The price of prudent banking

Systemic risk caused by non-prudent lending is obviously a danger to the economy. It is therefore important that the financial system has a level of legislation and regulation that ensures that risk is correctly measured and worn by those who seek to profit from it.

The world’s financial regulators are slowly adopting Basel standards for financial regulation in hope that it will remove the threat of systemic risk from banking.  But with risk comes price. So although Basel III is a long way off the warnings of that additional cost are already starting to appear .

Standard Life Investments has confirmed the fears of investment banks that tougher financial regulation could make it far more unattractive for fund managers to buy into future bank fundraisings.

Andrew Fraser, bond investment director at Standard Life, put out a note this morning that expressed concerns about financial regulation, arguing it could lead to higher funding costs, a reduced bond subscription bases and lower profits in the banking sector.

He said: “As regulation develops we think that it is likely to mean that spreads on bank bonds will trade at wider levels relative to history. Volatility in spreads will be persistent, implying investors will require a higher risk premium.”

Bank debt is currently worth $3 trillion – 44% of the total market. Future fundraising could total $1 trillion.

German Chancellor Angela Merkel had warned late last year that the private sector would need to bear some of the pain involved in bank refinancing. As part of the overall restructuring effort, regulators have said that new subordinated debt would need to be issued. Basel III would require banks to boost their capital reserves.

Investment banks have previously warned that buyside investors would react negatively to such regulatory pressures. Fraser’s warning appears confirmed these fears. The new terms and conditions may be off-putting to some institutional investors,” he said.

“As well as having to adjust to a new regulatory era in which bondholders may have to absorb losses in failing banks, investors also need to understand the complex structures in the next generation of securities issued by banks.”

Changes in the international regulations governing the use of senior bonds as capital, called Basel III, kick in from 2013. The new rules mean that so-called “bail-in” clauses, that make bondholders take a certain amount of pain in the event of a bank failure mean that bondholders are far more exposed to losses than they have been in the past.

It is fairly obvious from those words that debt funding is expected to come at a higher price under a more regulated system.

But it isn’t just debt funding side of the equation where regulation needs to be priced in.  As I mentioned recently Australia introduced new consumer protection legislation on January 1, and although I have been told by many that lenders are seeing this merely as a “nuisance”,  others have informed me that its impact could be significant. ( Sorry I can’t reveal sources on that one ).

posted yesterday that there may be some early evidence  from January’s credit data that this legislation is having more of an impact than people expected;  it is however too early to tell if that is correct. If you want more information on that law please see here and here.

That however is not the only piece of legislation regarding credit that is going to be introduced. 3 days ago the Australian Minister for Privacy and Freedom of Information announced that he had.

…. provided draft comprehensive credit reporting provisions to a Senate Committee for its review.

Credit reporting is the assessment of financial and other information about a prospective customer by a financial institution to assess their suitability for credit products.

The new credit reporting provisions are part of a broader suite of reforms the Gillard Government is preparing to implement in response to the Australian Law Reform Commission Report, For Your Information: Australian Privacy Law and Practice.

Under the Privacy Act, financial institutions are required to protect consumers’ private information, including details they use to assess a customers’ eligibility for banking products.

“The proposed provisions will permit credit providers to use more information than currently permitted when assessing an individual’s suitability to access credit,” Mr O’Connor said.

This is the next step in the introduction of comprehensive credit reporting in Australia.  So what is it ?

Australia currently operates under a ‘negative’ reporting system where the centralised information kept on consumers’ credit histories is limited essentially to certain personal details together with data on credit defaults and the number of applications for credit made by individuals (but not whether these applications were accepted or declined). In other words, the system records negative or neutral data about individuals while excluding ‘positive’ information. 

Comprehensive reporting seeks to broaden the type of information collected. The objective is to obtain a more accurate and ‘comprehensive’ picture of an individual’s credit history and present credit-worthiness. Such information might include an individual’s credit limits, current credit exposures and balances, the age of these exposures, past and present repayment patterns, delinquencies and defaults and the outcome of previous credit applications.

When this law is finally enacted credit providers will gain access to the following data.

  1. Whether a person is making timely payments on their credit.
  2. Whether they have been accepted/rejected for credit
  3. The limits of their current credit including loans.
  4. This available amount of redraw in their credit products.

The outcome of these changes is that credit providers can more easily detect people who are experiencing credit stress.  If a client has already maxed out all of their credit cards, then they will probably not be able to obtain another credit product. Currently, unless someone defaults on a credit card (or other loan), credit providers are blind to such details and therefore willing to provide more debt. 

I would expect that this legislation combined with the new consumer protection legislation will mean that credit providers will be much less willing (or unable) to provide higher levels of debt to people with an existing high debt burden.

Although I think both of these pieces of legislation will lead to more prudent lending, I also think that just like the implementation of Basel, they will lead to a fall in credit issuance. This additional stability will therefore come at a “cost” to the broader economy.


  1. Though it may be tough in th short and medium terms, insisting on better valuation standards will likely result in a more stable, more “truly” value-sensitive system.

    However, this won’t come without pain: much of the status quo consists of of entities that are at least founded upon what could be well-described as “misallocations of capital based upon poor valuations”.

