Basel III Capital Adequacy Ratios (CAR) will require banks to hold a minimum Total Capital of 8% against risk-weighted assets (RWA), the same as under Basel II, but with additional capital buffers of between 2.5% and 5.0% depending on credit market conditions. With an average ratio of 11.5% (September 2011), Australian banks are short of the maximum Basel III requirement of 13.0% for markets in a credit bubble.
The problem, however, lies not only with CAR but with the definition of risk-weighted assets. Under RWA, loans and investments are not taken at face value but adjusted for perceived risk. These adjustments vary widely between banks in different countries. US banks still apply Basel I risk-weightings:
- zero for cash and government debt (OECD Sovereigns);
- 20 percent for (OECD) banks;
- 50 percent for mortgages;
- 100 percent for corporates.
Their counterparts in Asia and Europe apply Basel II risk-weightings, with more lenient mortgage risk weights, averaging 15 percent and 14 percent respectively.
Australia’s 4 major banks similarly apply risk-weightings (supervised by APRA) for residential mortgages as low as 15%, with an average of 17%. That means the big four hold less than 2% capital against residential mortgages. Even after mortgage insurance, Deep T pointed out earlier this year, leverage is close to 50 times capital.
Basel III introduces a minimum 3% leverage ratio which ignores risk-weighting and compares Tier 1 capital to total exposure — total assets plus derivative exposure and off-balance sheet assets. But this is a catch-all and allows banks with high quality assets to continue leveraging at 33 times capital. Fed guidelines are more conservative, requiring a minimum leverage ratio of 4% (“adequately capitalized“) with a recommended 5% minimum for well-capitalized banks. The ratio, however, excludes off-balance-sheet assets. None of Australia’s four majors appear to meet the Fed’s requirement at September 2011 — ranging between 3.9% and 4.8% of Tier 1 capital to tangible assets.
With household debt at a historic high of 150% of disposable income, 3 times higher than in the early 1990s, Australia shows classic symptoms of a credit bubble and cannot afford to be complacent. There are three areas of the banking system that require attention. Capital adequacy ratios need to be lifted as well as risk-weightings for residential mortgages. Improving these two measures should enable Australia’s four major banks to achieve a minimum (Basel III) leverage ratio of 5%.
Sources:
Click to access bcbs189.pdf
http://en.wikipedia.org/wiki/Basel_III
http://en.wikipedia.org/wiki/Capital_requirement
Click to access wp1290.pdf
Click to access wp1225.pdf
Casualties of the externality
Click to access EY%20Reg%20Alert%20Basel%20III%20June%202012.pdf
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
