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.

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.

Analysis of Mortgage Risk Under Basel

The Bank of England just published a staff working paper “Specialisation in mortgage risk under Basel II“.  Lenders using the less sophisticated risk models (generally smaller banks) are found to have a higher concentration of higher-risk mortgages than those using the advanced models.

They looked at the two models which were introduced under Basel II, lenders’ internal models (IRB) and the less risk-sensitive standardised approach (SA) by using a dataset covering 7 million UK mortgages from 2005-15. The switch to Basel II gave lenders using IRB models a comparative advantage in capital requirements (compared to lenders using the SA approach), particularly at low loan-to-value (LTV) ratios, and this was reflected in prices and quantities. They concluded:

First, mortgage risk is concentrated in lenders using the SA approach, which is typically used by smaller lenders, suggesting a potential higher failure rate than among IRB banks.

Second, macroprudential tools may affect the strength of the specialisation mechanism. This should be accounted for in calibrating such tools.

Third, they validate the view from competition authorities who have identified the cost of adopting IRB as a potential barrier to entry and expansion. IRB provides a competitive advantage in low LTV ratio mortgages.

Finally, the effect, is not specific to the mortgage market and this needs  further research.

IRB risk weights increase with the LTV ratio, the main indicator for credit risk used by UK mortgage lenders. In contrast, SA risk weights are fixed at 35% for LTV ratios up to 80%, and are then 75% on incremental balances above the 80%

LTV threshold. IRB risk weights tend to be lower than SA risk weights across most LTV ratios, but the gap is larger for lower LTV ratios. In 2015, the gap between the average IRB risk weight and the SA risk weight was about 30 percentage points for LTV ratios below 50%, compared to less than 15 percentage points for LTV ratios above 80%. The scale of variation in risk weights between IRB lenders is smaller than the gap between the IRB average and SA risk weights, at least at lower LTV ratios.

IRB lenders gain a comparative advantage in capital requirements compared to SA lenders, particularly at low loan-to-value (LTV) ratios. This comparative advantage is reflected in prices and quantities.

We expect all lenders to price lower for lower LTV mortgages. But under Basel II versus I, IRB lenders did so by 31 basis points (bp) more, and increased the relative share of low-LTV lending in their portfolios by 11 percentage points (pp) more, than SA lenders. Such specialisation leads to systemic concentration of high risk (high LTV) mortgages in lenders who tend to have less sophisticated risk management.

With an average 30 percentage point gap between IRB and SA risk weights for LTV ratios below 50%, this corresponds to an economically significant price advantage of 30bp. From the perspective of a typical borrower at this LTV level, with a 50% LTV mortgage against a $200,000 property, repayable over a remaining 15 year term, 30bp translates to around $170 per year or 0.7% of median household disposable income. From the lender’s perspective, a 30bp disadvantage translates to several places in `best buy’ tables, and thus likely material loss of market share.

If instead of risk weights we consider directly the variation in capital requirements, which is driven by both risk weights and lender-specific capital ratio requirements, a 1pp reduction in capital requirements causes a 6bp decrease in interest rates. These latter results can also be interpreted as `pass-through’ rates from lender-specific changes in risk weights or capital requirements to prices, subject to limits on external validity due to the Lucas critique.

Finally, we find that the pass-through from capital requirements to prices is significant only when lenders have low capital buffers (the surplus of capital resources over all regulatory requirements). Lenders with a buffer below 6pp of risk-weighted assets increase prices by 1.7bp basis point for a 1pp increase in risk weights.

Note: Staff Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Any views expressed are solely those of the author(s) and so cannot be taken to represent those of the Bank of England or to state Bank of England policy. This paper should therefore not be reported as representing the views of the Bank of England or members of the Monetary Policy Committee, Financial Policy Committee or Prudential Regulation Authority Board.

APRA On Securitisation – Will It Benefit Smaller Players?

