Banks Pass Basel III Hurdle

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

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

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

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

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

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

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

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

APRA consults on changes to mutually owned ADIs’ capital framework

The Australian Prudential Regulation Authority (APRA) has released for consultation a discussion paper on proposed revisions to the capital framework for mutually owned authorised deposit-taking institutions (ADIs) to enable them to directly issue Common Equity Tier 1 (CET1) capital instruments.

In 2014, APRA developed a Mutual Equity Interest (MEI) framework for mutually owned ADIs that enables them to issue Additional Tier 1 and Tier 2 capital instruments that meet requirements for conversion into CET1 capital in certain circumstances. Because of their structure, mutually owned ADIs have traditionally not been able to issue ordinary shares that could qualify as CET1 capital.

The consultation announced today concerns proposed amendments to this MEI framework to allow mutually owned ADIs to issue CET1-eligible capital instruments directly. The proposed changes are intended to give mutually owned ADIs more flexibility in their capital management.

These proposed CET1-eligible capital instruments would share many of the same characteristics as ordinary shares and would, for example, be perpetual, subject to discretionary dividends and accounted for as equity. However, because these instruments are untested, APRA is proposing some restrictions on the amount that may be included in CET1 and, to accommodate the mutual corporate structure of issuing ADIs, proposes limits on MEI holders’ share of residual assets.

Following consideration of submissions received through this consultation, APRA anticipates it will release the final revised APS 111 in late 2017 for commencement as soon as practicable thereafter.

Australian Banks’ Stricter Capital Requirements Are Credit Positive – Moody’s

From Moody’s

On 19 July, the Australian Prudential Regulation Authority (APRA) announced that it will raise the minimum common equity Tier 1 (CET1) ratio for banks. The stricter capital requirements will make the banking system more resilient to any weakening of credit conditions, a credit positive.

Australia’s four biggest banks, the Australia and New Zealand Banking Group Ltd. (Aa3/Aa3 stable, a22), Commonwealth Bank of Australia (Aa3/Aa3 stable, a2), National Australia Bank Limited (Aa3/Aa3 stable, a2), and Westpac Banking Corporation (Aa3/Aa3 stable, a2), which use internal ratings based models for calculating risk-weighted assets, will be most affected. APRA increased the four banks’ minimum CET1 ratio 150 basis points to 9.5%, including a 1% charge for domestic systemically important banks (D-SIBs). Although the higher capital requirements will take effect in early 2021, APRA said that it expects banks to exceed the new requirement and have CET1 ratios of 10.5% by 1 January 2020 at the latest.

The minimum CET1 ratio for Macquarie Bank Limited (A2 stable, baa1), which also uses an internal ratings-based approach but is not a D-SIB, was similarly raised 150 basis points to 8.5%, effective 1 January 2020. For all the other banks, which use standardized models, the minimum CET1 ratio is 7.5%, a 50 basis point increase.

The new minimum CET1 ratio is an incremental increase from the banks’ current capital levels. The APRA has for some time indicated that it would tighten capital rules, and our Australian bank ratings fully reflect that possibility. To meet a CET1 target of 10.5%, the four big banks will need to raise their CET1 ratios between 40 and 90 basis points from their reported levels at March 2017 (see Exhibit 1). That translates into an aggregate capital shortfall of about AUD9.1 billion. However, the banks’ normalized annual internal capital generation is already around AUD6.5-AUD7.5 billion after dividend payments and dividend reinvestments. Also, in practice, they may need less additional capital because they have been actively reducing their risk-weighted assets by changing their business mixes.

Macquarie Bank’s CET1 ratio was 11.1% as of March 2017, well above its new 8.5% minimum. Smaller banks subject to a 7.5% minimum also mostly have CET1 ratios exceeding the requirement, so any capital shortage for them will be minimal.