    Hence, a shift towards more “true” and prudent valuation (eg. holistic and life-cycle valuations) will likely result in a significant shift in the nature of some entities, and even the complete destruction of others.

    A true value-based “correction”, in other words, and not without pain.

    My 2c

  2. I’m wondering why decreased systemic risk results in higher bond prices. Can think of several reasons:
    a) the regulatory shifts also diminish the too big to fail premium, which has enabled big banks to grow like crazy without facing rising risk premia. I don’t think so though, TBTF still exists for sure in Australian banks. So then, we now potentially have the worst of both worlds? Diminishing growth for bank assets built on a highly unstable liability structure. TBTF and TBT grow.
    b) bond holders are talking their book
    c) bond holders are momentum traders and react irrationally to decreasing risk

  3. FrankieFourFingers


    This paragraph sums it up: “Changes in the international regulations governing the use of senior bonds as capital, called Basel III, kick in from 2013. The new rules mean that so-called “bail-in” clauses, that make bondholders take a certain amount of pain in the event of a bank failure mean that bondholders are far more exposed to losses than they have been in the past.”

    I am surprised “bail-in” clauses were even legal in the first place. Fancy telling deposit-holders their money is the most secured, and then undermining that security by giving preference to bond holders without even notifying deposit-holders.

    • FrankieFourFingers

      Misquote in previous post. Start of second paragraph should have read: “I am surprised bond-holders were allowed to get preference ahead of deposit-holders”.

  4. Comprehensive credit reporting would be great, I already confuse my clients enough, another way of doing so would be excellent!

    In all seriousness though, it’s a good idea, it would give lenders more information on someones credit history and allow them to make smarter decisions on approval/rejections. Although I don’t think it will quite have the effect on debt issuance you think. It may lower it a bit, but if lenders can see that someone is always making repayments on time and they can afford the loan, they will be much more likely to approval additional lends.

    Comprehensive reporting would be win/win for me, since in my view, lenders are already quite prudent when it comes to vehicle/asset finance. So issuance would only drop a little and I will have all the information I need, up front, to say ‘yes’ or ‘no’ without wasting my time on duds.

  5. This is an interesting question. I agree that credit is likely going to come at a higher price under a more regulated system. But this is also very conveniently being used as an argument by the bankers to oppose the regulations. Regulate us more, and the flow of credit will stop, they say.

    There are quite a few studies out there (the BIS, etc) that cast a lot of doubt on this. Ie, you can probably raise capital requirements by quite a bit and it doesn’t have to affect lending spreads by very much. It would hurt their profits though, which is why it’s no surprise the bankers don’t like it.

  6. Nice find Richard.

    This is exactly what I have heard from “others”

    From the article

    “The Adviser was yesterday inundated by responses from brokers supporting Mr Baldwin’s critiscims of the NCCP Act.”

    Sounds like I may have been correct in my assessment of the greater impact then expected.

  7. As an American who has been living in Sydney for the last 5 years, and just took an Australian citizenship actually, I have been amazed by the lack of information at a bank’s disposal compared to the US about perspective customers.

    I’ve seen a US credit report many times and it includes all kinds of details as well as a numerical score calculated on a bunch of factors banks care about – submitted to the agency by all of the person’s creditors. It includes (all details going back 7 years):
    1.) All of your debts, what the terms are and what you pay each month on them.
    2.) In the case of credit cards or lines of credit what the balance was and how much you paid each month. It shows clearly whether you make minimum or low payments or whether you have historically paid down a charge/debt quickly
    3.) Any late payments (30, 60 and 90 days late)
    4.) Where you work and have worked previously
    5.) All of your previous addresses
    6.) Any defaults or bankrupcies etc

    When I go into a bank or a car dealer or wherever they instantly can ‘run’ a report on me that gives them all these details. It certainly is a different experience to here and I think a similar system here is inevitable. I just hope we do a better job of helping people clear up incorrect information or the results of identity theft than is the case in the US system.

  8. From Morrison & Foerster

    Here is some more info re: Implications

    “Banks may seek to refinance part or all of their outstanding Additional Tier 1 or Tier 2 capital, in anticipation of
    the new minimum “bail-in” criteria as well as the more stringent capital requirements under Basel III. Some have
    already started this process by issuing hybrid capital instruments, but with trigger events which are set by
    reference to defined capital ratios, rather than left to be decided at the discretion of the regulator.
    On 6 January 2011, the European Commission suggested in a consultation paper in relation to bank recovery and
    resolution that regulators could be given the power to write-down senior debt as part of the resolution tools.
    Given the overall uncertainty as to the factors which the regulators may take into account in determining the
    Trigger Event, it is unclear what kind of investor appetite there might be for new instruments which develop based
    on the new requirements.
    It will also be interesting to see the effect that the requirements have upon the issuance of hybrid debt
    instruments, particularly Tier 2 instruments which have previously only been required to absorb losses on a goneconcern basis, when a firm is wound-up or becomes insolvent. The new requirements are therefore likely to blur
    some of the distinctions between Tier 1 and Tier 2 instruments. It is possible that previous investors in Tier 2
    instruments may be unwilling to take the additional risk of the instruments being written-off or converted into
    common shares upon the occurrence of a trigger event.”