Basel III Implementation Status In Australia

The Basel Committee published its latest status report on Basel III implementation to end-September 2017 – the 13th progress report. This includes a status report on Australia:

There are areas (in red) where the deadline has passed, and as yet plans are not announced. Many other countries have red marks, but it is worth noting the Euro area is ahead of many other regions. Disclose is a major gap in Australia according to the committee.

APRA provided comments on the status.

It also, once again, highlights the complexity in the Basel framework. Here the overall Basel Committee statement summary.

As of end-September 2017, all 27 member jurisdictions have final risk-based capital rules, LCR regulations and capital conservation buffers in force. 26 member jurisdictions have issued final rules for the countercyclical capital buffers and for domestic systemically important banks (D-SIBs) frameworks.

With regard to the global systemically important banks (G-SIBs) framework, all members that are home jurisdictions to G-SIBs have final rules in force. 21 member jurisdictions have issued final or draft rules for margin requirements for non-centrally cleared derivatives and 22 have issued final or draft rules for monitoring tools for intraday liquidity management.

With respect to the standards whose agreed implementation date passed at the start of 2017, 20 member jurisdictions have issued final or draft rules of the revised Pillar 3 framework (as published in January 2015, ie at the end of the first phase of review), 19 have issued final or draft rules of the standardised approach for measuring counterparty credit risk (SA-CCR) and capital requirements for equity investments in funds, and 18 have issued final or draft rules of capital requirements for bank exposures to central counterparties (CCPs).

Members are now striving to implement other Basel III standards. While some members reported challenges in doing so, overall progress is observed since the previous progress report (as of end-March 2017) in the implementation of the interest rate risk in the banking book (IRRBB), the net stable funding ratio (NSFR), and the large exposures framework. Members are also working on or turning to the implementation of TLAC holdings, the revised market risk framework, and the leverage ratio. The Committee will keep on monitoring closely the implementation of these standards so as to keep the momentum in implementing the comprehensive set of the Committee’s post-crisis reforms.

Regarding the consistency of regulatory implementation, the Committee has published its assessment reports on all 27 members regarding their implementation of Basel risk-based capital and LCR standards.

Banks Pass Basel III Hurdle

The Basel Committee has published the results of its latest Basel III monitoring exercise based on data as of 31 December 2016. For the first time, the report provides not only global averages but also a regional breakdown for many key metrics. Data is included from 4 Australian “Group 1” banks and 1 “Group 2” bank.

Overall, banks now hold more capital, which is a good thing. Tier 1 capital ratios improved from 7.4% to 13.5%. In 2011 Tier 1 capital ratios were more than two percentage points lower in Europe and the Americas compared with the rest of the world. This relationship has now reversed.

  • Compared with the previous reporting period (June 2016) the average Common Equity Tier 1 (CET1) capital ratio under the fully phased-in Basel III framework has increased from 11.9% to 12.3% for Group 1 banks while is stable for Group 2 banks.
  • All Group 1 banks would meet the CET1 minimum capital requirement of 4.5% and the CET1 target level of 7.0% (ie including the capital conservation buffer). This target also includes the G-SIB surcharge where applicable.
  • There is no CET1 capital shortfall for Group 2 banks both at the minimum and target levels.
  • Applying the 2022 minimum requirements, 12 of the 25 G-SIBs reporting total loss-absorbing capacity (TLAC) data have a combined shortfall of €116.4 billion, compared with €318.2 billion at the end of June 2016.
  • Group 1 banks’ average Liquidity Coverage Ratio (LCR) improved by 5.0 percentage points to 131.4%, while the average Net Stable Funding Ratio (NSFR) increased from 114.0% to 115.8%. For Group 2 banks, the LCR and NSFR are more stable.
  • CET1 capital ratios for Group 1 banks have increased by 5.1 percentage points from 7.2% to 12.3% since June 2011, total capital ratios have increased by 6.6 percentage points from 8.7% to 15.3%.
  • Tier 1 capital ratios improved from 7.4% to 13.5%, mainly driven by increases in capital which more than offset a slight overall increase in risk-weighted assets (RWA).
  • In 2011 Tier 1 capital ratios were more than two percentage points lower in Europe and the Americas compared with the rest of the world. However, this relationship has reversed in the meantime. The reasons are twofold. First, the increase in capital since June 2011 was lower in Europe as compared to the other regions. Second, RWA fell for European Group 1 banks while RWA increased for banks in the Americas and, in particular, the rest of the world.
  • Since 2011, annual profits after tax have always been higher in the Americas and the rest of the world than in Europe.
  • Overall, around 20% of the profits have been generated by Group 1 banks in Europe, more than 30% in the Americas and almost half in the rest of the world.
  • Conversely, almost 60% of the CET1 capital raised has been raised by Group 1 banks in Europe.