The tighter capital requirement reflects the APRA’s concern about Australian banks’ reliance on foreign wholesale funding, which makes them vulnerable to sudden shifts in foreign investor sentiment. Australian banks issue around 70% of their long-term debt and 40% of their short-term debt to foreign investors (see Exhibit 2).
 The APRA has also flagged further increases in capital requirements in 2021. The regulator plans to increase the risk weights of certain assets, particularly for investor property loans and higher loan-to-value ratio loans. Although loss rates on mortgages remain low, housing loans make up 60% of Australian banks’ loan portfolios. Furthermore, a high and rising level of household debt has elevated risks within the household sector, making Australian banks’ credit quality more vulnerable to a shock. APRA also stated that its assessment of bank capital assumes that a framework for total loss-absorbing capacity will be introduced at a later date.

APRA Imposes Higher Capital Requirements

APRA has announced the new capital ratios, to meet the‘unquestionably strong’ benchmark. The four major Australian banks will need to have CET1 capital ratios of at least 10.5 per cent by effectively increasing requirements for all IRB banks by the equivalent of around 150 basis points. For other ADIs, the effective increase in capital requirements to meet the ‘unquestionably strong’ benchmark will be around 50 basis points. All ADIs are expected to meet the new benchmarks by 1 January 2020.

There will be another paper from APRA later looking at risk weights for mortgages given the industry concentration, so more changes to come?

Loans will become more expensive! It also re-balances competition between smaller banks and the larger players, and makes a move to advanced IRB less attractive, which will be a pain for those players in transition! Banks will probably need another $10-15 billion of capital, which is manageable, but will depress returns, and require loan repricing some more. Around 10 basis points needs to be recovered to maintain current profitability. If applied to mortgages and small business borrowers only, we estimate this to be a 20-25 basis point hike (varies by bank, and business mix).

The Australian Prudential Regulation Authority (APRA) today announced its assessment on the additional capital required for the Australian banking sector to have capital ratios that are considered ‘unquestionably strong’.

The 2014 Financial System Inquiry (FSI) endorsed the benefits of a strong and well capitalised banking system and recommended that APRA set capital standards such that capital ratios of authorised deposit-taking institutions (ADIs) are ‘unquestionably strong’. The Australian Government subsequently endorsed this recommendation.

The FSI’s endorsement of the benefits of a strongly capitalised banking system recognised Australia’s reliance on foreign borrowings, the need to ensure that Australia’s financial system continues to provide its core economic functions, even in times of stress, and the benefits that flow from reducing the perception of an implicit government guarantee and the associated economic inefficiency this creates.

APRA has today released an Information Paper which outlines APRA’s conclusions with respect to the quantum and timing of capital increases that will be required for Australian ADIs to achieve unquestionably strong capital ratios. The analysis draws on international comparisons, as suggested by the FSI, as well as other information that allows capital strength to be viewed from different perspectives.

In its assessment, APRA has focussed on the appropriate calibration of Common Equity Tier 1 (CET1) capital requirements, recognising that CET1 is the highest quality capital and therefore most likely to engender confidence in an ADI’s financial strength.

APRA has distinguished in its analysis between those ADIs using the more conservative standardised approach to capital adequacy, and those banks that are accredited to use internal models to determine their capital requirements.

ADIs using the internal ratings-based (IRB) approach to capital adequacy

For ADIs that use the internal ratings-based approach to credit risk, APRA has concluded that it is necessary to raise minimum capital requirements by around 150 basis points from current levels to achieve capital ratios that would be consistent with the goal of ‘unquestionably strong’.

This calibration recognises that ADIs using the IRB approach are currently operating with a higher capital surplus above regulatory minimums, in anticipation of APRA’s implementation of the FSI’s recommendation. APRA therefore expects that some of the increase in minimum requirements might be met through the surplus these ADIs hold in excess of minimum regulatory requirements.

In the case of the four major Australian banks, APRA expects that the increased capital requirements will translate into the need for an increase in CET1 capital ratios, on average, of around 100 basis points above their December 2016 levels. In broad terms, that equates to a benchmark CET1 capital ratio, under the current capital adequacy framework, of at least 10.5 per cent.

ADIs using the standardised approach to capital adequacy

For ADIs that use the standardised approach to credit risk, APRA has concluded that it is necessary to raise minimum capital requirements by approximately 50 basis points from current levels to achieve capital ratios that would be consistent with the goal of  ‘unquestionably strong’.