APRA says their recent changes to securitisation will enable a much larger funding-only market and so provide ADIs the opportunity to strengthen their balance sheet resilience by accessing new sources of term funding, hopefully at relatively attractive pricing. In addition, with the more straight-forward approach to achieving capital relief, securitisation can also be valuable for capital management purposes, perhaps this is particularly so for smaller ADIs and this may bring benefits to the competitive environment. So said Pat Brennan, Executive General Manager APRA,  when he spoke at the Australian Securitisation Forum Conference, Sydney and discussed the recent changes to the updated prudential standard APS 120 Securitisation (APS 120), and an associated prudential practice guide.

apra-pic

This marks the culmination of some five years of policy formulation, and APRA’s updates on progress over this period have featured prominently at previous ASF gatherings.

In all prudential policy development APRA is guided by its statutory mandate: to balance the objectives of financial safety and efficiency, competition, contestability and competitive neutrality – and in doing so, promote financial system stability.  In addition, when finalising the prudential settings for securitisation APRA also remained true to the principles that guided the policy development process throughout:

  • to facilitate a much larger, simple and safe, funding-only market;
  • to facilitate an efficient capital-relief securitisation market; and
  • to have a simpler and safer prudential framework.

Over the last five years APRA’s policy deliberations were greatly assisted by the active engagement of industry in the consultation process. This was both through the ASF and bi-laterally, through formal submissions and informal meetings.  It seems fitting at this point to reflect back on this process and note some key aspects of how policy evolved through the consultation process. I will then make a few comments thinking of the role of securitisation looking forward.

Funding only securitisation

Let me start with the subject of the first principle I noted – funding-only securitisation – that is where an Authorised Deposit-taking Institution (ADI) is not seeking capital relief, rather the focus is on accessing term funding to support their lending activities.

Early in the consultation process APRA had serious reservations regarding date-based calls when combined with a bullet maturity structure. Whilst contractually in the form of an option, such a feature may create an expectation that repayment will definitely occur on the stated date regardless of circumstances. This represents a prudential risk should investors be allowed the ‘best of’ either repayment from the underlying pool of loans or from the originating ADI. This type of arrangement is allowed in the case of covered bonds, but controlled within a legislative limit. To allow a proliferation of other covered bond-like arrangements would be imprudent.

Through consultation industry clearly articulated the benefits of bullet maturity structures:

  • with their more certain cash-flow structures, a much broader range of investors can be accessed;
  • hedging costs for ADIs are reduced, possibly materially so; and
  • these factors clearly support a much larger funding-only market.

Industry also accepted that the prudential risk can be managed by the requirements of APS 120, but also through the approach taken by ADIs. Specifically, an ADI should create no impression that the call is anything other than an option for the ADI, and that a call is only exercised when the underlying assets are performing. To put it plainly: an ADI must never bear losses that are attributable to investors.

The finalised APS 120 therefore facilitates bullet structures – this is probably the most significant single development in APRA’s securitisation reforms and is the product of constructive consultation and careful consideration by APRA of how to strike the best balance of the various elements of its mandate.

Tranching

Moving on, many in this room will recall APRA’s early aspiration for a simple, two-class structure with substantially all the credit risk contained in the lower ranking tranche. Such a structure would avoid the problems of complexity and opaqueness associated with securitisation – problems that manifested so clearly through the global financial crisis.

In a general sense simplicity is good – but finance is often not simple. Industry feedback was clear – the concept of a two-class structure has significant shortcomings as the risk preferences of investors in subordinated tranches are varied, and to have an active capital-relief securitisation market greater risk-differentiation, and therefore tranching, is necessary. APRA heard this not only from ADIs but other industry participants as well, including investors – and we were convinced.

As a result APRA has relaxed its approach regarding the number of tranches, though we hope industry will not pursue complexity for complexity’s sake – this is a trap structured finance has fallen into before, with unhappy outcomes.

As a side note, and one that applies much more broadly than securitisation, at times there is a need to consider how things may be, and not be unnecessarily anchored to the current reality we are familiar with. When APRA embarks on this type of consultation it can, on occasion, open possibilities for better outcomes, outcomes that were not previously contemplated, perhaps also bringing opportunities for industry innovation. Policy reform by its very nature is about changing the status quo and industry needs to acknowledge that just because something has traditionally been done a certain way is not, in itself, an argument that it should always be so.