Data have been provided for a total of 200 banks, comprising 105 large internationally active banks. These “Group 1 banks” are defined as internationally active banks that have Tier 1 capital of more than €3 billion, and include all 30 banks that have been designated as global systemically important banks (G-SIBs). The Basel Committee’s sample also includes 95 “Group 2 banks” (ie banks that have Tier 1 capital of less than €3 billion or are not internationally active).

The Basel III minimum capital requirements are expected to be fully phased-in by 1 January 2019 (while certain capital instruments could still be recognised for regulatory capital purposes until end-2021). On a fully phased-in basis, data as of 31 December 2016 show that all banks in the sample meet both the Basel III risk-based capital minimum Common Equity Tier 1 (CET1) requirement of 4.5% and the target level CET1 requirement of 7.0% (plus any surcharges for G-SIBs, as applicable). Between 30 June and 31 December 2016, Group 1 banks continued to reduce their capital shortfalls relative to the higher Tier 1 and total capital target levels; in particular, the Tier 2 capital shortfall has decreased from €3.4 billion to €0.3 billion. As a point of reference, the sum of after-tax profits prior to distributions across the same sample of Group 1 banks for the six-month period ending 31 December 2016 was €239.5 billion. In addition, applying the 2022 minimum requirements for Total Loss-Absorbing Capacity (TLAC), 12 of the G-SIBs in the sample have a combined incremental TLAC shortfall of €116.4 billion as at the end of December 2016, compared with €318.2 billion at the end of June 2016.

The monitoring reports also collect bank data on Basel III’s liquidity requirements. Basel III’s Liquidity Coverage Ratio (LCR) was set at 60% in 2015, increased to 70% in 2016 and will continue to rise in equal annual steps to reach 100% in 2019. The weighted average LCR for the Group 1 bank sample was 131% on 31 December 2016, up from 126% six months earlier. For Group 2 banks, the weighted average LCR was 159%, slightly up from 158% six months earlier. Of the banks in the LCR sample, 91% of the Group 1 banks (including all G-SIBs) and 96% of the Group 2 banks reported an LCR that met or exceeded 100%, while all Group 1 and Group 2 banks reported an LCR at or above the 70% minimum requirement that was in place for 2016.

Basel III also includes a longer-term structural liquidity standard – the Net Stable Funding Ratio (NSFR). The weighted average NSFR for the Group 1 bank sample was 116%, while for Group 2 banks the average NSFR was 114%. As of December 2016, 94% of the Group 1 banks (including all G-SIBs) and 88% of the Group 2 banks in the NSFR sample reported a ratio that met or exceeded 100%, while 100% of the Group 1 banks and 96% of the Group 2 banks reported an NSFR at or above 90%.

Note that in general, the estimates presented generally assume full implementation of the Basel III requirements as agreed up to end-2015 based on data as of 31 December 2016. The main part of this report does not reflect any standards agreed since the beginning of 2016, such as the revisions to the market risk framework which are presented separately in a special feature. No assumptions have been made about banks’ profitability or behavioural responses, such as changes in bank capital or balance sheet composition, either since this date or in the future. Furthermore, the report does not reflect any additional capital requirements under Pillar 2 of the Basel II framework, any higher loss absorbency requirements for domestic systemically important banks, nor does it reflect any countercyclical capital buffer requirements.

APRA On Basel and Local Standards

Wayne Byers spoke at The American Chamber of Commerce in Australia Business Briefing on International standards and national interests.

He described the current state of play with Basel III:

Although the core components of Basel III – a strengthening of the framework for bank capital, liquidity and funding – was agreed in 2010, the final points of detail still remain to be agreed. This is frustrating for regulators and banks alike. A decade on from the onset of the financial crisis, I don’t think anyone could say it is being rushed! And with a number of bank failures just in recent weeks in Canada, Italy and Spain, at a time when economic conditions are not particularly volatile, I also don’t think anyone could say the need to be vigilant about strengthening the financial system has diminished.

Although the finishing line for Basel III is in sight, we still haven’t yet found the alignment of interests that will allow the drafters to put down their pens and publish the final version. What is at the heart of the delay? Ultimately, it is the difficulty in aligning national interests with the common good. To have a common standard, all jurisdictions – and there are 27 of them at the Basel Committee table, represented by 45 individual agencies, who operate by consensus – are essentially agreeing to give up some degree of freedom as to their own domestic standard-setting. In many cases, this won’t be problematic since – as I will come back to in a minute – the minimum standard produced around the table in Basel will be lower than one would want to apply domestically. But in others it may involve a genuine trade-off between domestic considerations and the benefits of consistent international practice. Those trade-offs can be hard, even for experts, to measure and assess, let alone explain to non-experts.

The good news, though, is that the effort to find agreement continues. And it was pleasing to see the US Treasury, in its first report in response to the President’s Executive Order on financial regulation, acknowledge that ‘U.S. engagement in international financial regulatory standard-setting bodies remains important’3 and that it ‘supports efforts to finalize remaining elements of the international reforms at the Basel Committee…to strengthen the capital adequacy of global banks.’4 At a time when there is genuine concern about the potential for fragmentation of global financial markets, such statements can only be welcomed.