Given the diversity of capital ratios currently reported by ADIs that use the standardised approach, it is not possible to translate this into an expected increase in actual capital ratios. Many ADIs already hold a capital surplus substantially in excess of current minimum regulatory requirements, and will likely absorb this increase within their existing capital resources without any need to raise additional capital.

Implementation and timetable

APRA considers that ADIs should, where necessary, initiate strategies to increase their capital strength to be able to meet these capital benchmarks by 1 January 2020 at the latest.

In parallel with this build up in capital strength, APRA intends to release a discussion paper on proposed revisions to the capital framework, designed to establish capital requirements that will underpin ADIs having unquestionably strong capital ratios, later in 2017. Subject to finalisation of the international reforms, this will outline the direction of APRA’s implementation of the forthcoming Basel III changes to risk weights as well as measures to address Australian ADIs’ structural concentration of exposures to residential mortgages. It will also outline options APRA is considering to improve transparency and international comparability of ADI capital ratios. Following the discussion paper, APRA expects to consult on draft prudential standards giving effect to the new framework in late 2018, leading to the release of final prudential standards in 2019 which are anticipated to take effect in early 2021.

APRA’s expectation that ADIs meet the capital benchmarks outlined in the Information Paper by 2020, a year ahead of the expected effective date of the new prudential standards, reflects the importance to Australia of ADIs having unquestionably strong capital ratios, and that this should be achieved in a timely manner. By 2020, five years would have elapsed since the release of the final FSI report. Against that background, APRA encourages ADIs to consider whether they can achieve the capital benchmarks more quickly.

APRA Chairman Wayne Byres said: “APRA’s objective in establishing unquestionably strong capital requirements is to establish a banking system that can readily withstand periods of adversity without jeopardising its core function of financial intermediation for the Australian community.

“Today’s announcement is the culmination of nearly a decade’s financial reform work aimed at building capital strength in the financial system following the global financial crisis. Australia has a robust and profitable banking industry and APRA believes this latest capital strengthening can be achieved in an orderly way.

“Capital levels that are unquestionably strong will undoubtedly equip the Australian banking sector to better handle adversity in the future, and reduce the need for public sector support. However, a strong capital position still needs to be complemented by sound governance and risk management within ADIs, and on-going proactive supervision by APRA,” Mr Byres said.

In combination, the increases outlined in the Information Paper will complete a significant strengthening of risk-based capital ratios within the Australian banking system in recent years. In meeting this new benchmark, for example, the four major banks will have, on average, increased their CET1 ratios by the equivalent of more than 250 basis points since the release of the FSI report.

The Information Paper is available on APRA’s website here: www.apra.gov.au/adi/Publications/Pages/other-information-for-adis.aspx

US Banks Now Significantly More Capitalised

The US Federal Reserve Board has announced it has completed its review of the capital planning practices of the nation’s largest banks and reports that their ratios have more than doubled from 5.5 percent in the first quarter of 2009 to 12.5 per-cent in the fourth quarter of 2016.

Each US bank is listed, so we can make comparisons, unlike the “behind closed door” arrangements in Australia, where regulatory disclosure is so poor.

CCAR, in its seventh year, evaluates the capital planning processes and capital adequacy of the largest U.S.-based bank holding companies, including the firms’ planned capital actions such as dividend payments and share buybacks. Strong capital levels act as a cushion to absorb losses and help ensure that banking organizations have the ability to lend to households and businesses even in times of stress.

“I’m pleased that the CCAR process has motivated all of the largest banks to achieve healthy capital levels and most to substantially improve their capital planning processes,” said Governor Jerome H. Powell.

Figure A provides the aggregate ratio of common equity capital to risk-weighted assets for the firms in CCAR from 2009 through the fourth quarter of 2016. This ratio has more than doubled from 5.5 percent in the first quarter of 2009 to 12.5 per-cent in the fourth quarter of 2016. That gain reflects a total increase of more than $750 billion in common equity capital from the beginning of 2009 among these firms, bringing their total common equity capital to over $1.2 trillion in the fourth quarter of 2016.