Risk retention

Risk retention is another area where consultation lead to a significant change in APRA’s thinking. Whilst the originate-to-distribute model has not been prevalent in Australia, APRA’s early view was that if there was to be a risk retention requirement it should be set at a level that will truly make a difference and bring alignment of interests between originators and investors.  We proposed a level of 20 per cent. At the time there was also an expectation that international practices would be broadly consistent.

As time progressed a variety of skin-in-the-game requirements emerged internationally, generally set at lower levels. Assisted by industry feedback APRA reflected that an Australian requirement, in addition to the varied international requirements, would add regulatory burden for limited prudential benefit. So when balancing APRA’s mandate in the context of the feedback received through consultation, we placed greater weight on efficiency considerations and hence did not implement a risk retention requirement.

Capital requirements

Whilst APRA’s securitisation reforms relate mainly to ADIs as issuers, we are also naturally interested in the amount of capital ADIs hold for their securitisation exposures. We have updated capital requirements following the Basel Committee’s framework, but with adjustments reflecting the Australian context and in light of APRA’s objectives.

Once such adjustment is that APRA has not implemented the approach involving the use of internal models for setting regulatory capital requirements. Instead APRA has implemented the remaining two approaches from the Basel framework: an approach based on external ratings and a standardised approach. Whilst many in industry would have preferred APRA to allow the use of internal models, as we have implemented the risk weight floor of 15 per cent this considerably limits the potential differences in outcomes. This is because a floor of 15 per cent is likely to have been applied to the majority of securitisation exposures if internal models were used, reflecting the relatively high credit quality of the underlying loans. In addition, not implementing the internal models approach is consistent with the objective to have a simpler and safer prudential framework.

A second adjustment is APRA’s requirement that an ADI deducts holdings of subordinated tranches from their own capital. There is frequent comment on APRA’s conservative approach to capital settings throughout the prudential framework. The Basel framework sets minimum standards and the relevant authorities around the globe are expected to set higher standards where they see this as being appropriate – Australia is not alone in setting conservative standards. In the Australian context, with the majority of ADI assets being residential mortgage loans, APRA’s view is there is substantial potential risk in having any incentive in the prudential framework for ADIs to hold the more risky tranches of other originator’s securitisations.

After the lengthy and detailed consultation, APRA is firmly of the view the principles underlying these adjustments are appropriate. I note that, as a result of the consultation process, APRA did relax the level at which the deduction approach applies as industry outlined that with limited additional risk certain common securitisation structures will be viable for ADIs to use if such a relaxation was applied.

Warehouse arrangements

Throughout the process of reforming APRA has been motivated to remove the current unsustainable situation that can arise through warehouse arrangements where capital leaves the banking system with no reduction in risk in the system. In 2014 APRA proposed that a concession remain, but be limited in time to a period of one year.  This proposal proved unpopular with industry, which APRA found a little surprising at the time given it was designed to retain the concession in full for a year, and we anticipated this would be economically attractive over at least a two year period. Nevertheless, industry feedback was clear and negative.

In 2015 we put this subject back to industry to propose potential solutions, noting that in the absence of any viable option being identified APRA would simply treat warehouses as any other securitisation – either capital relief or funding only depending on the degree to which each arrangement meets the relevant requirements.

The feedback we received generally asked for the existing concession to remain indefinitely, and as APRA had said, that was unsustainable. So on warehouses, the consultation process did not offer any viable alternatives.

The final APS 120 accommodates warehouses, but with no special treatment when compared to other forms of securitisation. APRA hopes that efficient funding structures are agreed between market participants so the benefits of warehouse arrangements can continue.

From these examples you can see that the final form of APS 120 is different to how it would have appeared if it was finalised even just two years ago, and very different to how it would have appeared if it was finalised a year or two prior to that. APRA has materially changed some policy positions and modified others as a direct result of consultation. In a few areas, where the prudential stakes were sufficiently high, APRA did not change its basic position – though the consultation process brought healthy challenge to APRA’s approach and caused us to consider aspects of the policy from a new perspective. In both cases – where policy was changed and where it was not – a constructive consultation process proved essential to arrive at the best possible prudential policy.

