leverage ratio Archives - the patient investor

March 14, 2019March 14, 2019

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, Interest.co.nz)

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?

July 20, 2017

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.

May 15, 2017

At last, some sensible commentary on bank levy | MacroBusiness

From Leith van Onselen:

……The bank levy helps internalise some of the cost of the extraordinary public support that the big banks receive from taxpayers via the Budget’s implicit guarantee (which provides a two-notch improvement in the banks’ credit ratings), the RBA’s Committed Liquidity Facility, the implementation of deposit insurance, and the ability to issue covered bonds. All of these supports have helped significantly lower the banks’ cost of funding and given them the ability to derive super profits.

As noted by Chris Joye on Friday, the 0.06% bank levy is also very ‘cheap’, since it would only recover around one-third of the funding advantage that the big banks receive via taxpayer support:

“If the two notch government support assumption is removed from these bonds, their cost would jump by 0.17 per cent annually to 1.11 per cent above cash based on the current pricing of identical securities. So the majors are actually only paying 35 per cent of the true cost of their too-big-to-fail subsidy…

Requiring banks to pay a price for the implicit too-big-to-fail subsidy is universally regarded as best practice because it minimises the significant moral hazards of having government-backed private sector institutions that can leverage off their artificially low cost of capital to engage in imprudent risk-taking behaviour.”

Again, what better way to internalise some of the cost of the government’s support than extract a modest return to taxpayers via the 6 basis point levy on big bank liabilities?

The Turnbull Government’s unexpected bank levy announcement is the single best thing to come out of the 2017-18 Budget. It deserves widespread support from the community and parliament.

I have my doubts that the new bank levy is a step in the right direction. Most observers would agree that the banks are getting a free ride at the taxpayers expense, but this is not a solution.

Remember that the Commonwealth Treasury is not an insurance fund. And the risk premiums (levy) collected will go to fill a hole in the current budget, not to build up a fund against the future risk of a banking default.

There is no way to avoid it. Australian banks are under-capitalized, with about 6% capital against unweighted risk exposure (leverage ratio). Charging a bank levy does not solve this. Raising (share) capital does.

The levy merely provides the banks with another argument against raising more capital. I would much rather see a levy structured in such a way that it penalizes banks who do not carry sufficient capital, creating an incentive for them to raise further equity.

Neel Kashkari, President of the Minneapolis conducted a study to determine how much capital banks need to carry to avoid relying on taxpayer bailouts. The conclusion was that banks need about 15% capital against (unweighted) risk exposure. Too-big-to-fail banks require slightly more: a leverage ratio of about 18%.

Source: At last, some sensible commentary on bank levy – MacroBusiness

April 18, 2016

Morgan Stanley earnings fall 53 pc

Morgan Stanley (MS) is the latest bank heavyweight to release their first-quarter (Q1) 2016 earnings, reporting a 53 percent fall in diluted earnings per share ($0.55) compared to the first quarter of last year ($1.18).

Net revenues dropped 21%, primarily to a sharp 43% fall in the Institutional Securities (Trading) business and an 18% fall in Investment Banking. Non-interest expense cuts of 14% were insufficient to compensate. Declines were widespread, with Europe, Middle East & Africa (EMEA) (-36%) the worst affected.

Tier 1 Capital (CET1) improved to 14.5% (Q1 2015: 11.6%) of risk-weighted assets, while Leverage (SLR) improved to 6.0% (Q1 2015: 5.1%).

The dividend was held at 15 cents (Q1 2015: 15 cents), increasing the payout ratio to a still modest 27%, from 13% in Q1 2015.

Bob Doll’s newsletter this week says:

The uneven market uptrend in place since mid-February resumed last week, with the S&P 500 Index climbing 1.7%. The primary catalyst appeared to be better-than-expected corporate earnings results in the still-early reporting season, particularly from the banking sector. As a result, bank stocks performed particularly well, rising 7% last week, marking the best weekly gain in over four years. Investors also focused on better economic data coming from China and ongoing evidence that the U.S. economy is growing slowly.

We have had five heavyweights, JPM, BAC, WFC, C and MS all report declining earnings per share. Most had cut non-interest expenses but insufficient to compensate for falling revenues and rising provisions for credit losses. I’m afraid there isn’t much evidence of growth in the US economy and banking results reflect a tough environment. Beating earnings estimates doesn’t mean much if your earnings are falling.

MS is in a primary down-trend, having broken primary support at $30. Long-term Momentum below zero confirms. Expect a rally to test resistance and the descending trendline at $30 but respect is likely and would warn of another test of the band of primary support at $20 to $22. Breach would offer a target of the 2011 low at $12*.

* Target calculation: 30 – ( 40 – 30 ) = 20

Goldman Sachs (GS) is due to report Tuesday.

April 16, 2016

Citigroup (C) adds to banking woes

Citigroup (C) was the last of the bank heavyweights to release their first-quarter (Q1) 2016 earnings this week, reporting a sharp 27 percent fall in diluted earnings per share ($1.10) compared to the first quarter of last year ($1.51).

Revenues (net of interest) dropped 11% while non-interest expenses reduced by 3%. There was a modest 7% increase in the provision for credit losses (including benefits and claims). The fall in net revenues was largely attributable to a 27% decline in institutional business from Europe, Middle East & Africa (EMEA) and an 8% decline in North America. Consumer business also dropped in Latin America (13%) and Asia (9%).

Tier 1 Capital (CET1) improved to 12.3% (Q1 2015: 11.1%) of risk-weighted assets, while Leverage (SLR) improved to 7.4% (Q1 2015: 6.4%).

The dividend was held at 5 cents (Q1 2015: 5 cents), increasing the payout ratio to a parsimonious 5%, from 3% in Q1 2015.