Nevertheless, I think the current work in Basel will largely mark the end of the cycle, and we are largely done when it comes to major new international standards.

But the question is how to implement locally. In Australia he says

APRA does not see any case for implementing a domestic regulatory framework that is less robust than the international norms. Australia cannot simultaneously rely more than most on cross-border funding, and seek to be exempted from some or all of the regulatory requirements applying in other parts of the world. In any event, even if we attempted to implement a weaker set of domestic rules, international markets and counterparties would hold Australian banks to the international standards and measures anyway. So we see little value in trying to stand apart from the rest of the world, claiming to know better.

But it is also true that international standards are not always settled in the exact form that we would prefer if we had complete freedom to write the rules ourselves. We have a seat at the table, and seek to use our influence to shape the final form of any agreement, but compromise is inevitably necessary.

And the standards should be higher than the minimum:

…even within international standards, there are often areas in which national discretion is granted. That is, the standard allows a choice, usually on narrow technical issues, that is deliberately and explicitly left to the domestic authority. In these cases, we can make a decision we think works best for Australian circumstances and, regardless of the decision taken, still be seen as in compliance with the international standard.

But the most important factor in balancing international standards and national interests is that, at least in the financial regulatory world, international standards are minimum standards. It is quite open to us to improve upon them, reflecting our own circumstances. In Australia, we have long taken the view that we should aspire to a higher standard of safety than provided by solely adhering to minimum Basel standards. In part that reflects the nature of our highly concentrated banking system, and also the lack of pre-funded deposit insurance. We seek to ensure that Australia’s banking system is considerably more resilient than has generally been the case for international banking in recent decades. It is all too evident that the incidence of banking crises has been too frequent, their costs have been extraordinarily high, and many communities around the world are still wearing the consequences. We think we should try to do better.

So this leaves the door firmly open for higher capital ratio in the approach which we expect soon. Worth remembering that every 1% uplift on capital for the majors costs around $15bn, or slightly more.  We think it is likely the majors will be required to hold more capital, either by way of a counter-cyclical buffer, or a change to the DSIB buffer.  We also think mortgage risk weights may continue to rise.

Any change will put further upward pressure on mortgage interest rates.  Worth too reflecting on the UK announcement, we covered this morning, there the Bank of England is lifting the counter-cyclical buffer by 1%, half now and half in November!

Basel III Status Update – Where Australia Stands

The Basel Committee on Banking Supervision has today issued the Twelfth progress report on adoption of the Basel regulatory frameworkThis included a status summary for Australian Banks and shows that there are substantial steps to be taken to complete the current implementation, yet alone responding to the APRA-led proposals for further capital reform, which we expect to be the result of a discussion paper expected later in the year.

The complexity of the Basel capital frameworks continues to grow.

This report sets out the adoption status of Basel III standards for each BCBS member jurisdiction as of end-March 2017. It updates the Committee’s previous progress reports which have been published on a semiannual basis since October 2011 under the Committee’s Regulatory Consistency Assessment Programme (RCAP).

The report shows that:

  • all 27 member jurisdictions have final risk-based capital rules, LCR regulations and capital conservation buffers in force;
  • 26 member jurisdictions have issued final rules for the countercyclical capital buffers;
  • 25 have issued final or draft rules for domestic systemically important banks (D-SIBs) frameworks and, with regards to the global systemically important banks (G-SIBs) framework, all members that are home jurisdictions to G-SIBs have final rules in force;
  • 20 have issued final or draft rules for margin requirements for non-centrally cleared derivatives.

Further, while some members have reported challenges in implementing the following standards for which the implementation dates have now passed, the report shows that:

  • 21 member jurisdictions have issued final or draft rules of the revised Pillar 3 framework;
  • 19 have issued final or draft rules of the SA-CCR and capital requirements for equity investments in funds;
  • 17 have issued final or draft rules of capital requirements for CCP exposures.

Member jurisdictions are now turning to the implementation of other Basel III standards, including those on TLAC holdings, the market risk framework, the leverage ratio and the net stable funding ratio.

The Basel III framework builds on and enhances the regulatory framework set out under Basel II and Basel 2.5. The attached table is designed to monitor the adoption progress of all Basel III standards, which will come into effect by 2019. The monitoring table no longer includes the reporting columns for Basel II and 2.5, nor those Basel III standards that have been implemented by all BCBS members (definition of capital, capital conservation buffer and liquidity coverage ratio).

