-based models”. These models allow banks to determine how risky their assets are, and therefore how much expensive and unusable capital they have to set aside for loss-absorption, to match the risk profile of their assets.

That’s like you or I determining how risky we are as borrowers, and therefore deciding how much interest we should be charged on the money we borrow.

European banks have pushed back against curbing internal risk-based models. They resent not being able to have absolutely everything their own way. And the Basel Committee has proven to be a push-over.

Australian banks have pushed back too, with a not-so-subtle threat that customers will bear the costs of higher capital levels. If Byers and APRA do what they are supposed to, and what the government told them to do in late 2015, Australia’s banks will need to raise A$15 billion or more to rectify their thin capital position.

That’s $15 billion not earning returns or bringing in bonuses. No wonder our bankers aren’t happy.

And while APRA and Byers have fiddled on this issue and effectively ignored government instructions, and Australian banks remained capital-thin, conditions have arisen that economist John Adams argues may result in an “economic Armageddon” for Australia.

If that happens, guess who will be bailing out the banks? You, the taxpayer.

Author: Andrew Schmulow , Senior Lecturer, Faculty of Law, University of Western Australia

Trump could ‘sow the seeds’ of next GFC

From InvestorDaily.

US President Donald Trump’s plans to ease banking regulation poses a risk to global financial stability, according to a UNSW professor.

University of Sydney associate professor Eliza Wu said the relaxation of the Dodd-Frank Act, introduced by former President Barack Obama to protect bank consumers after the global financial crisis of 2008, increases the sectors exposure to “risky financial products”.

“While investors may be happy about the proposed deregulation, the future prospects for global financial stability are not great as President Trump sows the seeds of the next global financial crisis,” she said.

Ms Wu said the Basel Committee on Banking Supervision’s decision to delay the finalisation of the new Basel 3 rules had also contributed to “uncertainty regarding banking regulatory reforms” currently facing the global banking sector.

“This is increasingly putting pressure on national prudential regulators to maintain and impose their own regulatory standards – this is worrying as a level playing field for banks operating around the world is critical for achieving global financial stability,” she said.

“When the playing field is not level, banks will respond by ‘rushing to the bottom’ and shift their operations to places where the regulation is less stringent.”

Under these circumstances, Australia would “inevitably lose out” as the country’s high regulatory standards would result in less competition within the domestic banking sector, Ms Wu said.

Applying Basel III to small banks

Dr Andreas Dombret Member of the Executive Board of the Deutsche Bundesbank spoke on the finalisation of Basel III  – “One size fits all? Applying Basel III to small banks and savings banks in Germany“.

A demanding 2017 lies ahead of banks and savings banks: While the sector is witnessing a structural scale-back of sorts, low interest rates and competition from digital service providers are weighing on profit opportunities. At the same time, the risks that need to be managed have not got any smaller – no, the challenges posed by the low-interest-rate environment are, together with mounting interest rate risks, making them even more demanding.

Many institutions are therefore seeking new strategies and rethinking their business models. To make matters more difficult, a raft of further regulatory reforms is just around the corner.

2 Basel III and the completion of regulatory reform

I’m talking, first and foremost, about the finalisation of Basel III in the Basel Committee on Banking Supervision and its transposition into EU law by way of CRR II and CRD V.

The finalisation of Basel III is the topic of much discussion at the moment, which centres specifically around approaches for calculating risk-weighted assets (RWA). Although many parts of this last package of reforms are already done and dusted – primarily the fundamental revamping of trading-book approaches – some final parts are still being debated in the Basel Committee. This is the case with respect to reforms concerning the treatment of credit risk and operational risk, for instance.

Many banking industry representatives are afraid that this last package of reforms will create a new set of burdens. I see it the other way around: these reforms are necessary, as they complement and round out the Basel reform process. What we saw during the financial crisis was that the approaches to calculating RWA produced capital requirements that were too low in some cases, and a response is urgently needed.

