Aussie banks get a wake up call from across the Tasman

I have long called for Australian banks to increase their equity capital in order to withstand a potential banking crisis in Australia. The Murray Commission found that banks, in a crisis, would act as “an accelerant rather than a shockabsorber”.

Now the RBNZ has announced plans to force the big four banks to hold more capital in their New Zealand banking operations. From Clancy Yeates at the Sydney Morning Herald:

The Reserve Bank of New Zealand has mounted a firm defence of its plan to force Australia’s major banks to hold $NZ12.5 billion ($A12.12 billion) more in capital in their banking operations across the Tasman, saying the “highly profitable” businesses would have to accept lower returns.

In an interview on Wednesday, RBNZ deputy governor Geoff Bascand also justified the plan to bolster bank balance sheets by emphasising the social costs of banking crises and arguing New Zealand could not rely on Australian parent companies for a bail-out in severe shock.

……The big four Australian banks made $4.4 billion in cash profits from their New Zealand operations in 2018 representing about 15 per cent of their total combined profit with ANZ tipped to experience the most significant hit.

Mr Bascand said the central bank had estimated the big four’s NZ return on equity, until recently 14 to 15 per cent, would decline by between and 1 and 3 percentage points as a result of the change.

Earlier, Bascand said:

“At one time, the owners of a bank had plenty of skin in the game; in fact, there was a time when banks got most, or all, of their money from their owners. However, over the last century, banks have started to use less of their own money and more of other people’s, and the balance has almost entirely reversed. While we are not attempting to turn back the clock …..We believe that more ‘skin in the game’ for banks will result in:

  • Banks being better able to absorb large, unexpected losses
  • Society being less at risk from banking crises
  • Reduced fiscal risk…..As the global financial crisis illustrated, when banks fail there can be a severe domino effect that puts pressure on governments to step in with financial support
  • Bank shareholders and management being less inclined to take excessive risks”

(Gareth Vaughan,

The RBNZ proposal calls for systemically important banks to hold a minimum of 16% Tier 1 capital against risk-weighted assets, of which 6% would be a regulatory minimum and 10% would act as a counter-cyclical buffer to absorb losses without triggering “resolution or failure options”. Bear in mind that risk-weighting significantly understates total assets and that leverage ratios, reflecting un-weighted assets, are about 55% of the above (i.e. 8.8%).

The banks have protested, warning that increasing capital will raise interest rates to borrowers.

…..The RBNZ has acknowledged interest rates charged by banks will probably rise as a result of the change, but Mr Bascand said it estimated the impact would be about half a standard 0.25 percentage point move in official interest rates.

If banks’ borrowing rates did rise more sharply than expected, he said the RBNZ could offset this through monetary policy…..

What the banks failed to consider (or mention) is that investors are prepared to accept lower returns on equity if there is lower associated risk. Also banks with strong balance sheets have historically experienced stronger growth. Both lower risk and stronger growth would help mitigate the costs of additional capital.

Question is, why are RBNZ raising concerns about bank capital and not APRA? Another case of regulatory capture?

Australia: Good news and bad news

First, the good news from the RBA chart pack.

Exports continue to climb, especially in the Resources sector. Manufacturing is the only flat spot.

Australia: Exports

Business investment remains weak and is likely to impact on long-term growth in both profits and wages.

Australia: Business Investment

The decline is particularly steep in the Manufacturing sector and not just in Mining.

Australia: Business Investment by Sector

But government investment in infrastructure has cushioned the blow.

Australia: Public Sector Investment

Profits in the non-financial sector remain low, apart from mining which has benefited from strong export demand.

Australia: Non-Financial Sector Profits

Job vacancies are rising which should be good news for wage rates. But this also means higher inflation and, down the line, higher interest rates.

Australia: Job Vacancies

The housing and financial sector is our Achilles heel, with household debt climbing a wall of worry.