  • The following aspects of the risk-based capital standards are still being implemented:
    o Countercyclical buffer: The countercyclical buffer is phased in parallel to the capital conservation buffer between 1 January 2016 and year-end 2018, becoming fully effective on 1 January 2019.
    o TLAC holdings: The TLAC holdings standard was issued by the Committee in October 2016. It applies to all banks and describes the prudential treatment for holdings of instruments that comprise TLAC for the issuing G-SIB. The standard will take effect from 1 January 2019.
    o Minimum capital requirements for market risk: In January, the Committee issued the revised minimum capital requirements for market risk, which will come into effect on 1 January 2019.
    o Capital requirements for equity investment in funds: In December 2013, the Committee issued the final standard for the treatment of banks’ investments in the equity of funds that are held in the banking book, which took effect from 1 January 2017.
    o SA-CCR: In March 2014, the Committee issued the final standard on SA-CCR, which took effect on 1 January 2017. It replaced both the Current Exposure Method (CEM) and the Standardised Method (SM) in the capital adequacy framework, while the IMM (Internal Model Method) shortcut method is eliminated from the framework.
    o Securitisation framework: The Committee issued revisions to the securitisation framework in December 2014 and July 2016 to strengthen the capital standards for securitisation exposures held in the banking book, which will come into effect in January 2018.
    o Margin requirements for non-centrally cleared derivatives: In September 2013, the Committee issued the final framework for margin requirements for non-centrally cleared derivatives. Subsequently, in March 2015, the Committee published a revised version. Relative to the 2013 framework, the revised version changes the beginning of the phase-in period for collecting and posting initial margin on non-centrally cleared trades from 1 December 2015 to 1 September 2016. The full phase-in schedule has been adjusted to reflect this nine-month change in implementation. The revisions also institute a six-month phase-in of the requirement to exchange variation margin, beginning 1 September 2016.
    o Capital requirements for bank exposures to central counterparties: In April 2014, the Committee issued the final standard for the capital treatment of bank exposures to central counterparties. These came into effect on 1 January 2017.
  • Basel III leverage ratio: In January 2014, the Basel Committee issued the Basel III leverage ratio framework and disclosure requirements. Implementation of the leverage ratio requirements began with bank-level reporting to national supervisors until 1 January 2015, while public disclosure started on 1 January 2015. The Committee will carefully monitor the impact of these disclosure requirements. Any final adjustments to the definition and calibration of the leverage ratio will be made by 2017, with a view to migrating to a Pillar 1 (minimum capital requirements) treatment on 1 January 2018 based on appropriate review and calibration.
  • Monitoring tools for intraday liquidity management: This standard was developed in consultation with the Committee on Payment and Settlement Systems to enable banking supervisors to better monitor a bank’s management of intraday liquidity risk and its ability to meet payment and settlement obligations on a timely basis. The reporting of the monitoring tools commenced on a monthly basis from 1 January 2015 to coincide with the implementation of the LCR reporting requirements.
  • Basel III net stable funding ratio (NSFR): In October 2014, the Basel Committee issued the final standard for the NSFR. In line with the timeline specified in the 2010 publication of the liquidity risk framework, the NSFR will become a minimum standard by 1 January 2018.
  • G-SIB framework: In July 2013, the Committee published an updated framework for the assessment methodology and higher loss absorbency requirements for G-SIBs. The requirements came into effect on 1 January 2016 and become fully effective on 1 January 2019. National jurisdictions agreed to implement the official regulations/legislation that establish the reporting and disclosure requirements by 1 January 2014.
  • D-SIB framework: In October 2012, the Committee issued a set of principles on the assessment methodology and the higher loss absorbency requirement for domestic systemically important banks (D-SIBs). Given that the D-SIB framework complements the G-SIB framework, the Committee believes it would be appropriate if banks identified as D-SIBs by their national authorities were required to comply with the principles in line with the phase-in arrangements for the G-SIB framework, ie from January 2016.
  • Pillar 3 disclosure requirements: In January 2015, the Basel Committee issued the final standard for revised Pillar 3 disclosure requirements, which took effect from end-2016 (ie. banks are required to publish their first Pillar 3 report under the revised framework concurrently with their year-end 2016 financial report). The standard supersedes the existing Pillar 3 disclosure requirements first issued as part of the Basel II framework in 2004 and the Basel 2.5 revisions and enhancements introduced in 2009.
  • Large exposures framework: In April 2014, the Committee issued the final standard that sets out a supervisory framework for measuring and controlling large exposures, which will take effect from 1 January 2019.
  • Interest rate risk in the banking book: In April 2016, the Committee issued the final standard for Interest Rate Risk in the Banking Book (IRRBB), which is expected to be implemented by 2018.

APRA releases consultation package on revisions to large exposures

Last week, APRA released a consultation draft aimed at reducing “contagion risk”. Banks would be required to limit their exposures to unrelated counterparties to 25 per cent of Tier 1 Capital and 15 per cent of Tier 1 Capital to exposures to a bank designated as a global systemically important bank. This would bring Australian banks into line with Basel recommendations.

The Australian Prudential Regulation Authority (APRA) has today released for consultation a discussion paper setting out proposed revisions to its prudential framework on large exposures for authorised deposit-taking institutions (ADIs).

APRA’s large exposure framework aims to limit the impact of losses when a counterparty defaults, and restrict contagion risk from spreading across the financial system.

The proposed revisions are intended to strengthen the supervisory framework for large exposures, reduce system-wide contagion risk and maintain an alignment to the Basel Committee on Banking Supervision’s large exposures standards.