That is why the Basel III package will not be complete until these further reforms have been implemented, and that is why we are referring to the process as the finalisation of Basel III. What I want, here and now, is to clearly disabuse people of the notion that a completely new standard is being introduced.

Of course, what is being asked of institutions is significant and by no means negligible. However, all outstanding reforms are based on the existing regulatory framework and take it a step further. I therefore believe that they should be easier to implement than many fear.

That said, I do understand why banks and savings banks would be jittery at the prospect of a further increase in capital requirements. That is why, in the Basel III finalisation process, the Bundesbank has come out strongly against a further increase in capital requirements. Our motto must therefore be that no agreement in Basel is better than a bad agreement. At the same time, though, an international standard has a very high value that must not be underestimated. This is all the more true in a time in which more and more countries are turning inwards. The Bundesbank will also continue to work towards a compromise on Basel III – one that benefits Germany.

3 Reforms and smaller institutions: a one-size-fits-all solution or graduated rules?

Let me turn now to a second, different topic. In talks with smaller banks and savings banks about the post-crisis reforms, I hear one concern being echoed time and again: that smaller institutions perceive the operational burdens of regulation as being particularly overwhelming. As they put it, a burden that is much more onerous on small banks and savings banks than on their much larger competitors. This is an issue I take very seriously, for the banks and savings banks are right.

Therefore, for the next few minutes I will discuss the question as to whether banking regulation should be offered only as a one-size-fits-all solution for all banks and savings banks – or whether multiple different regulatory regimes should be created to fit different sizes of institutions.

Ladies and gentlemen, it is my firm view that there is absolutely no way a one-size-fits-all approach can do justice to today’s banking landscape – with its very large and complex institutions, its numerous smaller and regional institutions, and the wide expanse of medium-sized institutions! It will positively damage the structure of our banking system – a structure that gave us stability during the financial crisis.

You may well all be familiar with the allegation that the purpose of the new regulatory regime is to encourage more and more consolidation in the industry – including Germany’s banking industry. Of course, mergers among banks and savings banks must not be a taboo topic – but, by the same token, they must not be a regulatory objective, either. I admit to being a fan and proponent of diversity in terms of bank size and business model, as this makes our banking system more stable. Supervisors are not supposed to be making structural policy; rather, they ought to be actively working towards proportionality in regulation.

This is precisely why banking regulation and banking supervision are already designed with a large degree of proportionality. However, the ambitious reforms following the financial crisis have made the rulebook more complex, particularly because the rules were oriented to the epicentre of the financial crisis: large and medium-sized institutions with risky business models.

This new regime has made compliance a much more difficult and time-consuming affair. This overhead is high for each and every institution – regardless of its size. However, small banks and savings banks, owing to their smaller staff sizes, are far less able to spread the costs of compliance across their employees and have to either hire additional staff or enlist external aid. This leads to comparatively higher burdens.

For that reason – and because smaller institutions pose less of a threat to financial stability than medium-sized to large institutions – I think that offering relief to small banks and savings banks is the right thing to do.

One thing that is of paramount importance to me, however, is this: any relief measures being discussed here have to solve the actual problem – which is not, first and foremost, the minimum capital requirements, but primarily the operational burdens imposed by the need to comply with complex rules.

What this means specifically is that any relief for smaller banks and savings banks must be about removing operational burdens – and of this I am firmly convinced. On the other hand, there cannot and must not be any easing of capital and liquidity requirements.

Moreover, no relief should be permitted to jeopardise financial stability. Medium-sized, highly systemically interconnected institutions – those referred to as “too interconnected to fail” – and those institutions with risky business models should not be provided any relief. The recent financial crisis, during which many insolvent institutions had to be bailed out, is still fresh in all of our minds. We also need to be careful not to create any loopholes that end up being used by so many small institutions that a situation of general distress results.