Looking forward we all hope to see the Australian securitisation market grow and prosper. Having a much larger funding-only market would provide ADIs the opportunity to strengthen their balance sheet resilience by accessing new sources of term funding, hopefully at relatively attractive pricing. With the more straight-forward approach to achieving capital relief, securitisation can also be valuable for capital management purposes, perhaps this is particularly so for smaller ADIs and this may bring benefits to the competitive environment.

APRA is soon to finalise the Net Stable Funding Ratio (NSFR) to be applied to 15 larger, more complex ADIs, and this is expected to be implemented in 2018 alongside the securitisation reforms. The Australian banking system has some notable features that are not very common around the globe. On the asset side the banking system essentially funds lending for housing on its collective balance sheet, whilst on the liability side the Australian banking system has a relatively low deposit to loan ratio. Whilst the affected ADIs are reasonably well placed to meet the NSFR requirement, new opportunities to strengthen funding profiles will assist in strengthening this measure over time – and this strengthening will make the system more resilient.

Whilst a much larger Australian securitisation market depends on market forces, which have ebbed and flowed considerably in recent years, it seems certain that over time opportunities to grow the market will present themselves.  The updated prudential framework, and accommodating bullet maturity structures in particular, places ADIs well to take advantage of those opportunities as they arise.

A Revised Basel Framework – State of Play

We have an update on the Basel Committee’s work to finalise the global regulatory framework from William Coen, Secretary General. He spoke on “Bank capital: a revised Basel framework” at a panel discussion at the 2016 Annual Membership Meeting of the Institute of International Finance, Washington DC, 7 October.  The objective is to reduce risk-weighted asset variability with a focus on outliers, while not significantly increasing overall capital requirements. However, this does not mean that the minimum capital requirement for all banks will remain the same – variability in risk-weighted assets can only be reduced if there is some impact on the outlier banks.

calc-pic

Our goal is to finish by the end of the year. The Committee’s post-crisis reforms have been comprehensive and wide-ranging. I am pleased to say that we are close to finalising these reforms, which will provide clarity and certainty to supervisors and market participants.

Second, the bulk of the outstanding reforms relate to reducing excessive variability in risk-weighted assets. A high degree of variability in capital ratios has been demonstrated across a number of empirical studies by the Committee, academics and analysts. The Committee’s objective is to restore the credibility of the risk-based capital framework, which is an integral element of the Committee’s post-crisis reforms.

This is not an exercise in increasing regulatory capital requirements, although I do not rule this out as a possible outcome for outlier banks.

Finally, maintaining a risk-sensitive framework is an important objective, but this has to be carefully balanced with the need for simplicity and comparability.

Progress in finalising the Basel Committee’s reform agenda

The Basel Committee’s policy development process

So where do we stand and what remains to be done? Since late last year, we have published four consultative documents that would revise the current standards for: (i) the standardised approach for credit risk; (ii) operational risk; (iii) the internal ratings-based (IRB) approaches for credit risk, including a potential “output floor”; and (iv) the leverage ratio. The Committee received and analysed comments from a wide range of stakeholders. In parallel with the consultative process, we launched a comprehensive cumulative quantitative impact study (QIS). This allows us to test different scenarios and combinations of scenarios.

The comments we review and the results of our QIS are important inputs to this process – we spend a considerable amount of time assessing these inputs. But we are also aware of their limitations and bias. Data quality, in particular, is a challenge and, even under the best of circumstances, there will always be an element of bias in the data. This is understandable: our exercises often require data that are not readily accessible, and banks must therefore estimate certain outcomes based on the data that are available. In short, QIS exercises are a labour-intensive, painstaking process for banks and for bank supervisors but an essential part of our policy development process. The cumulative QIS exercise will allow the Committee to make a well informed judgment on the overall impact of its remaining reforms and on the component pieces of that package.

A package of proposals

Let me say a few words about each part of the package we will finalise by year-end. I stress the word “package” since there are clearly trade-offs associated with the various policy levers. For example, the more weight that is placed on using standardised approaches to calculating risk-weighted assets, the less weight that is needed on other policy levers, such as input and output floors.