The decline in the common equity ratio in the first quarter of 2015 resulted from the incorporation of risk-weighted assets calculated under the standardized approach under the capital rules that the Board adopted in 2013, which had a one-time effect of reducing all risk-based capital ratios. However, the aggregate common equity capital ratio of the 34 firms increased by around 65 basis points between the first quarter of 2015 and the fourth quarter of 2015. Previously, risk-weighted assets were calculated under a prior version of the capital rules.

In the aggregate, the 34 firms participating in CCAR 2017 have estimated that their common equity will remain near current levels between the third quarter of 2017 and the second quarter of 2018, based on their planned capital actions and net income projections under their baseline scenario.

When considering a firm’s capital plan, the Federal Reserve considers both quantitative and qualitative factors. Quantitative factors include a firm’s projected capital ratios under a hypothetical scenario of severe economic and financial market stress. Qualitative factors include the strength of the firm’s capital planning process, which incorporate risk management, internal controls, and governance practices that support the process.

This year, 13 of the largest and most complex banks were subject to both the quantitative and qualitative assessments. The 21 other firms in CCAR were subject only to the quantitative assessment. The Federal Reserve may object to a capital plan based on quantitative or qualitative concerns, and if it does, a firm may not make any capital distribution unless authorized by the Federal Reserve.

The Federal Reserve did not object to the capital plans of Ally Financial, Inc.; American Express Company; BancWest Corporation; Bank of America Corporation; The Bank of New York Mellon Corporation; BB&T Corporation; BBVA Compass Bancshares, Inc.; BMO Financial Corp.; CIT Group Inc.; Citigroup, Inc.; Citizens Financial Group; Comerica Incorporated; Deutsche Bank Trust Corporation; Discover Financial Services; Fifth Third Bancorp; Goldman Sachs Group, Inc.; HSBC North America Holdings, Inc.; Huntington Bancshares, Inc.; JP Morgan Chase & Co.; Keycorp; M&T Bank Corporation; Morgan Stanley; MUFG Americas Holdings Corporation; Northern Trust Corp.; The PNC Financial Services Group, Inc.; Regions Financial Corporation; Santander Holdings USA, Inc.; State Street Corporation; SunTrust Banks, Inc.; TD Group US Holdings LLC; U.S. Bancorp; Wells Fargo & Company; and Zions Bancorporation.

The Federal Reserve did not object to the capital plan of Capital One Financial Corporation, but is requiring the firm to submit a new capital plan within six months that addresses identified weaknesses in its capital planning process.

 

APRA On Basel and Local Standards

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

He described the current state of play with Basel III:

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

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

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

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

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

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

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

And the standards should be higher than the minimum:

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

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

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

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

Australia’s big banks could still face increased mortgage risks

From Business Insider.

Among the major banks, Commonwealth Bank is least favoured due to its exposure to the mortgage market and the weakest capital position among its peers.

Big Australian banks could still face increased risk weightings on their mortgage loan books, regardless of this month’s international banking review.

That’s the view of Morgan Stanley analysts, who argue that Australia’s bank regulator, APRA, has the scope to enforce higher risk weightings to meet its own definition of an “unquestionably strong” capital position for the banks.

Higher risk weightings for mortgages would require the majors to increase their levels of Tier 1 capital in order to meet minimum capital ratio requirements.

The analysts highlighted comments by Brad Carr, director of banking prudential policy at the Institute of International Finance. Carr said that the Basel IV requirements wouldn’t be particularly onerous on Australian banks, given their already strong capital positions in comparison to international peers.

However, Morgan Stanley is of the view that APRA could use its authority domestically to enforce stricter capital requirements in addition to the Basel IV guidelines.

Referring to Basel IV as more of a minimum international standard, the analysts highlighted recent comments from APRA about higher lending risks and the high concentration of home loans in the asset portfolios of Australian banks.

Morgan Stanley says that for every 5% increase (from the current level of 25%) will require the big 4 Australian banks to raise another $3.3 billion worth of capital:

Of the Big 4, Morgan Stanley says Westpac is the most exposed to more stringent capital requirements, given the size of its home loan portfolio.

For a 5% risk weighting increase, Westpac would be required to raise another $1.2 billion, while on the other end of the spectrum ANZ would have to raise around $500 million.