I am therefore firmly convinced that institutions need to be regulated with a sense of proportionality without diluting the new regulatory regime. I am committed to ensuring that the debate on greater proportionality is not used as a pretext for reducing capital and liquidity requirements but that it instead results in an actual reduction in operational burdens on smaller banks and savings banks.

4 Greater proportionality – but how?

How can the goal of regulatory proportionality be achieved in a reasonable manner without any side effects?

There are two conceivable approaches. The first is a details-driven approach that involves introducing special exceptions or adjustments to individual rules.

The second is the creation of separate regulatory frameworks for smaller institutions, on the one hand, and large multinational institutions, on the other.

The details-driven approach has already been pursued as part of the EU reforms I explained earlier, with the Commission emphasising a reduction in the burden on smaller institutions in all reform areas. In its draft consultative document, it has proposed a variety of relief measures and de minimis thresholds, such as in disclosure and reporting requirements. Institutions below these thresholds will be subject to considerably simplified rules, with some requirements even being abolished altogether, which is something I can only welcome.

We just need to be careful not to set the de minimis thresholds too high, as otherwise there would be considerable risks that were inadequately regulated.

With that in mind, I would like to return to the conviction I expressed earlier on: relief measures that reduce capital and liquidity requirements need extremely careful consideration. Examples include some of the exemptions to the leverage ratio (LR) and the net stable funding ratio (NSFR). Another is the considerable enlargement of the SME factor. Whereas real economic growth is unlikely to receive any boost, the minimum requirements for institutions’ risk provisioning could be weakened.

Let me come to the second approach: the two-tiered system. The fact that work is being done on a details-driven approach doesn’t mean at all that this fundamental approach cannot be pursued as well.

Specifically, we are talking about a fundamental approach that envisages a dedicated rulebook for smaller institutions – an approach that would systematically address the excess burden placed on smaller institutions’ operational capacities.

In this scenario, only banking multinationals would be subject to the fully loaded Basel III requirements in the EU. This would be appropriate from a risk perspective: we would be regulating global banking institutions under a harmonised set of global rules, while smaller institutions and those operating within a certain region would be governed by graduated rules that do justice to their different business models and risk profiles by setting less complex requirements.

The Basel Committee would also benefit from such a dedicated rulebook for banks operating internationally. If the 28 member states knew that the fully loaded Basel standards were only applicable to large, internationally active banks, we wouldn’t have to worry any more about detailed national exemptions, but could instead devote our entire energy to the key task: standards for large, internationally active banks.

I feel very much that Brussels and Basel should examine this approach with an open mind. Such a systematic approach to relieving the burden on smaller institutions, to the extent that it is deliverable, is generally superior to a patchwork of exemptions. In this connection, I am very eager to open up a dialogue with the banking community. To this end, a joint working group was recently established, comprising delegates from the Federal Ministry of Finance, the Bundesbank, BaFin and the central associations of the German banking industry, in order to develop proposals along these lines.

5 Conclusion

Ladies and gentlemen, the implementation of Basel III will impose further demands on banks and savings banks – but I think that less time and effort will be required than many currently fear.

With regard to the implementation of reforms, two things are of paramount importance to me. Under no circumstances must we water down what has been achieved since the financial crisis; rather, we must maintain a robust regime of rules.

That said, a one-size-fits-all approach will not do justice to the banking landscape. One of the objectives guiding the actions taken to finalise the agenda of reforms in Europe should therefore be to lessen the operational burdens on small, low-risk institutions – ie to make the final regulatory regime more granular.

The objective must not be to erode minimum capital requirements and thereby open a new gateway for stability problems. Instead, it is about reducing operational burdens on small institutions without hollowing out capital and liquidity requirements.

This, ladies and gentlemen, is how we can secure a diverse, successful and, above all, stable financial sector – to serve the German economy.

