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.

Proposed UK Bank Capital Changes Are Credit Negative

From Moody’s.

Last Friday, the UK’s Prudential Regulation Authority (PRA) proposed a more flexible approach to determining Pillar 2A capital requirements for banks calculating risk-weighted assets (RWAs) according to the standardised approach. The PRA’s proposal aims to use Pillar 2A to reduce some of the variation between standardised risk weights and internal models outputs for similar risks, remove future duplication between IFRS 9 provisions for expected loss and the standardised approach, create incentives for smaller lenders to move away from higher risk mortgage lending and facilitate greater competition among UK banks.

We expect that the proposed changes will reduce the capital requirements for small banks and building societies, freeing up capital for further growth. However, in an already competitive market, with many smaller firms growing faster than the market, increased competition will negatively pressure margins and reduce profitability for all banks, a credit negative.

The proposal more closely aligns the RWAs calculated with the standardised approach and the internal ratings-based approach by allowing lenders the PRA deems adequately governed and well managed to benefit from lower Pillar 2A capital requirements if their loan portfolio is considered low risk. Disincentives would be created for higher-risk lending for which standardised risk weights are often equal to or lower than the upper band of the PRA’s internal ratings-based benchmarks. The PRA’s proposal follows the Competition Market Authority’s report recommending greater competition in the UK retail banking.

The proposal also seeks to address the potential for an effective double counting of expected loss that these firms may incur with the adoption of IFRS 9 on 1 January 2018, which would not have applied to lenders using the internal ratings-based approach.

We expect that the UK banks and building societies that we rate and which use the standardised approach will largely receive reduced Pillar 2A requirements under this proposal because of their focus on residential mortgages with limited high loan-to-value (LTV) exposures. These banks’ low-LTV and residential mortgage focus, as shown in Exhibit 1, means that they are likely to benefit from capital relief without significant incentives to change lending practices. However, all of these institutions have achieved material growth in their mortgage books over the past few years, targeting increases in volume to offset increasing margin pressure. We view negatively further incentives to foster growth for these firms through a relaxation of Pillar 2A capital requirements because doing so will weaken the affected banks’ stress capital resilience. Exhibit 2 shows banks’ reported common equity Tier1 capital ratios. We note that most of the affected banks we rate are already expanding their lending faster than the market, with annual growth of around 10% (excluding Yorkshire Building Society) in 2016, compared with 4% market growth.

We expect the PRA’s proposal to contribute to already-strong competition in the UK mortgage market, adding negative pressure to net interest margins, and negatively affecting the profitability of the banks we rate.

Affected firms are also likely to benefit from a lower minimum requirement for own funds and eligible liabilities (MREL) as a result of these proposals because of a reduction in the combined Pillar 1 and Pillar 2A capital requirements, reducing the loss-absorption capacity for creditors in the event of their failure. A subset of these firms, which have total assets in excess of £15-£25 billion, are likely to see the greatest MREL relief because they are subject to the strictest form of the requirements.

Latest Basel III monitoring results

The Basel Committee has published the results of its latest Basel III monitoring exercise based on data as of 30 June 2016 in a 65 page report. Virtually all participating banks meet Basel III minimum and target CET1 capital requirements as agreed up to end-2015. The report does not reflect any standards agreed since the beginning of 2016, such as the revisions to the market risk framework.

It also highlights that the capital build processes will continue as the higher targets come into force. Higher capital costs, and this will translate into higher loan rates as banks seek to preserve shareholder returns.

The report provides summary data for a total of 210 banks, comprising 100 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 110 “Group 2 banks” (ie banks that have Tier 1 capital of less than €3 billion or are not internationally active). It includes Australia’s “big four” banks and one other using data from APRA.

On a fully phased-in basis, data as of 30 June 2016 show that virtually all participating banks 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 the surcharges on G-SIBs, as applicable).

Between 31 December 2015 and 30 June 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 €5.5 billion to €3.4 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 30 June 2016 was €263 billion. In addition, applying the 2022 minimum requirements for Total Loss-Absorbing Capacity (TLAC), 18 of the G-SIBs in the sample have a combined incremental TLAC shortfall of €318 billion as at the end of June 2016, compared with €416 billion at the end of 2015.

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 126% on 30 June 2016, slightly up from 125% six months earlier. For Group 2 banks, the weighted average LCR was 155%, up from 148% six months earlier. Of the banks in the LCR sample, 88% of the Group 1 banks and 94% 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 114%, while for Group 2 banks the average NSFR was 115%. As of June 2016, 84% of the Group 1 banks and 86% of the Group 2 banks in the NSFR sample reported a ratio that met or exceeded 100%, while 98% of the Group 1 banks and 96% of the Group 2 banks reported an NSFR at or above 90%.

The results of the monitoring exercise assume that the positions as of 30 June 2016 were subject to the fully phased-in Basel III standards as agreed up to end-2015. That is, they do not take account of the transitional arrangements set out in the Basel III framework, such as the gradual phase-in of deductions from regulatory capital. Furthermore, the report does not reflect any standards agreed since the beginning of 2016, such as the revisions to the market risk framework (analysed separately in a special feature). No assumptions were made about bank profitability or behavioural responses, such as changes in bank capital or balance sheet composition. For that reason, the results of the study may not be comparable with industry estimates.

 

Basel III – The Net Stable Funding Ratio – FAQs Updated

The Basel Committee on Banking Supervision has issued the second set of frequently asked questions (FAQs) and answers on Basel III’s Net Stable Funding Ratio (NSFR).

This is a pretty technical document, but does guide readers through the complex rules. Once again it underscores the journey to complexity which the Basel Committee has been on.

To promote consistent global implementation of these requirements, the Committee periodically reviews frequently asked questions and publishes answers along with any necessary technical elaboration of the rules text and interpretative guidance. The Committee has received a number of interpretation questions related to the October 2014 publication of the NSFR standard. The FAQs published today correspond to the text set out in that standard.

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.