The consultation package released today includes a draft revised Prudential Standard APS 221 Large Exposures (APS 221), as well as associated reporting standards, reporting forms and reporting form instructions.

The discussion paper proposes revisions to large exposure requirements, including that:

  • the limit to an unrelated ADI and their subsidiaries be reduced from 50 per cent of Total Capital to 25 per cent of Tier 1 Capital;
  • a new limit of 15 per cent of Tier 1 Capital be applied to exposures to a bank designated as a global systemically important bank, and to exposures between banks designated by APRA as domestic systemically important banks; and
  • new criteria apply to identifying a group of connected counterparties and measuring large exposure values.

APRA invites written submissions on the proposals in the discussion paper by Wednesday 5 July 2017.

APRA expects to release a response paper and its final revised APS 221 and associated reporting package in the second half of 2017.

APRA’s intention is that the revised large exposure requirements will come into effect from 1 January 2019, in line with the internationally-agreed timetable.

Basel Committee Guidelines on Prudential Treatment of Problem Assets

Moody’s says the newly released Basel Committee Guidelines on Prudential Treatment of Problem Assets Are Credit Positive for Banks.

Last Tuesday, the Basel Committee on Banking Supervision (BCBS) published Guidelines on the prudential treatment of problem assets (definition of nonperforming exposures and forbearance). The guidelines address the current absence of a common and internationally applicable definition of nonperforming exposures and forbearance and will help harmonize the definition and treatment of banks’ problem loans, a credit positive for banks.

Uniformity across jurisdictions and banks will reduce discrepancies in the recognition and treatment of problem assets. Uniformity will also make international comparisons of banks’ nonperforming exposures, loss recognition and provisioning less challenging.

The BCBS definition of nonperforming exposures is not a substitute for the regulatory classification of defaulting assets and the accounting definition of impaired assets, but supplements these other designations. The BCBS definition extends the nonperforming categorization to all exposures (excluding trading book and derivatives) that are more than 90 days past due or where there is evidence that a full repayment is unlikely.
The scope is wider than under regulatory standards, where default is recognized only after 180 days past due for exposures secured by real estate and exposures to the public sector. It also goes beyond the accounting concept of credit-impaired exposures defined in International Financial Reporting Standard No. 9.5 In addition, nonperforming exposures can be re-categorized as performing only after standards on debt repayment and a debtor’s creditworthiness are met. The re-categorization rule will increase the stock of nonperforming exposures for some banks under this measure.

As shown in the exhibit below, forbearance is defined as a concession granted on exposures where counterparties have financial difficulties, and which the bank would not otherwise have considered. Concessions can take various forms, including extension of term, rescheduling and interest rate reduction. Forbearance is a newly identified concept that can apply to performing or nonperforming exposures. A forborne exposure can return to normal status only if all payments have been made during a probation period of one year and the debtor has resolved its financial difficulty.

In the European Union (EU), similar standards became effective in September 2014. The implementation of these new standards was a critical step in the recognition and treatment of problem assets by EU banks. At the implementation date, the ratio of nonperforming exposures on gross loans published by EU banks was 7%, one percentage point higher than the ratio of impaired and past-due loans, and subsequently decreased to 5.1% in December 2016. The ratio of forborne exposures was 3.2% as of the same date.

An international standard for nonperforming and forborne exposures will require cross-border banks to implement a common definition of problem assets, forcing them to address rising risks in timely manner. It will translate into some disclosure requirements whereby banks will have to publish amounts of nonperforming and forborne exposures, allowing market participants to compare banks’ problem assets, risk provisioning and credit loss recognition. This guideline is key for a harmonized framework to assess asset risk, but it does not address other sources of discrepancies, such as the definition of default, which makes the comparison of banks’ risk-weighting calculation challenging.

APRA Looking At Capital Ratios For Mortgages

Wayne Byres speech “Fortis Fortuna Adiuvat: Fortune Favours the strong”, as Chairman of APRA, at the AFR Banking & Wealth Summit, makes two significant points.

First, there are elevated risks in the residential lending sector (even after the recent tactical announcements on interest only loans). Banks remain  highly leveraged businesses.

Second, despite the delays from Basel, APRA will consult this year on potential changes to the capital ratios, reflecting the Australian Banks’ focus on mortgage lending and the need to be “unquestionably strong”.

A further indication that mortgage costs will continue to rise!

In the past few days, there has been a great deal of attention given to our recent announcement on additional measures to strengthen one particular part of the financial system: the residential mortgage lending market. These measures build on the steps we have taken over the past two years to bolster loan underwriting practices and moderate investor lending, in an environment that we considered to be one of heightened risk.

Those measures had a positive impact (Chart 1), but at the same time the risk environment certainly hasn’t moderated:

  • house prices remain high;
  • household income growth remains subdued;
  • the already high ratio of household debt to income has got higher;
  • the already low official cash rate has got lower (although not all of this reduction has flowed to borrowers, particularly investors; and
  • competitive pressures haven’t diminished.