ANZ remains the favoured pick of Morgan Stanley analysts, with superior earnings per share (EPS) to its peers and a strong capital position.

Why Talk of Bank Capital ‘Floors’ Is Raising the Roof

From The IMFBlog.

Calculating how much capital banks should hold is often a bone of contention between regulators and banks. While there has been considerable progress on reaching consensus on an international standard, one key issue remains unresolved. This is a proposal to establish a “floor,” or minimum, for the level of capital the largest banks must maintain.

Some financial institutions and national authorities question the need for a “floor,’’ arguing either that differences in business models or other elements of the global regulatory framework—notably limits on the amount of leverage banks may take on—make them redundant. We disagree. The floor reduces the chances that banks can game the system to reduce their capital buffers to levels that aren’t aligned with their risks. It is an essential element of global efforts to create a level playing field for banks operating across countries by strengthening common standards for regulation, supervision and risk management.

Why is the issue of calculating capital levels so important? Bank capital serves as a buffer available to absorb losses. When capital is depleted, deposits and other borrowed funds are put at risk, and this can lead to bank runs, bank failures and wider systemic distress. Banks should hold capital commensurate with the business risks they take and the risks they pose to the wider system.

Key element

The Basel Committee on Banking Supervision, which brings together regulators from 28 countries, establishes rules governing the appropriate level of capital. The current version of these rules, known as Basel III, is a key element of the international regulatory reform agenda put in motion following the global financial crisis of 2008.

Adopted in late 2010 for implementation over a seven-year period, Basel III has led to a significantly safer financial system. Not only are banks capitalized with more and higher-quality capital than before, they also meet new standards for liquidity risk (ensuring banks hold enough liquid assets to meet maturing liabilities in times of stress) and limits on leverage (how much banks can borrow relative to their capital.)

The largest global banks have been gradually allowed to use their own internal models to calculate capital needed for different types of risk. The Basel Accord of 1988, known as Basel I, used only standard risk weights provided by supervisors. In 1996, some banks were allowed to develop their own, internal models for evaluating market risk.

Safety net

Basel II, adopted in 2004, introduced both a standardized approach (similar to Basel I but using risk weights based on external credit ratings) and an internal ratings-based approach (based on banks’ own internal models). But it added a wrinkle: banks had to apply both approaches for a period of two to three years before being fully reliant on their internal models. And, in addition, capital levels had to be at least as conservative as a “floor” equivalent to 80 percent of the level calculated from standard risk weights.

The floor serves as a safety net to internal risk-based approaches. It gives banks and their supervisors time to intervene should changes be needed before signing off on the use of full-fledged internal models. Basel III kept the internal models from Basel II, but it did not keep the floor. The Basel committee now seeks to reintroduce the floor.

Why is the issue contentious? In testing whether the new method was being applied consistently across institutions in different countries, the Basel Committee found that banks with similar portfolios came up with very different capital requirements when they used internal models. This raised the possibility that some banks were underestimating the risks or gaming the models to deliver outcomes that required less capital. Hence addressing risk weight variability became a top priority.

To solve this problem, the Basel Committee considered several proposals:

  • Revising the standardized approach to better capture the riskiness of bank assets, making it a better complement to the internal risk-based approach;
  • limiting the use of the internal risk-based approach; and
  • implementing a floor to mitigate internal model risk and to make it easier to compare outcomes across banks.

The floor—though not new—would become a more permanent feature of the enhanced Basel III capital framework, based on the revised standardized approach. This approach offers the best of both worlds: the flexibility of the internal models combined with the minimum standard represented by the floor.

The discussion raging now is whether there is a need for a floor, given that the leverage ratio established under Basel III serves already as backstop. And if there is a floor, should it be set at 80 percent, as specified in Basel II, or some other level?

Banks’ concerns

Some banks using internal models worry that their capital requirements could go up if these floors were applied, which would reduce their profitability. The governing body of the Basel Committee, however, has emphasized that the enhancements to Basel III should not lead to a significant, overall increase in capital requirements across banks.