More On Rental Yields – It Matters Where You Buy

We continue our update on our rental yield modelling, using data from our household surveys. Last time we looked across the average gross and net yields (in cash-flow terms) by state, and also at average capital gains. Today we drill into the location specific analysis and also look at our master household segmentation.

But before we look at the data specifically, it is worth reflecting on why we show the data the way we do. New rules from Basel will require banks to hold more capital against loans which are required to be serviced from income other than rent. As a result, the question of net yield – meaning rental income, less loan repayments and other costs before tax suddenly become more important. Whilst the Basel rules are yet to be finalised (there are internal squabbles between members as to where to set the limits), this data is significant – and needs to be separated from any equity held in the property – as equity is no guide to loan serviceability, only an indicator of potential risk should a sale be forced.

So now we turn to our household master segments. We find a startling truth. Most affluent households seem to be able to hold investment property where net yields are still positive, whereas less affluent households – those on the urban fringe, battlers, stressed older households and multicultural segments, as well as young growing families; on average have net yields in negative territory. Whilst there are a smaller number of these households, compared with the number of more affluent households who hold investment property, it is telling. In addition – and no surprise – more affluent households on average have more equity in the property (and more properties per household).

Another way to look at the investment portfolio is by regions and locations. We use a list of 50 or so, which cover the country. There are variations across these.  On average households in Horsham, Ballarat and Wangaratta have little equity in their investment properties, and are well underwater in terms of net rental yields.

At the other end of the spectrum, investment properties in Darwin, Tasmania and areas of Queensland are in much more positive territory.

Investors in Warnambool, Canberra and in the Central Coast have the highest average paper capital profits (current property value less outstanding mortgage). But of course many investment households have large mortgages so they can offset interest against other income thanks to negative gearing.

The pressure of rising investment loan interest rates, low rental income growth, and in some cases, vacant property are all having an impact. But the fallout is not equally spread across the country, or across households.

APRA On The Countercyclical Capital Buffer

APRA released a brief update to support their zero Countercylical Capital Buffer setting. As they say “the countercyclical capital buffer is designed to be used to raise banking sector capital requirements in periods where excess credit growth is judged to be associated with the build-up of systemic risk. This additional buffer can then be reduced or removed during subsequent periods of stress, to reduce the risk of the supply of credit being impacted by regulatory capital requirements”.

APRA may set a countercyclical capital buffer within a range of 0 to 2.5 per cent of risk weighted assets. On 17 December 2015, APRA announced that the countercyclical capital buffer applying to the Australian exposures of authorised deposit-taking institutions (ADIs) from 1 January 2016 would be set at zero per cent. An announcement to increase the buffer may have up to 12 months’ notice before the new buffer comes into effect; a decision to reduce the buffer will generally be effective immediately.

APRA reviews the level of the countercyclical capital buffer on a quarterly basis, based on forward looking judgements around credit growth, asset price growth, and lending conditions, as well as evidence of financial stress. APRA takes into consideration the levels of a set of core financial indicators, prudential measures in place, and a range of other supplementary metrics and information, including findings from its supervisory activities. APRA also seeks input on the level of the buffer from other agencies on the Council of Financial Regulators.

A range of core indicators are used to justify their position. Here are their main data-points.

Credit growth

Credit-to-GDP ratio (level, trend and gap)

The credit-to-GDP gap is defined as the difference between the credit-to-GDP ratio and its long-run trend. The long-run trend is calculated using a one sided Hodrick-Prescott filter, a tool used in macroeconomics to establish the trend of a variable over time. The credit-to-GDP gap for Australia is currently negative at -3.9. The Basel Committee suggests that a gap level between 2 and 10 percentage points could equate to a countercyclical capital buffer of between 0 and 2.5 percent of risk-weighted assets.

Housing credit growth

The pace of housing credit growth has slowed this year, growing at 6.4 per cent year on year as at September 2016, down from 7.5 per cent at the time the buffer was initially set. Investor housing credit growth fell from 10 per cent to 4.9 per cent over the same period, however the pace of growth has been increasing again more recently. APRA has identified strong growth in lending to property investors (portfolio growth above a threshold of 10 per cent) as an important risk indicator for APRA supervisors.