It’s important to be clear that our goal in implementing the additional measures we announced on Friday is not to determine house prices. Housing prices are not within the control, nor the mandate, of the prudential regulator. Nor, as the Reserve Bank Governor said last night, can prudential measures address underlying supply-demand issues within the housing market. Rather, our role in the current environment is to promote a higher-than-normal degree of prudence – definitely by lenders and, ideally, also borrowers – in both credit decisions and balance sheet strength. On this occasion, we have focussed on interest-only lending to complement our earlier measures. Although there are perfectly legitimate reasons why individual borrowers might prefer an interest-only loan, in aggregate the level of interest-only lending creates additional vulnerabilities and we came to the view some additional moderation in this area was warranted.

We chose not to lower the investor lending growth benchmark at this point in time, given the need to accommodate the increasing supply of housing in the construction pipeline. However, limitations on the volume of new interest-only lending will impact investors more acutely than owner-occupiers, given that around two-thirds of lending to investors is on an interest-only basis. Furthermore, although the 12-month annual growth rate for investor lending is currently below the 10 per cent benchmark, the run rate in more recent months has been closer to (if not a little above) 10 per cent on an annualised basis. Therefore, even with the benchmark unchanged, lenders are still likely to have to tighten their lending practices and slow lending from that in recent months to ensure they remain comfortably below the desired level.

This latest step is a tactical response to current market conditions – we can and will do more (or less) as conditions evolve. We also developing a more strategic response that recognises that, in the Australian banking system, housing lending risks and capital adequacy are far from independent issues.

The banking system certainly has higher capital adequacy ratios than it used to. But overall leverage has not materially declined. The proportion of equity that is funding banking system assets has improved only modestly, from a touch under 6 per cent a decade ago to just on 6½ per cent at the end of 2016. Notwithstanding the extra capital that new regulation has required, banking remains a highly leveraged business.

Unquestionably strong

One way to think about our objective in establishing ‘unquestionably strong’ capital requirements is that we should be able to assert, with credibility, that the banking system can withstand reasonably foreseeable adversity and continue to provide its core function of financial intermediation for the Australian community.

Unfortunately, there is no universal measure of financial strength that provides a clear cut answer to that test. So we need to be able to look at this question through multiple lenses. In thinking about the concept of ‘unquestionably strong’, there are three basic ways to do that:

  • relative measures: the FSI adopted a relative approach in suggesting that unquestionably strong regulatory capital ratios would be positioned in the top quartile of international peers. We have said on a number of occasions that we do not intend to tie ourselves mechanically to some particular percentile, but top quartile positioning is a useful sense check which we can certainly use to guide our policy-making.
  • alternative measures: regulators do not have exclusive domain over measures of financial strength. There are a range of alternative measures, such as those used by rating agencies, which can be used to benchmark Australian banks. Again, we do not intend to tie ourselves too closely to these measures, but it would be difficult to argue the banking system is unquestionably strong if alternative measures of capital strength, particularly those that are influential in investment decision-making, were to suggest something to the contrary.
  • absolute measures: relative and alternative measures are useful guides, but the real test for a bank to claim it is unquestionably strong is whether it can comfortably survive extreme but plausible adversity. So stress testing, which doesn’t rely on relativities with other banks, or competing measures of strength, provides another useful guide for us.
    Using multiple measures will provide useful insights on the banking system’s strength, but unfortunately will be unlikely to give us a single ‘right’ answer. At best it will provide a range for possible calibration which would reasonably meet our objective that, whichever lens you look through, we can credibly claim to have capital standards that produce an unquestionably strong banking system. We will still need to exercise judgement, taking account of other dimensions of risk within the system – both quantitative (such as liquidity and funding) and qualitative (such as risk management and risk culture within banks, and the strengths of the statutory framework and crisis management powers on which the stability of the system is built). Inevitably, some will argue the calibration should be higher, and others think it too high, but at the very least our logic and rationale should be transparent, and we can readily explain how our decisions are consistent with the FSI’s intent.

As things stand today, our plan is to issue an information paper around the middle of the year, which will set out how we view the banking system through the various lenses that I have just mentioned, the extent of further strengthening required, and the timeframe over which that can be achieved in an orderly manner.

Beyond establishing the aggregate level of capital, we will need to follow that up with consultation on how the regulatory framework should allocate that capital across the different types of risk exposure. Some of those changes will flow from the inevitable direction of the work in Basel that I referred to earlier: this will include, for example, greater limitations on the use of internal credit risk models, and the inevitable removal of operational risk models. These changes will primarily impact the larger banks.