Australia: Housing Prices and Household Debt

House prices are shrinking despite record low interest rates.

Australia: Housing Prices

Broad money and credit growth are slowing, warning of a contraction.

Australia: Broad Money and Credit Growth

Bank profits remain strong.

Australia: Bank Profits

But capital ratios are low, with the bulk of profits distributed to shareholders as dividends. The ratios below are calculated on risk-weighted assets. Raw leverage ratios are a lot weaker.

Australia: Bank Capital Ratios

One of the primary accelerants of the housing bubble and household debt has been $900 billion of offshore borrowings by domestic banks. The chickens are coming home to roost, with bank funding costs rising as the Fed hikes interest rates. In the last four months the 90-day bank bill swap rate (BBSW) jumped 34.5 basis points.

The banks face a tough choice: pass on higher interest rates to mortgage borrowers or accept narrower margins and a profit squeeze. With an estimated 30 percent of households already suffering from mortgage stress, any interest rate hikes will impact on both housing prices and delinquency rates.

I continue to avoid exposure to banks, particularly hybrids where many investors do not understand the risks.

I also remain cautious on mining because of a potential slow-down in China, with declining growth in investment and in retail sales.

China: Activity

Australia: APRA capitulates to Big Four banks

From Clancy Yeates at The Age:

Quelling investor fears over moves to strengthen the financial system, the Australian Prudential Regulation Authority on Wednesday said major banks would have until 2020 to increase their levels of top-tier capital by about 1 percentage point, to 10.5 per cent.

The target was much more favourable to banks than some analyst predictions, with some bank watchers in recent months warning lenders may need to raise large amounts of equity or cut dividends to satisfy APRA’s long-running push for “unquestionably strong” banks.

Markets are now confident banks will hit APRA’s target, estimated to require about $8 billion in extra capital from the big four, through retained earnings or by selling new shares through their dividend reinvestment plans…..

“The scenario where banks had to raise significant capital appears to be off the table for now,” said managing partner at Arnhem Asset Management, Mark Nathan.

Mr Nathan said the banks’ highly prized dividends also looked “safer”, though were not likely to increase. National Australia Bank and Westpac in particular have high dividend payout ratios, which could put dividends at risk from other factors, such as a rise in bad debts……

APRA’s chair Wayne Byres said the changes could be achieved in an “orderly” way, and the new target would lower the need for any future taxpayer support for banks.

“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,” he said.

APRA chairman Wayne Byres used the words “lower the need for any future taxpayer support.” Not “remove the need…..” That means banks are not “unquestionably strong” and taxpayers are still on the hook.

A capital ratio of 10.5% sounds reasonable but the devil is in the detail. Tier 1 Capital includes convertible (hybrid) debt and risk-weighted assets are a poor reflection of total credit exposure, including only that portion of assets that banks consider to be at risk.

Recent bailout experiences in Europe revealed regulators reluctant to convert hybrid capital, included in Tier 1, because of fears of panicking financial markets.

Take Commonwealth Bank (Capital Adequacy and Risks Disclosures as at 31 March 2017) as a local example.

The Tier 1 Capital Ratio is 11.6% while Common Equity Tier 1 Capital (CET1), ignoring hybrids, is more than 17% lower at 9.6%.

But CBA risk-weighted assets of $430 billion also significantly understate total credit exposure of $1,012 billion.

The real acid-test is the leverage ratio which compares CET1 to total credit exposure. For Commonwealth this works out at just over 4.0%. How can that be described as “unquestionably strong”?

Minneapolis Fed President Neel Kashkari conducted a study last year in the US and concluded that banks need a leverage ratio of at least 15% to avoid future bailouts. Even higher if they are considered too-big-to-fail.

Australian banks rally on Murray Report

The ASX 200 Financial sector (ex-REITs) responded well to release of David Murray’s report into the financial services industry. As the largest constituent of the ASX 200 index, comprising more than one-third of market capitalization, sector performance is critical in determining future direction of the broader index. Breach of resistance at 7220 suggests that the correction is over. Follow-through above 7400 would confirm a fresh primary advance.