Business credit growth

Business credit growth increased marginally in the first half of 2016. However, business credit growth has fallen over recent quarters; annual growth in business credit was 4.8 per cent over the year to end September 2016, down from 6.3 per cent as at September 2015. Notwithstanding the lower overall rate of growth, commercial property lending growth (not shown) has remained strong, growing 10.5 per cent year on year as at September 2016.

Asset Prices

National housing price growth remains strong, but has slowed relative to 2015 peaks, growing nationally at around 3.5 per cent over the 12 months to September 2016. However, over a shorter horizon, prices have been reaccelerating recently with six month-ended annualised price growth of 7.2 per cent nationally as at September 2016 (albeit still a slower pace than 2015 peaks). Conversely, rental growth and household income growth have been relatively weak. Looking beyond the national averages, conditions vary significantly across individual cities and regions. In particular, housing price growth has strengthened in Sydney and Melbourne over recent months with six month-ended annualised growth rates of 11.4 per cent and 9.0 per cent respectively.

Non-residential commercial property has also been exhibiting strong price growth, though this has moderated somewhat in recent months (not shown).

Lending indicators

APRA monitors a range of data and qualitative information on lending standards. For residential mortgages, the proportion of higher-risk lending is a key metric. Over the past few years, APRA has heightened its regulatory focus on the mortgage lending practices of ADIs in order to reinforce sound lending practices. This has included, but not been limited to, the introduction of benchmarks on loan serviceability and investor lending growth, and the issuance of a prudential practice guide on sound risk management practices for residential mortgage lending.

In general, higher-risk mortgage lending has been falling recently with the share of new lending at loan-to-valuation ratios greater than 90 per cent falling from 9.5 per cent to 8.1 per cent over the year to September 2016. Other forms of higher-risk mortgage lending including high loan-to-income and interest-only lending (not shown) have also moderated from 2015 peaks, although there has been some pick-up in the share of interest-only lending recently.

In business lending, banks have showed some evidence of tightening lending standards more recently, in particular for commercial property lending, with the lowering of loan-to-valuation and loan-to-cost ratios on certain development transactions (not shown).

Lending rates had been steadily falling for both housing and business lending to historical lows. More recently however, lending rates have fallen by less than the cash rate, with banks passing on around half of the August cash rate reduction. Lending rates have also risen in recent weeks in response to higher costs in wholesale funding markets. In particular, a number of ADIs have recently announced increases to their mortgage lending rates with some ADIs specifically targeting investor and interest-only loans.

APRA’s confidential quarterly survey of credit conditions and lending standards provides qualitative information on whether conditions are tightening or loosening in the industry.

Financial Stress

Indicators of financial stress are used in informing decisions to release any countercyclical capital buffer. While a wide range of indicators could signify a deterioration in conditions, APRA has identified non-performing loans as its core indicator of financial stress.

The share of non-performing loans remains low, though it has increased moderately over 2016, to 0.93 per cent as at September 2016, largely driven by increases in regions and sectors with exposures to mining.

So, everything is looking rosy, in their view. However, the high household debt to income ratio and the fact that debt servicing is supported by ultra low interest rates is not included adequately in their assessment – seems myopic in my view, but then this continues the regulatory group-think.  In addition the use of “confidential quarterly survey data” highlights the lack of industry disclosure.

Delayed Completion of Basel 3 Reform Is Credit Negative for Banks

According to Moody’s the 3rd January announcement from the Basel Committee on Banking Supervision (BCBS) that the final decision on the completion of the Basel 3 reform (also referred to as Basel 4) has been postponed, is credit negative for Banks. The delay could also dent investors’ confidence in banks’ capital ratios and result in higher cost of funding.