But, coming back to my starting point, probably the biggest issue we will need to resolve in ensuring capital is appropriately allocated is whether and how we adjust the risk weights for housing-related exposures. Our announcement last week reflected a tactical response to current conditions in the housing market. We will continue to refine these sorts of measures as long as they are needed. But a longer term and more strategic response will involve a review, during the course of our work on ‘unquestionably strong’, of the relative and absolute capital requirements for housing exposures. That should not be taken to imply that there will be a dramatic increase in capital requirements for housing lending: APRA has always imposed capital requirements for housing exposures that are well above international minimum standards, so we do not start with glaring deficiencies. By anyone’s standard, however, we have a banking system that has a notable concentration in housing. It is therefore important we give that issue particular attention as we think about how to put the concept of ‘unquestionably strong’ into practice.


Basel Committee’s Adverse Assessment of G-SIBs Risk-Reporting Practices Is Credit Negative

Moody’s says last Tuesday, the Basel Committee on Banking Supervision reported that most global systemically important banks (G-SIBs) have an unsatisfactory level of compliance with the Basel Committee’s principles for effective risk data aggregation and risk reporting.

This assessment is credit negative for G-SIBs because it signals that most still do not have the appropriate quality of risk management practices and decision-making processes that the Basel Committee identified as important following the 2007-09 global financial crisis. The Basel Committee indicated that it is critical for banks and their supervisors to make the full and timely implementation of its principles a priority.

The Basel Committee cited a wide range of examples in which G-SIBs failed to meet the principles. These examples include the following:

  • A lack of structured policies and frameworks to consistently assess and report risk data aggregation and risk reporting implementation activities to the board and senior management.
  • Risk data aggregation and risk reporting policies not approved or fully developed across the global organization.
  • Incomplete IT infrastructure projects aimed at improving data quality and controls by unifying disparate or legacy IT systems
  • Various data quality control deficiencies in areas such as reconciliation, validation checks and data quality standards.
  • Treating implementation of the principles as a onetime compliance exercise rather than a dynamic and ongoing process.
  • Incomplete integration and implementation of bank-wide data architecture and frameworks (e.g., data taxonomies, data dictionaries and risk data policies).
  • An overreliance on manual processes and interventions to produce risk reports, which risk inhibiting a G-SIB’s ability to produce reports quickly in crisis situations.
  • Difficulties in executing and managing complex and large-scale IT and data infrastructure projects, such as resources and funding issues and deficiencies in project management.
  • Static risk management reporting frameworks that do not take full account of strategic planning decisions such as risks pertaining to merger and acquisition activities.
  • An inability to monitor emerging trends through forward-looking forecasts and stress tests.

According to the Basel Committee, half of the G-SIBs were materially non-compliant with, or had not implemented, the principle for the design, building and maintenance of a data architecture and IT infrastructure that fully supports risk data aggregation capabilities and risk-reporting practices. More than half of the G-SIBs involved in the Basel Committee’s assessment were largely or fully compliant with each of the other principles. The report provides details of compliance among the G-SIBs but does not identify specific compliance details of each G-SIB.

The Basel Committee’s report focused on 30 global banks from around the world that were designated as G-SIBs in 2011 or 2012 and which were subject to a January 2016 implementation deadline.

The key challenges that G-SIBs faced when implementing the principles were technical issues and problems determining materiality thresholds. Only one G-SIB achieved full compliance with all principles by the January 2016 deadline, and the committee expected another to have achieved full compliance by the report’s publication date last Tuesday. The Basel Committee expects 24 G-SIBs to achieve full compliance by the end of 2018, while it does not expect four to be fully compliant until a later date.

Supervisors plan to communicate details of the assessment results to G-SIBs’ boards of directors and senior management by June 2017. Supervisory measures that are available include requests for specific remediation action plans and deadlines, independent reviews, increasing supervisory intensity, imposing capital add-ons and restricting business activities.

Enhancements to the Basel Pillar 3 Disclosure Framework Released

The Basel Committee on Banking Supervision has issued Pillar 3 disclosure requirements – consolidated and enhanced framework. This standard represents the second phase of the Committee’s review of the Pillar 3 disclosure framework and builds on the revisions to the Pillar 3 disclosure published by the Committee in January 2015.

The Pillar 3 disclosure framework seeks to promote market discipline through regulatory disclosure requirements. The enhancements in the standard contain three main elements:

  • Consolidation of all existing BCBS disclosure requirements into the Pillar 3 framework – These disclosure requirements cover the composition of capital, the leverage ratio, the Liquidity Coverage Ratio (LCR), the Net Stable Funding Ratio (NSFR), the indicators for determining globally systemically important banks (G-SIBs), the countercyclical capital buffer, interest rate risk in the banking book and remuneration.
  • Two enhancements to the Pillar 3 framework – This standard introduces a “dashboard” of a bank’s key prudential metrics which will provide users of Pillar 3 data with an overview of a bank’s prudential position, and a new disclosure requirement for those banks which record prudent valuation adjustments (PVAs) to provide users with a granular breakdown of how a bank’s PVAs are calculated.
  • Revisions and additions to the Pillar 3 standard arising from ongoing reforms to the regulatory policy framework – This standard includes new disclosure requirements in respect of the total loss-absorbing capacity (TLAC) regime for G-SIBs issued in November 2015, and revised disclosure requirements for market risk arising from the revised market risk framework published by the Committee in January 2016.