ASX 200 Financial ex Property

David Murray’s Financial System Inquiry

The Final Report of the Financial System Inquiry, led by ex-Commonwealth Bank CEO David Murray, calls on Australian banks to become “unquestionably strong” to prevent another financial crisis. The FSI calls for increased bank capital in the form of common equity, with capital ratios increasing from an average of 9.1% to the 12.2% threshold for the top quartile of international banks. The FSI also proposes that banks increase their average risk-weighting for home mortgages to 25-30% compared to current weightings as low as 15%.

Chris Joye from the AFR estimates that the first proposal would require about $21 billion in new capital, while increased risk-weighting would require an additional $15 billion. There may be some overlap between the two, but the combined requirement is likely to be more that $30 billion.

Impact on consumers is likely to be negligible. The FSI projects that a 1% increase in bank capital ratios would increase the weighted cost of capital by 6 basis points (0.06%) because of the higher cost of equity capital.

Bank Funding Costs with Increased Capital

But this does not take account of lower risk premiums required, for debt and equity, when capital is increased. A reduction of debt funding costs to 3.65% and equity to 14.75% would offset the increase in equity capital; so the actual cost increase may be considerably smaller.

A resilient banking system would not only avoid significant losses of GDP (as high as 158 percent) in the event of a financial crisis, but would save up to 900,000 jobs according to the FSI. In addition, reduced risk of a government bailout would minimize the threat to government debt levels and Australia’s AAA credit rating. Banks would also benefit through improved profitability and stronger growth prospects.

My concerns with FSI are mainly long-term. Raising capital ratios to the top quartile of international banks would certainly improve the resilience of Australian banks, but this is a moving target. We can expect average capital held by international banks to increase as other countries conduct their own reviews into the adequacy of bank funding. Also, leverage ratios (ignoring risk-weighting) remain low and should be progressively lifted towards a long-term goal of 6 to 8 percent. Reliance solely on risk-weighted capital ratios can encourage industry-wide concentration in low-risk-weighted assets which in turn will elevate risk. Lastly, bail-in bonds are dangerous — any attempt at conversion would destroy creditor confidence in the banking system with far-reaching repercussions — and should be discouraged.

I believe that stronger capital ratios are a win for both Australian taxpayers and bank shareholders. Implementation of the FSI recommendations would be a major advance towards building a resilient and sustainable banking sector.

Increasing bank capital is in the interest of shareholders

Westpac CEO Gail Kelly warns that all Australians will have to carry the cost of making the financial system safer:

“Of course you can ever increase capital and become ever more safe, but that does come at a cost. The increasing of capital ends up having ultimately having a diminishing return in terms of safety, but the costs are real, capital is not free. Those costs will flow through to impact the economy more broadly, noticing and noting that banks are strong intermediaries within the Australian economy.”

What Gail fails to consider is that Australians already carry the cost of an unsafe banking system, with the broad economy contracting when banks suffer solvency or liquidity problems. And the taxpayer effectively stands as guarantor in the event of a failure.

I agree that capital comes at a cost — higher than the direct cost of deposit funding which capital would partially replace. But when one factors in the cost of the vast infrastructure required to attract and service those deposits, the margin narrows. Increasing the level of capital will also make banks safer and reduce the risk premium, further lowering the average cost of capital. And not only for equity: improved risk ratings will lower the cost of deposit-funding as well.

Banks with higher capital ratios also benefit from higher asset and loan growth according to studies conducted by the Bank for International Settlements.

Making the banking system safer is not only in the interests of the taxpayer, but also bank shareholders.