  • Standardised approach for credit risk1 – In the two consultations the Committee conducted on this topic, we explicitly noted that our intention was to improve the standard’s risk sensitivity. The intention was not to increase overall regulatory capital requirements. The Committee intends to adhere to this objective. This does not mean that there will be no changes in capital requirements. Indeed, if we achieve our objective, then capital requirements on riskier exposures should increase, while decreasing for lower risk exposures.
  • Internal ratings-based approaches2 – Our March consultative paper expressed concern about banks’ modelling practices and the degrees of freedom in estimating risk components such as probably of default, loss-given-default and exposure at default. The Committee proposed to remove the option to use the IRB approaches for certain exposures, where it is judged that the model parameters cannot be estimated sufficiently reliably for regulatory capital purposes. This objective can be achieved through various combinations of approaches, which the Committee is still assessing.
  • At the aggregate level, credit risk accounts for on average three quarters of a bank’s minimum capital requirements. Operational risk,3 on the other hand, accounts for an average of around 15% of minimum capital requirements. The Committee is considering adjustments to the March consultation paper on operational risk. I expect that the fundamental elements of the revised operational risk framework will be maintained (ie combining a simple accounting proxy of operational risk with a bank’s internal loss data). Nevertheless, the Committee is considering refinements to the methodology that go in the direction of simplifying the framework and enhancing its robustness.
  • Output floor – Discussions are still under way to replace the existing transitional capital floor based on the Basel I framework that the Committee, in 2009, agreed to keep in place.4 The floor is meant to mitigate model risk and measurement error stemming from internally modelled approaches and would place a limit on the benefit a bank derives from using its internal models for estimating regulatory capital.

There are several other elements of the Basel III package that the Committee will finalise by year-end, including the leverage ratio exposure measure and a surcharge for global systemically important banks.5 The Committee is also finalising the treatment of credit valuation adjustment (CVA) risk. CVA risk is complex but on average accounts for only 2% of minimum capital requirements and is significant for a relatively small number of banks. We are carefully weighing the benefits of a risk sensitive treatment for this risk with the associated complexity and global applicability.

I would also like to say a few words about the Committee’s market risk rules as, similar to CVA, the contribution of market risk to minimum capital requirements is relatively low (ie on average less than 5%) and of particular relevance for a small number of large banks. The Committee has compiled frequently asked questions and is developing responses to these FAQs to provide greater clarity on how the standard is expected to work in practice. The Committee is considering the impact of the new market risk rules as part of its regular QIS monitoring exercises, and is continuing its work on the P&L attribution test, which is a key determinant of whether a bank can use internal models for market risk or is required to apply the standardised approach.

Impact of the final reforms

So what will be the cumulative impact of these reforms? The answer, of course, depends on the final package of proposals that the Committee agrees to, and which is ultimately endorsed by Governors and Heads of Supervision (GHOS). I can reiterate that the objective is to reduce risk-weighted asset variability with a focus on outliers, while not significantly increasing overall capital requirements. However, this does not mean that the minimum capital requirement for all banks will remain the same – variability in risk-weighted assets can only be reduced if there is some impact on the outlier banks. So some banks which are genuinely outliers may face a significant increase in requirements as a result. We are studying the impact taking account of all the moving parts and (i) a variety of policy scenarios, (ii) different bank sizes and (iii) various business models.

Will European Banks Be Let Off The Capital Hook?

The logic since the GFC is that capital ratios need to be higher, so if a bank gets into difficulty, there is a greater chance it can be managed to an outcome without needing government bail-outs or depositors loosing their shirts. This is one way of managing the “Too Big To Fail” problem. For example, in Australia, the big four have lifted their overall ratios from 10% to 14%. Tier 1 capital has also risen. But of course higher capital costs.

APRA-Majors-June-2016

However, now it seems that European Banks (who have been struggling to lift capital ratios to a reasonable level – The 2016 stress testing is worth reading) may be let off the hook.

A speech by VP Dombrovskis at the European Banking Federation Conference: Embracing Disruption has suggested that revised regulations due soon are likely to water down capital requirements in Europe. Significantly, the speaker is in charge of Financial Stability, Financial Services and Capital Markets Union in the EU.