The scheduled January meeting of the Group of Central Bank Governors and Heads of Supervision (GHOS) to agree on final capital regulations was postponed because of the lack of agreement on calibrating parameters for the use of internal capital models. The protracted process is credit negative for banks and signals the supervisors’ difficult reach for a consensus on adopting rules for a common/global capital framework, which is critical to preserve a level playing field.

The delay could also dent investors’ confidence in banks’ capital ratios and result in higher cost of funding.

GHOS’ decision to postpone the meeting is unsurprising given differing views among BCBS members. The BCBS is striving to define a revised framework that fairly reflects risks and does not result in “significant” capital increases. Officials from EU countries including France and Germany and the European Commission are worried about choking off bank lending to economies where loans are the primary form of corporate finance. Although what would constitute a significant capital increase has not been quantified, BCBS Chairman Stefan Ingves last month acknowledged that this objective does not mean avoiding any increase for any bank and it may result in significant increases at some banks.

BCBS members agree on the overarching objective, which is to restore confidence in banks’ calculation of their risk-weighted assets (RWAs). That means achieving greater consistency and reducing variability in the calculation methodology for RWAs. The BCBS seeks to constrain the benefit of modelling techniques: in some cases, supervisors consider that the models too frequently result in low capital requirements and the BCBS is specifically targeting banks that have developed aggressive modelling techniques. However, defining the threshold at which such capital benefits become unacceptable is proving thorny for BCBS.

BCBS has a consensus on the need to get rid of unjustified variability, yet lacks a consensus on the acceptable level of difference between the “standardized” measure of risks and banks’ internal model estimates. Banks will be required to assess their risks under both methods and the general floor, which will be set between 60% and 90% of standardized risk weights, will determine the benefits risk modelling could bring: the lower the floor, the greater banks can benefit from models’ outcomes. Those regulators who place greater trust in banks’ internal models favor a lower floor while others, based on well-documented failures that occurred during the financial crisis, argue the standardized approach should drive the outcome, and therefore prefer a higher floor. The more intensive use of models by EU banks makes them sensitive to the floor.

The final decision on the general floor will attract a lot of attention from investors. If the general floor is set at a high level (close to 90%), the GHOS will have been relatively conservative; even more so if the implementation period is short. Were the floor to be set closer to 60% with a long transition phase, it would indicate a more permissive stance. However there are also many technical parameters that are critical to form a view on the framework’s toughness (or lack thereof); for example, floors could be imposed at the model level (setting a minimum level of probability of default or loss given default).

For now, the absence of an agreement and the BCBS’ difficulties in clinching a deal continue to fuel investors’ lack of confidence in RWAs and hence in capital ratios and skepticism towards the adoption of harmonized rules.

Basel III Reforms Delayed

The finalisation of the Basel III reforms has been delayed, according to a press release today.  No details were given of which issues remain to be resolved, nor a revised time frame.

The Group of Central Bank Governors and Heads of Supervision (GHOS), the oversight body of the Basel Committee on Banking Supervision, welcomes the progress made towards completing the Basel Committee’s post-crisis regulatory reforms.

However, more time is needed to finalise some work, including ensuring the framework’s final calibration, before the GHOS can review the package of proposals. A meeting of the GHOS, originally planned for early January, has therefore been postponed. The Committee is expected to complete this work in the near future.

“Completing Basel III is an important step towards restoring confidence in banks’ risk-weighted capital ratios, and we remain committed to that goal,” said Mario Draghi, Chairman of the GHOS and President of the European Central Bank.

Stefan Ingves, Chairman of the Basel Committee and Governor of Sveriges Riksbank, said that the Committee will continue to work on outstanding details. “The Committee will keep working to finalise its reforms aimed at fixing shortcomings highlighted by the financial crisis to make banks safer and more resilient,” he stated.