Note that this standard does not include disclosure requirements arising from the Committee’s ongoing finalisation of the Basel III reforms. Disclosure requirements agreed by the Committee following the issuance of this standard will be included within the scope of the third phase of the review of the Pillar 3 framework.

The standard incorporates feedback from Pillar 3 preparers and users collected during the public consultation conducted in March 2016. Clarifications have been made relating to the disclosure requirements, in particular those pertaining to TLAC.

The implementation date for each of the disclosure requirements is set out in the standard. In general, the implementation date for existing disclosure requirements consolidated under the standard will be end-2017. For disclosure requirements which are new and/or depend on the implementation of another policy framework, the implementation date has been aligned with the implementation date of that framework

RBNZ Announces Banking Capital Review

The New Zealand Reserve Bank has announced a review on Bank Capital.

They plan to release a high level Issues Paper in April, outlining the areas of the capital framework that the Reserve Bank intends to examine, followed by more detailed consultation papers. They will be seeking stakeholders’ views in three broad areas: what sorts of capital instruments should qualify (the numerator); how risk exposures should be measured (the denominator); and the minimum capital ratios and buffers.

The Issues Paper will request stakeholders’ initial views on the areas we intend to cover and issues that might warrant particular attention. Further consultation documents with options for changes to the framework and recommended policy positions will be targeted for the third quarter. They plan to conclude the Review by the first quarter of 2018.

The Purpose of the Review

The aim of the Capital Review is to identify the most appropriate regulatory framework for setting capital requirements for New Zealand banks. Consistent with the Reserve Bank’s legislative purposes, minimum capital requirements should promote the maintenance of a sound and efficient financial system.  In broad terms, higher levels of capital will improve the soundness of the financial system as the likelihood of bank failures is reduced and the potential impact of credit cycles is moderated.

However, the capital regime may reduce the efficiency of financial intermediation if ratios are pushed too high or standards are made overly complex. Capital is a more expensive form of funding for the banks and so higher capital ratios can potentially increase the overall cost of funding the system as well as improving its soundness.

Our aim is to agree a capital regime that ensures a very high level of confidence in the solvency of the banking system, while avoiding unnecessary economic inefficiency.

In pursuing this objective, the Capital Review will look at the three key components of the regulatory capital regime:

  • The definition of eligible capital instruments
  • The measurement of risk, in particular the risk weights attached to credit exposures
  • The minimum capital ratios and buffers

These three factors are interdependent and the links between them must be carefully considered. The calibration of the capital ratios needs to be set in the context of the risk weights applying to exposures as well as the capacity of eligible capital instruments to absorb losses. Also, the role of capital buffers versus hard minimum requirements needs to be considered.

The Capital Review will examine how well the Reserve Bank’s current framework operates and consider potential improvements. The Reserve Bank will consult the banks and the public on its findings and on any proposed changes to the capital framework.

Outcomes of the Review will be heavily influenced by the international regulatory context, the risk characteristics of the New Zealand system and the Reserve Bank’s regulatory approach.

New Zealand domestic context

The Capital Review will assess how our future capital framework might be shaped by domestic considerations. These relate to New Zealand’s risk profile, the shape of our financial system and also our regulatory approach.

New Zealand’s exports are concentrated in a small number of commodity-based sectors which can be subject to considerable price volatility. Bank exposures to commodity export industries are a key risk in the domestic system. Residential mortgage exposures are also a major source of risk given the system’s heavy exposure to housing and the capacity for house prices to become very stretched – as at present.

New Zealand is a net debtor country, having run current account deficits continuously over the past 40 years. About half of the country’s gross external debt is issued by the New Zealand banking system which then on-lends to businesses and households.  This reliance on external funding is an important vulnerability of the New Zealand system, as starkly demonstrated during the GFC. While liquidity buffers must be the first line of defence against funding market disruptions, a strongly capitalised system also helps to mitigate the risk of reduced market access.

New Zealand’s financial system is less diversified relative to peer countries. Financial intermediation is concentrated in a few large institutions and capital markets play a relatively minor role.

Rating agency risk assessments of the large New Zealand banks is heavily influenced by expectations of support from the Australian parent banks. Under the S&P regime, this factor lifts the ratings of the large New Zealand banks by an average of 4 notches from BBB+ on a standalone basis, to AA- , the rating applied to the Australian parents. While the implicit support of the parent banks is valuable for the New Zealand system, it is also a vulnerability. For example, in recent times the Australian parent banks have been on negative outlook and, separately, APRA has placed restrictions on the ability of the parent banks to give credit support to their international subsidiaries. Should implicit parental support be eroded, it is important that our banks be seen as strong on a standalone basis in order to maintain their international standing.

The Capital Review will draw on the emerging international literature on optimal capital and include an assessment of optimal capital that takes account of New Zealand-specific characteristics. The final calibration of capital requirements will also take account of the results and insights from bank stress-testing and other analytical work we are undertaking in support of the Capital Review.