Read more at This Breathtaking Overstep From Gail Kelly Shows It’s Time To Call Australia’s Bankers To Account | Greg McKenna

Australia’s Major Banks Say The Murray Enquiry Used The Wrong Numbers… | Business Insider

From Greg McKenna:

The AFR reports ….the Australian Bankers Association CEO Steven Munchenberg said the banks are “concerned that if some of the statements in the interim report – that Australia’s capital is middle of the road, that housing is a ­systemic risk – are allowed to remain unchallenged and are then taken out of context that is going to cause us a lot of future grief”.

Munchenberg says the Inquiry hasn’t calculated the capital ratios correctly.

“The approach was simplified and didn’t take into account the complexities and nuances of how capital is determined in Australia, including deductions required by APRA and some of the areas where APRA has adopted a more conservative approach, and as a result underestimated the amount of capital in Australia relative to overseas”, he told the AFR.

Forget the nuances and comparisons to the plight of other banks. Australian banks need to almost double their capital and adopt a more conservative approach to home mortgage lending if they are to withstand future shocks. 3 to 5 percent capital against total exposure doesn’t get you very far. The history of low mortgage failures over the last 3 decades, in an expansionary phase of the credit market, is unlikely to be repeated during a contraction.

Read more at Australia's Major Banks Say The Murray Enquiry Used The Wrong Numbers To Calculate Capital | Business Insider.

Jon Cunliffe: The role of the leverage ratio….

Sir Jon Cunliffe, Deputy Governor for Financial Stability of the Bank of England, argues that the leverage ratio — which ignores risk weighting when calculating the ratio of bank assets to tier 1 capital — is a vital safeguard against banks’ inability to accurately model risk:

….. while the risk-weighted approach has been through wholesale reform, it still depends on mathematical models — and for the largest firms, their own models to determine riskiness. So the risk-weighted approach is itself subject to what in the trade is called “model risk”.

This may sound like some arcane technical curiosity. It is not. It is a fundamental weakness of the risk based approach.

Mathematical modelling is a hugely useful tool. Models are probably the best way we have of forecasting what will happen. But in the end, a model — as the Bank of England economic forecasters will tell you with a wry smile — is only a crude and simplified representation of the real world. Models have to be built and calibrated on past experience.

When events occur that have no clear historical precedent — such as large falls in house prices across US states — models based on past data will struggle to accurately predict what may follow.

In the early days of the crisis, an investment bank CFO is reported to have said, following hitherto unprecedented moves in market prices: “We were seeing things that were 25 standard deviation moves, several days in a row”.

Well, a 25 standard deviation event would not be expected to occur more than once in the history of the universe let alone several days in a row — the lesson was that the models that the bank was using were simply wrong.

And even if it is possible to model credit risk for, say, a bank’s mortgage book, it is much more difficult to model the complex and often obscure relationships between parts of the financial sector — the interconnectedness — that give rise to risk in periods of stress.

Moreover, allowing banks to use their own models to calculate the riskiness of their portfolio for regulatory capital requirements opens the door to the risk of gaming. Deliberately or otherwise, banks opt for less conservative modelling assumptions that lead to less onerous capital requirements. Though the supervisory model review process provides some protection against this risk, in practice, it can be difficult to keep track of what can amount to, for a large international bank, thousands of internal risk models.

The underlying principle of the Basel 3 risk-weighted capital standards — that a bank’s capital should take account of the riskiness of its assets — remains valid. But it is not enough. Concerns about the vulnerability of risk-weights to “model risk” call for an alternative, simpler lens for measuring bank capital adequacy — one that is not reliant on large numbers of models.

This is the rationale behind the so-called “leverage ratio” – a simple unweighted ratio of bank’s equity to a measure of their total un-risk-weighted exposures.

By itself, of course, such a measure would mean banks’ capital was insensitive to risk. For any given level of capital, it would encourage banks to load up on risky assets. But alongside the risk-based approach, as an alternative way of measuring capital adequacy, it guards against model risk. This in turn makes the overall capital adequacy framework more robust.