About the Basel Committee and the GHOS

The Basel Committee comprises 45 members from 28 jurisdictions, consisting of central banks and authorities with formal responsibility for the supervision of banking business. The Committee reports to the central bank Governors and (non-central bank) heads of supervision from the Committee’s members

APRA releases final standard on the Net Stable Funding Ratio

The Australian Prudential Regulation Authority (APRA) has today released the final revised Prudential Standard APS 210 Liquidity (APS 210) and Prudential Practice Guide APG 210 Liquidity (APG 210) which incorporates, among other things, the Net Stable Funding Ratio (NSFR) requirements for some authorised deposit-taking institutions (ADIs).

APRA’s objective in implementing the NSFR in Australia for ADIs that are subject to the Liquidity Coverage Ratio (LCR), implemented in 2015, is to strengthen the funding and liquidity resilience of these ADIs.

The NSFR encourages ADIs to fund their activities with more stable sources of funding on an ongoing basis, and thereby promotes greater balance sheet resilience. In particular, the NSFR should lead to reduced reliance on less-stable sources of funding, such as short-term wholesale funding, that proved problematic during the global financial crisis.

The release of the final prudential standard and prudential practice guide on liquidity follows submissions received on APRA’s September response paper: Basel III liquidity – the Net Stable Funding Ratio and the liquid assets requirement for foreign ADIs. APRA has released today a letter addressing the issues raised in these submissions, while APRA’s final position also takes account of comments received in submissions to the initial March 2016 discussion paper on these matters.

APRA Chairman Wayne Byres said ‘the final policy settings will reinforce the steps that ADIs have taken to strengthen their funding profiles in recent years, and ensure that strengthening is sustained over the long term.’

In addition to addressing the Net Stable Funding Ratio requirements, the final APS and APG 210 released today also address a number of other changes noted in the September response paper. The new APS 210 will commence on 1 January 2018, while the new APG 210 replaces the existing APG 210 from today.

Liquid assets requirement for foreign ADIs
As noted in the September 2016 response paper, APRA will retain the 40 per cent LCR as the default liquid assets requirement for foreign ADIs, but allow foreign ADIs with simpler business activities to apply to use the alternative Minimum Liquidity Holdings (MLH) approach.

Background information

Q: What is the Net Stable Funding Ratio (NSFR)?
A: The NSFR is a quantitative global liquidity standard established by the Basel Committee on Banking Supervision that seeks to promote more stable funding of banks’ balance sheets. The standard establishes a minimum stable funding requirement based on the liquidity characteristics of an ADI’s assets and off-balance sheet activities over a one-year time horizon, and aims to ensure that long-term assets are financed with at least a minimum amount of stable funding.

Q: Why is APRA introducing the NSFR?
A: The NSFR seeks to promote more stable funding of banks’ balance sheets. As the Basel Committee on Banking Supervision noted, when announcing its new international liquidity framework in 2009, throughout the global financial crisis many banks had failed to operate with adequate liquidity and unprecedented levels of liquidity support were required in order to sustain the financial system. The crisis illustrated how quickly and severely liquidity risks can crystallise and certain unstable sources of funding can evaporate, compounding concerns related to the valuation of assets and capital adequacy.

Q: Which ADIs will the NSFR apply to?
A: The NSFR will apply to those locally-incorporated ADIs that are also subject to the Liquidity Coverage Ratio (LCR). There are currently 15 LCR ADIs:  AMP Bank; Arab Bank; Australia and New Zealand Banking Group; Bendigo and Adelaide Bank; Bank of China; Bank of Queensland; Citigroup; Commonwealth Bank of Australia; HSBC Bank; ING Bank; Macquarie Bank; National Australia Bank; Rabobank Australia; Suncorp-Metway; and Westpac Banking Corporation.

Q: Why is APRA only applying the NSFR to ADIs with the Liquidity Coverage Ratio (LCR)?
A: Non-LCR ADIs typically have simpler funding models with most of their balance sheet funded by their deposit base which is considered to be a more stable source of funding. Given the balance sheets of these ADIs will already be financed with significant amounts of stable funding, APRA does not consider there would be any additional benefits from the imposition of the formal NSFR framework for these ADIs.