C is in a primary down-trend, having broken primary support at $48. Long-term Momentum below zero confirms. Expect a rally to test resistance at $48 but respect is likely and would warn of another test of the band of primary support at $34 to $36. Breach would offer a target of the 2011 low at $24*.

* Target calculation: 36 – ( 48 – 36 ) = 24

We have had four heavyweights, JPM, BAC, WFC and C, all report declining earnings per share. Most had cut non-interest expenses but insufficient to compensate for falling revenues and rising provisions for credit losses.

It looks like we are on track for a tough earnings season.

November 10, 2014

Global Bank Regulator Calls for Larger Capital Cushions | CFO

Matthew Heller reports that the Financial Stability Board, chaired by BOE Governor Mark Carney, is set to table fresh proposals at the upcoming G20 meeting in Brisbane. The world’s top 30 “systemically important” banks will be required to substantially increase their capacity to absorb losses without requiring a bailout.

The new rules would require global systemically important banks to hold minimum capital of 6% of total assets against losses — twice the provisional leverage ratio required by Basel III rules. In addition, banks would be required to have capital equal to at least 16% and as much as 20% of their risk-weighted assets, such as loans.

Even if the big four banks in Australia are not on the list, they are systemically important from an Australian perspective and should hold similar levels of capital.

September 7, 2014

Financial reform: Call to arms | FT.com

Martin Wolf on how much capital banks should be required to hold:

The new regulatory regime is an astonishingly complex response to the failures of this model. But “keep it simple, stupid” is as good a rule in regulation as it is in life. The sensible solution seems clear: force banks to fund themselves with equity to a far greater extent than they do today.

So how much capital would do? A great deal more than the 3 per cent ratio being discussed in Basel is the answer. As Anat Admati and Martin Hellwig argue in their important book, The Bankers’ New Clothes, significantly higher capital – with true leverage certainly no greater than 10 to one and, ideally, lower still – would bring important advantages: it would limit the implicit subsidy to banks, particularly “too big to fail” ones; it would reduce the need for such intrusive and complex regulation; and it would lower the likelihood of panics.

An important feature of higher capital requirements is that these should not be based on risk-weighting. In the event, the risk weights used before the crisis proved extraordinarily fallible, indeed grossly misleading…..

There is no magic in the number of 10 times leverage (or 10% Tier 1 Capital to Total Assets) but the larger the buffer, the greater the protection against fluctuations in asset values. The Basel III minimum leverage ratio of 3% is too low to offer adequate protection, even with the highest quality assets, and while 10% is not readily attainable in the short-term, it makes a suitable long-term target.

August 28, 2014

Banks hold more risk than before GFC | Chris Joye

Chris Joye explains why risk-weighted capital ratios used by Australia’s major banks are misleading and why true leverage is more than 20 times tier 1 capital.

It was only after 2008 when regulators allowed the majors to slash risk-weightings on home loans from 50 per cent to 15 per cent today that we have seen their reported and purely academic tier one capital measured against these newly “risk-weighted” loan assets which shrunk in value spike from 6.7 per cent in December 2007 to 10.5 per cent in June 2014.

By arbitrarily boosting the risk-free share of major bank home loans from 50 per cent to 85 per cent via the regulatory artifice that is a risk-weighting, one gets the fictional jump in their tier one capital that everyone believes is real.

July 30, 2014

Shilling: Big Banks Shift to Lower Gear | The Big Picture

Gary Shilling describes how US regulators are getting tough with big banks:

Break-Up

Like unscrambling an egg, it’s hard to envision how big banks with many, many activities could be split up. But, of course, one of the arguments for doing so is they’re too big and too complicated for one CEO to manage. Still, there is the example of the U.K., which plans to separate deposit-taking business from riskier investment banking activities – in effect, recreating Glass-Steagall.

In any event, among others, Phil Purcell believes that “from a shareholder point of view, it’s crystal clear these enterprises are worth more broken up than they are together.” This argument is supported by the reality that Citigroup, Bank of America and Morgan Stanley stocks are all selling below their book value Chart 5. In contrast, most regional banks sell well above book value.

Push Back
Not surprising, current leaders of major banks have pushed back against proposals to break them up. They maintain that at smaller sizes, they would not be able to provide needed financial services. Also, they state, that would put them at a competitive disadvantage to foreign banks that would move onto their turf.

The basic reality, however, is that the CEOs of big banks don’t want to manage commercial spread lenders that take deposits and make loans and also engage in other traditional banking activities like asset management. They want to run growth companies that use leverage as their route to success. Hence, their zeal for off-balance sheet vehicles, proprietary trading, derivative origination and trading, etc. That’s where the big 20% to 30% returns lie – compared to 10% to 15% for spread lending – but so too do the big risks.

Capital Restoration
….the vast majority of banks, big and small, have restored their capital….Nevertheless, the FDIC and Federal Reserve are planning a new “leverage ratio” schedule that would require the eight largest “Systemically Important Banks” to maintain loss-absorbing capital equal to at least 5% of their assets and their FDIC-insured bank subdivisions would have to keep a minimum leverage ratio of 6%. This compares with 3% under the international Basel III schedule. Six of these eight largest banks would need to tie up more capital. Also, regulators may impose additional capital requirements for these “Systemically Important Banks” and more for banks involved in volatile markets for short-term borrowing and lending. The Fed also wants the stricter capital requirements to be met by 2017, two years earlier than the international agreement deadline….

CEO remuneration is largely driven by bank size rather than profitability, so you can expect strong resistance to any move to break up too-big-to-fail banks. Restricting bank involvement in riskier enterprises — as with UK plans to separate deposit-taking business from riskier investment banking activities — may be an easier path to protect taxpayers. Especially when coupled with increased capital requirements to reduce leverage.

July 21, 2014

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.