It is our view that the risk-weighted capital adequacy ratio, leverage ratio and output floors are all essential elements of a robust capital framework:

  • The capital adequacy ratio relates risk to capital, but it is complex and makes it difficult to compare capital outcomes among banks.
  • The leverage ratio constrains the overall ability of the bank to grow its balance sheet out of proportion to capital. It is not risk sensitive but is simple to calculate and provides a backstop to the risk-weighted capital ratio.

 The floor addresses the risk that a model may not perform as expected when banks use it to calculate capital. It allows banks to continue using more risk-sensitive approaches but constraints any unwarranted capital relief, while also making it easier to compare institutions through disclosure of the standardized approach outputs.

While we welcome the additional risk sensitivity that internal models bring, we remain cautious about their unconstrained use. Supervisory capacity to ensure effective prudential oversight of internal models remains a work in progress. At the same time, banks will always have incentives to game the models and reduce the amount of capital they hold. Indeed, a recent study by Federal Reserve economists finds manipulation of risk weights to be widespread.

Well-capitalized banks are more likely to lend to the real economy and less likely to indulge in excessive risk-taking that could threaten the stability of the financial system. This only strengthens the case for a robust capital framework.

Properly calibrated and carefully phased, the Basel III enhancements of a floor on risk models can help prevent excessive variability in capital outcomes and allow for meaningful comparison across institutions and countries, while still permitting for risk sensitive approaches to take hold. The capital floor is a linchpin of this system.

Tighter Property Regulations to Weigh on Hong Kong Banks

Fitch Ratings expects tighter regulations on property-related lending to have a material but manageable capital impact on Hong Kong banks.

The Hong Kong Monetary Authority has further tightened regulations on mortgages and bank lending to property developers that in turn extend mortgages outside the supervisory framework in an effort to cool the property market and strengthen the banks’ credit risk management.

We expect the growth in domestic residential mortgages, which accounted for 5.6% of system-wide assets at end-March 2017, to slow while direct lending to property developers (6.3%) may shrink.

Fitch estimates that increasing the risk weight on loans to property developers to 50% or 100% from an assumed 30%, coupled with an increase in the risk weight floor for residential mortgages to 25% from the current 15%, could reduce Fitch Core Capital ratios by at least 50 bp and up to 420 bp for banks that use the internal ratings-based approach.

The impact will be manageable as the new rules will be phased in and banks have maintained above-average capitalisation, supported by internal capital generation and one-off disposals.

Notwithstanding the above, Fitch revised the banking system outlook over the next 12 months to stable from negative on 11 May 2017 while the medium-term outlook for Hong Kong banks’ operating environment remains negative as the financial systems of Hong Kong and China continue their integration.

We expect short-term cyclical pressure on the banks’ financial performance to ease, based on positive signs in the domestic economy. Fitch expects annual GDP growth of around 2% in 2017 and 2018 for Hong Kong.

ANZ APRA Mortgage Risk Weight Up to 28.5%

The new risk weight for mortgages at ANZ will be around 28.5% according to information released today. This is higher than some expected, but still well below the 35-40% weighting of the regional banks, so continues to highlight the relative benefits the large players have. This is before the next round of discussion on risk weights we expect from APRA later in the year.

The rise in risk weights has been one of the main drivers of mortgage repricing, which is impacting all lenders in the sector to varying degrees.

In an ASX announcement on 8 August 2016, ANZ said that it expected the average risk weight for its Australian residential mortgage lending book would increase following changes by the Australian Prudential Regulation Authority (APRA) to capital requirements for Australian mortgages and a review by APRA of ANZ’s mortgage capital model.

APRA has now completed its review of ANZ’s mortgage capital model and approved the new model for Australian residential mortgages to be adopted from June 2017.

Adoption of the new model is expected to decrease ANZ’s Level 2 Common Equity Tier-1 ratio by 26 basis points based on ANZ’s balance sheet at 31 March 2017, representing an average risk weight applied to the Australian mortgage portfolio of a little over 28.5%.

This impact is consistent with ANZ’s 2017 capital management plan and no additional capital management actions are required as a result.

As indicated at ANZ’s First Half 2017 financial results, the Group expects APRA to make further changes to sector capital requirements through a clarification to the “unquestionably strong” capital framework.