A Reminder Of The Basel III Logic

To many, the required changes to capital under Basel III may seem obtuse and overly complex. So the timely speech given by Stefan Ingves, Governor of the Sveriges Riksbank and Chairman of the Basel Committee on Banking Supervision is worth reading. He gives a clear articulation of why Basel III exists. Crises are expensive and should be avoided, he says.

When financial crises afflict us it becomes obvious to all how much damage they cause. Unfortunately, this insight is often temporary, as it is easy – even a human survival instinct – to forget problems and leave them behind us. As a representative of the Basel Committee I therefore see it as an important task to remind you of how costly financial crises are to the national economy and how important it is that we have robust regulatory frameworks that reduce both the cost of crises and the probability that they will occur.

He showed this chart as a reminder of what happened after the GFC, as numerous and well know banks were bailed out.

why-basel-iiiHe also discussed the core assumption that increasing capital protects society, as well as the banks themselves.


A crucial cause of the most recent financial crisis was that banks around the world had taken on too much risk. This was possible for two reasons. Firstly, the regulatory framework applying at the time did not sufficiently influence the banks’ risk taking. Secondly, the banks themselves evidently did not have the will or ability to manage their risks on their own. The answer was the Basel III Agreement – a comprehensive package of reforms with the main purpose of strengthening the banks’ capital base to ensure that they can manage losses in a better way and improve the banks’ liquidity management.

In 2013, the Basel Committee therefore published a number of reports analysing what capital requirements the banks’ internal models generated. The reports show that there are major differences in the banks’ capital requirements. They also show that these differences cannot be explained by the differences in the underlying risk in their assets, but are instead due to the way the banks measure risk. The fact that this is so not only makes it difficult to compare capital requirements between the banks, it also reduces the credibility of the international capital regulations. The Committee’s current work therefore concerns to a large extent ensuring that the models used by the banks are reliable and reflect the risks in their operations in a correct manner.

This work includes revising and to some extent limiting the banks’ scope to use internal models to calculate their risk-weighted assets and thereby their capital requirements. For instance, the Basel Committee is planning to introduce floors for a number of the parameters the banks estimate themselves. The result of this is that we will see less difference in the banks’ capital requirements for assets with similar risk profiles. Let me make myself clear: The idea is not that we shall return to Basel I. The banks will be able to continue using internal models in their risk management. What the Committee’s current work concerns is instead bringing order to the risk-based system to increase the credibility of the capital requirements the banks have and to make it easier to compare them. Without this work, there is a risk of further erosion of confidence in the regulations.

Another important part of the Committee’s work involves modernising and developing standard methods so that they become more risk sensitive and thereby better adapted to banks with international operations. For many types of exposure, such as lending with property as collateral, the current standard measures often give the same risk weight regardless of the loan-to-value ratio. This will probably be changed so that the capital requirement varies according to the loan-to-value ratio. This work also covers trying to reduce the mechanical dependence on external credit ratings, which is in line with the objectives stated by G20.

Critics have expressed fears that the reforms I am talking about now will lead to minimum capital for certain banks increasing radically, which in turn risks resulting in a real economic decline. Here I would like to point out that the Basel Committee’s ongoing reform work does not aim to significantly increase the total global capital requirements.

Instead, it concerns ensuring that all banks around the world have adequate resilience to manage financial crises and that risks are covered by capital in a uniform way in all banks and all countries. One result of this exercise is that banks that currently have very low risk weights will probably face higher capital requirements, while banks with very high risk weights may face lower capital requirements. Designing a uniform global regulatory framework is not an easy task, particularly as banking systems differ from country to country, but also because we are living in a changing world. The Basel Committee’s work is therefore largely a question of finding compromises that all member countries can support and which will stand the test of time.