The leverage ratio is often described as a “backstop” to the “frontstop” of the more complex risk-weighted approach. I have to say that I think this is an unhelpful description. The leverage ratio is not a “safety net” that one hopes or assumes will never be used.

Rather, bank capital adequacy is subject to different types of risks. It needs to be seen through a variety of lenses. Measuring bank capital in relation to the riskiness of assets guards against banks not taking sufficient account of asset risk. Using a leverage ratio guards against the inescapable weaknesses in banks’ ability to model risk.

Read more at Jon Cunliffe: The role of the leverage ratio and the need to monitor risks outside the regulated banking sector – r140721a.pdf.

Banks try scare tactics to avoid calls for more capital

ANZ chief executive Mike Smith is the latest banker to warn that the push to increase bank capital ratios will reduce access to bank finance. The AFR reports Smith as saying:

It is not just about banks, it is about the real economy – about corporations, business and individuals… It is one thing for a bank to ­complain about regulation but it is another thing for a corporation to say we are not getting finance because of this regulation that is being imposed on the banks.

Methinks bank resistance to increased capital requirements is more about protecting bonuses than about protecting shareholders or the broad economy. Shareholders would benefit from lower funding costs and improved stock ratings associated with a stronger balance sheet, while Bank of England’s Andrew Bailey had this to say about the impact of stronger capital ratios on bank lending:

I do however accept that there remains a perception in some quarters that higher capital standards are bad for lending and thus for a sustained economic recovery…… Looking at the broader picture, the post-crisis adjustment of the capital adequacy standard is a welcome and necessary correction of the excessively lax underwriting and pricing of risk which caused the build up of fragility in the banking system and led to the crisis. I do not however accept the view that raising capital standards damages lending. There are few, if any, banks that have been weakened as a result of raising capital.

Analysis by the Bank for International Settlements indicates that in the post crisis period banks with higher capital ratios have experienced higher asset and loan growth. Other work by the BIS also shows a positive relationship between bank capitalisation and lending growth, and that the impact of higher capital levels on lending may be especially significant during a stress period. IMF analysis indicates that banks with stronger core capital are less likely to reduce certain types of lending when impacted by an adverse funding shock. And our own analysis indicates that banks with larger capital buffers tend to reduce lending less when faced with an increase in capital requirements. These banks are less likely to cut lending aggressively in response to a shock. These empirical results are intuitive and accord with our supervisory experience, namely that a weakly capitalised bank is not in a position to expand its lending. Higher quality capital and larger capital buffers are critical to bank resilience – delivering a more stable system both through lower sensitivity of lending behaviour to shocks and reducing the probability of failure and with it the risk of dramatic shifts in lending behaviour.

The BOE and BIS tell us that higher capital ratios will improve bank lending, yet Mr Smith is trying to scare regulators with threats that it will have the opposite effect.

Read more at Andrew Bailey: The capital adequacy of banks – today’s issues and what we have learned from the past | BIS.

And at ANZ CEO Mike Smith Rebuffs Murray Inquiry Call For More Bank Capital | Business Insider.

Crawling, not walking, to non-mining led growth | MacroBusiness

Leith van Onselen quotes the latest JP Morgan report on the Australian economy:

…risk of a recession is “inevitably higher now than usual; the economy has built up vulnerabilities over time that have been masked by the continued growth in output and national income… the downside of avoiding recession is that Australia has carried these excesses through a succession of growth cycles”.

Households are particularly at risk from expensive house prices and high levels of household debt. Which brings me back to the unnecessary risks bank regulators are taking by condoning low bank capital ratios of between 4.0% and 4.5% of total credit exposure. Risk-weighting of bank assets provided a smokescreen, inflating perceived ratios to around 10%, while encouraging over-exposure to (low risk-weighted) residential mortgages.

Read more at Crawling, not walking, to non-mining led growth | | MacroBusiness.