Equalising average risk weights across the world cannot be the answer, we need an intelligent solution which takes account of the individual banks’ situations and maintains a risk sensitive approach to setting capital requirements.  Different banks have different business models which involve different levels of risk.  This needs to continue to be recognised so as to preserve Europe’s diverse financial landscape.

The Commission remains committed to striking the right balance between supporting reforms at a global level and respecting the diversity of Europe’s financial sector.  We will continue to strive for a financial framework that gives companies enough space to innovate and consumers the certainty they need.  And we will follow through on our work to review our legislative framework and make targeted adjustments to support investment and sustainable growth in Europe.

A solution we could not support is one which would weigh unduly on the financing of the broader economy in Europe.  At a time when we are focused on supporting investment, we want to avoid changes which would lead to a significant increase in the overall capital requirements shouldered by Europe’s banking sector.  This is a clear Commission position. It received strong backing from all EU countries in July.  It is in line with the Basel Committee’s commitment.

With this work in mind, we will come forward with a revision of our own legislation the Capital Requirement Regulation and its sister directive CRD this autumn.  Our aim has not changed.  We want legislation which supports financial stability, but allows banks to lend and support investment in the wider economy.

 

A Hybrid Is Not A Higher Yielding Deposit Alternative

Within the APRA speech we discussed earlier, there was an important little paragraph, which warrants separate coverage. It concerns the emergence of “hybrid” instruments, which banks have been offering, with a fixed return higher than deposit interest rates – returns which in the current low interest rate environment many will find attractive. However APRA makes the point, they should not be considered as higher yield alternatives to deposits as they are intrinsically less safe. Should a bank find they fall below certain capital ratios, the hybrid becomes the first line of defence, and will not pay out. These risks need to be understood.

Piggy-Bank-3

Searching for new capital when a business is distressed, and time is of the essence, is ideally to be avoided. And we want to minimise the risk that the taxpayer has to come to the rescue. With that in mind, the post-crisis regulatory framework has built mechanisms that trigger automatic corrective action to help restore a firm’s capital when it has been diminished. There is a lot of discussion and debate on the merits of so-called bail-inable instruments and bail-in powers, including in response to the FSI’s third recommendation that APRA implement a framework for recapitalisation capacity sufficient to facilitate the orderly resolution of an Australian ADI and minimise taxpayer support. But the idea of bail-in is not something completely new: certain recapitalisation mechanisms already exist in the Australian framework. Examples include:

  • the use of the capital conservation buffer, which imposes increasing limitations on a ADI’s ability to make discretionary distributions to capital providers and employees as the ADI approaches its minimum regulatory requirements;
  • the trigger that exists in Additional Tier 1 instruments (often referred to as ‘hybrids’) that provide for the instrument to be written off, or converted to equity,
    in the event that an ADI’s capital ratio falls below 5.125 per cent; and
  • the point of non-viability trigger in both Additional Tier 1 and Tier 2 instruments, which provides for the instruments to be written off or converted to equity in the event that APRA considers that the ADI would become non-viable without such action (or some other form of support).

These latter two recapitalisation mechanisms, in particular, are designed to provide some ‘breathing space’ to allow for orderly resolution. They are not designed to deliver resurrection, but more modestly to provide scope for an ADI’s services to customers to continue while new owners and managers are being put in place. Strengthening this by increasing loss absorption and recapitalisation capacity further, as recommended by the FSI, remains a work in progress and likely to take some time to complete. We are, as I have said elsewhere, hastening slowly in response to that recommendation given the importance of getting the policy settings right.

However, the new mechanisms that have already been instituted within existing capital instruments are a very important part of the new regulatory framework. Viewing these capital instruments as simply higher-yielding substitutes for vanilla fixed-interest investments, let alone deposits, is something to be counselled against, since from APRA’s perspective holders of these instruments are providing the important first lines of defence that we can call into action, in some instances even ahead of shareholders, to aid an orderly resolution.

Capital Is Not Enough – APRA

In a speech by APRA Chairman Wayne Byres, “Finding success in failure” delivered in Sydney today at the Actuaries Institute conference, ‘Banking on Capital’, he discusses capital standards for authorised deposit-taking institutions (ADI’s) and why a sole reliance on capital to deliver financial stability is an unwise strategy:

Bank-Lens

  • ‘When we judge a bank’s capital to be high or low, or something in the middle, we are making a judgement that takes into account a range of issues that impact on bank risk profiles: funding and liquidity, asset quality, governance, risk management and risk culture, to name a few, all come into the equation in some way or another.’
  • ‘To attempt to provide the community with an iron clad guarantee that nothing can go awry would require severe limitation on the risk-taking ability of the banking system, and prevent it from fulfilling the vital and productive roles that it plays in intermediating between borrowers and lenders and facilitating the smooth functioning of payments throughout the economy. Put simply, a zero failure regime is not desirable.’
  • ‘If we accept that failures, while hopefully still reasonably rare, are nevertheless inevitable, then preparation to minimise their impact is an essential investment.’
  • ‘Planning and investing to facilitate their own demise is something that financial firms inevitably struggle to do, so APRA will be reinforcing its expectations in relation to ADI’s [Financial Claims Scheme (FCS)] testing programs in the near future, with a view to ensuring there is genuine readiness to activate the FCS if it is ever needed.’

APRA, along with our colleagues amongst the Council of Financial Regulators, has spent a great deal of time in recent years looking in a fairly hard-nosed way at how well Australia stacks up against these preconditions. The conclusion was somewhat mixed: there are no glaring deficiencies, but a number of areas for improvement.

  • The importance of active supervision, and a willingness to intervene where appropriate, were some of the hard lessons that APRA took to heart following the HIH episode. Justice Owen found APRA under-resourced to identify problems, and slow to respond to them once found. These were fair conclusions, and APRA worked hard under my predecessor to build both its capacity and conviction. Fifteen years on from HIH, efforts to further improve our supervision – to identify risks early and respond promptly – remain at the forefront of our latest strategic plan, and I expect they will always feature prominently in APRA’s priorities.
  • When it comes to powers to intervene, the FSI’s Final Report noted there are some gaps and deficiencies in the Australian statutory framework for crisis management and resolution when compared with international standards.6 This includes the need for such things as broader investigation powers; strengthened directions powers; improved group resolution powers; enhanced powers to deal with branches of foreign banks; and more robust immunities to statutory and judicial managers. In his speech last week, the Treasurer noted the Government’s intention to make improvements in this area, which we see as a very valuable (and low cost) investment in the stability in the financial system.
  • Crisis planning is critical. Last year at this event I spoke about our plans for recovery and resolution planning. During the past year, I’m pleased to say larger ADIs have submitted new plans based on updated guidance issued by APRA, and we are now reviewing and benchmarking the plans in order to highlight areas of better practice that will further increase the credibility of plans in subsequent iterations.7 On resolution planning, more detailed work is also underway with specific firms to consider the planning required to ensure that APRA is able to use our resolution powers when needed. Our focus here is on the assessment of critical functions, intra-group dependencies such as critical shared services, and the identification of potential barriers to resolvability.
  • No matter how good the plan, however, stabilising and restructuring a financial firm that is no longer viable in its current form is rarely going to be a quick and easy exercise. So it is important that, while a resolution plan is being implemented, the firm’s critical functions can be maintained so as to reduce potential losses and minimise the disruption to the broader financial system. Key to doing this is that the firm has the financial resources to allow it to continue to operate while its business is reorganised.

 

European Union Banks To Have 3% Leverage Ratio

According to Moody’s, last Wednesday, the European Banking Authority (EBA) formally recommended the introduction of a minimum 3% leverage ratio for banks in the European Union (EU) by 1 January 2018.

The 3% leverage ratio would be credit positive for banks because it would become a complementary capital requirement to a bank’s risk-weighted capitalisation. As a non-risk sensitive measure, it would act as a backstop to risk-sensitive capital approaches and excessive internal model calibration of risk weights.

Before the introduction of the leverage ratio as a regulatory tool in the Basel III framework, banks used leverage as a means to increase profits by earning the premium between the expenses of the additionally raised funds and the yield of risky, often illiquid, investments. Banks that are highly leveraged are considerably more vulnerable than others to unexpected losses.

The EBA finds that among the 246 entities in its study’s sample, the aggregate capital shortfall for banks that do not yet comply with a 3% level would amount to €6.4 billion, based on a Basel III fully loaded Tier 1 definition over total exposure (including on- and off-balance sheet items). This amount is derived from shortfalls at 21 banks. However, as shown, the high sensitivity of shortfalls above this target ratio reflects the EU banking sector’s challenges in terms of deleveraging and adjusting business models (a 3.5% leverage ratio equates to a €25.4 billion capital shortfall; 4% = €84.9 billion; 4.5% = €166.7 billion; and 5% = €281.6 billion).

EBU1The EBA’s findings suggest that introducing the leverage ratio will have profound effects on business models, as reflected by the range of actual leverage ratios it found from 2.8% for public development banks up to 8.7% for automotive & consumer credit banks. In addition, its empirical findings from the benchmarking study show that small and medium-sized entities (The EBA defines small banks as entities with a total leverage ratio exposure below €10 billion and medium banks with an equivalent volume of €10 billion to €100 billion) are already in compliance with the suggested 3% leverage ratio. In this context, the EBA mentions that there is no need to deviate from this baseline requirement for smaller banks.

For our rated banks in the European Union, we find that the average leverage ratios (as measured by Tier 1 capital divided by total assets) for different countries is sufficiently above the minimum threshold of 3% as of 31 December 2015, as shown in Exhibit 2. However, the results vary considerably by country. Here is the EBA’s median and average leverage ratio from its benchmarking study.

EBU2 The EBA’s recommendation is in line with the oversight body of the Basel Committee on Banking Supervision (BCBS) agreement in its January 2016 meeting, which also recommended a minimum level of 3% and in addition,
stricter requirements for global systemically important institutions.

Likewise, the BCBS will finalize its calibration this year and the EBA intends take up further work along the committee’s findings. Additionally, it will also consider higher leverage ratio requirements for domestic systemically important institutions.

APRA Reaffirms Revised Mortgage Risk Weight Target

The Australian Prudential Regulation Authority (APRA) has today reaffirmed its objective, announced in 2015, to raise Australian residential mortgage risk weights applied by banks using internal models to an average of at least 25 per cent.

Chess-Husing

In July 2015 APRA announced changes to the treatment of residential mortgages for banks able to use internal models for capital adequacy purposes. In particular, APRA adjusted the risk weight calculation used by authorised deposit-taking institutions (ADIs) accredited to use the internal ratings-based (IRB) approach to credit risk. The adjustment was intended to increase the average risk weight on Australian residential mortgage exposures, measured across all IRB ADIs, from approximately 16 per cent to an average of at least 25 per cent. The increase in IRB risk weights came into effect from 1 July 2016.

Subsequent to the announcement in July 2015, APRA has also required IRB ADIs to make a range of other changes to their models as part of its routine supervisory processes, with a view to improving their comparability, reliability and risk sensitivity. The impact of these modelling changes, when combined with the adjustment proposed in July 2015, would have been an average risk weight that was well in excess of the 25 per cent risk weight targeted by APRA in its original announcement.

APRA has therefore advised the relevant ADIs that it will recalibrate the adjustment advised in July 2015, with a view to ensuring the original target of an average risk weight for Australian residential mortgages of at least 25 per cent is achieved, while not significantly exceeding this target. In doing so, APRA has taken into account modelling changes that have been instituted, as well as some that are to be completed over the coming quarters; in some cases, this recalibration is conditional on the ADIs completing (offsetting) modelling improvements.

This adjustment to mortgage risk weights remains an interim measure, pending the outcome of the deliberations of the Basel Committee on Banking Supervision (Basel Committee) to finalise reforms to the capital adequacy framework, and APRA’s subsequent consideration of how those reforms should be applied in Australia. In the meantime, APRA continues to target an average residential mortgage risk weight for IRB banks of at least 25 per cent. As modelling changes work through the system, APRA expects the average across all IRB banks will vary somewhat over time, but still be consistent with the objective of achieving an average risk weight of at least 25 per cent.