Recently I read an article which tried to excuse the media for missing the GFC based on the premise that no one is really interested in this type of analysis or would believe it if they read a decent analysis of the risks of catastrophic events occurring. Instead of giving up on my controversial topic, this made me think about, why? My conclusion is that controversial views on the risks within a system must be continually debated and the deep detail outlined.
So, to continue my previous work, this piece is a laypersons take on a very complicated area of financial regulation that highlights why Australia’s major banks have very thin capital buffers on residential mortgages. My strong belief is that this system is set up to fail or be rescued. To understand the detail may give clues and confidence in recognizing when this will occur.
As previously outlined, Australia’s big four banks, which I call “Mega Bank” are allowed to use an Internal Risk Based approach under Basel II to calculate risk weighted assets and minimum capital requirements. APRA follows the Basel II standards and regulates the approach under Prudential Standard 113 (APS 113). APS 113 covers the full IRB approach to credit risk for all bank assets. My analysis today concentrates on residential mortgages as these make up the bulk of Mega Bank assets and have by far the lowest capital requirements. Readers who want to go the extra mile should read the referenced document in full.
As a general overview APS 113 is a disjointed document and lacks accountability on whom or which organization is actually responsible for managing the risk of unforeseen consequences. It provides a formulaic approach to calculations without clear definitions and with no process for interpretation or responsibility for a process to ensure a reasonable approach to interpretation of definitions, statistics or external risks occurs. The almost 100 pages of APS 113 are more appropriate as a regulator’s guidance notes then a Prudential Standard. Far too much of, “ this is the way it should be done”: and far too little of “who’s responsible for getting it right or balanced”. This makes the standard perfectly gameable by banks, who are purely motivated by minimizing capital requirements and increasing returns on capital. Regulators actually creating moral hazard is the result with the risk born by the taxpayer.
My next main criticism is the fundamental flaw in the whole IRB approach to residential mortgages. Basel II and APS 113 treat all retail loans in almost the same manner. That is residential mortgages, car loans, personal loans and credit cards are to use the same basic methodology for determining minmum capital requirements. I believe this is a huge issue as all retail IRB approaches are based around historical loan performance and normal distributions. The difference with residential mortgages, besides being very long term, is that the provision of increasing credit availability and lowering underwriting standards can and does influence the value of the collateral supporting the loan. This distorts and decreases the expected loss statistics over” short” periods of time for residential mortgages, whereas for other retail assets the opposite probably occurs. Neither APS113 nor the Basel standards acknowledge the possibility of this occurring, why would Mega Bank?
To state simply, the methodology used under APS 113 to calculate minimum capital requirements for residential mortgages encourages a bank to increase risk through the provision of increasing credit and lowering underwriting standards because the formulas will actually calculate low risk capital requirements whilst significantly increasing future systemic risk. The more a bank lends on housing the lower the risk calculated and the higher the return on capital. I think this is perverse, many others clearly think otherwise.
Now to the detail. The following is the actual formula that APS113 requires to be used:
- where PD is the probability of default
- LGD is the loss given default
- R is the correlation, given as 0.15
- N is the standard normal cumulative distribution function and
- G is the inverse standard normal cumulative distribution function.
PD and LGD are taken to be the banks expected (ie unstressed) loss parameters, based on historical performance. Their product is then the bank’s Expected Loss (EL).
The effect of the formula (making plenty of assumptions) is to attempt to insulate the bank against 99.9% of loss scenarios, and to then reduce this by the EL which is required to be covered by provisions. The formula is not incorrect and used appropriately would give a balanced conservative risk based approach, but it is gamed and here’s how.
APS 113 stipulates that Mega Bank must use at least 5 years performance data to establish PD. As if 5 years data is going to give the ability to create a normal distribution from the performance of loans during that period. As the bank’s only reliable data metric is LVR then that is used to map performance. Unless the bank’s other assumption is that house prices will fall, then the data will give a PD that is highly skewed to the left of a normal distribution and cannot be relied upon to be normal over changing economic conditions or decreasing house prices.
Simply, the methodology of using a normal distribution can only be valid if enough performance data is collected over a long enough time period in contrasting economic circumstances.
Mega Bank uses the formula and APS 113 to its advantage to minimise capital, all with the approval of APRA by using short term performance during rising house prices as normal. Surprisingly there is also no definition of “default” which leaves the whole PD assessment open to gaming. Do mortgagors that qualify for the Borrower’s Assist program, fall within the definition of default? Readers may have their own views that Mega Bank and APRA make sufficient adjustments for the above issues to not put the bank or taxpayers at risk, or that under Basel III sufficient adjustment will be made to remove any systemic risk (see below).
The facts, however, speak for themselves. Megabank has less than 2% capital against the total residential mortgage book including mortgage insurance, with little capital adjustment in operating risk calculations to increase that amount of capital overall. Mega Bank with the approval of APRA is incentivized to write more and more residential mortgages in preference to all other loan classes. Whilst this is really a diabolical situation, I believe APRA staff do their best with what they have. Mega Bank follows the rules as set by Basel II and APRA standards and has massive resources to support their case. APRA do not have the resources to compete with Mega Bank. However, the RBA does.
Under the proposed Basel III reforms, APRA will introduce a counter cyclical buffer of capital. This counter cyclical buffer would seem to be a system strengthening measure that will be universally adopted across the globe. Although I agree with a carefully used counter cyclical buffer, I do not think it’s a solution to the issues concerning residential mortgages in this country. The base assumption of the counter cyclical buffer is that the IRB approach under Basel II is being used and applied appropriately. It’s not meant as a solution to inadequate methodology. However, the Basel III reforms for determining the counter cyclical buffer do suggest an interesting process, as follows:
APRA proposes to introduce the Basel III countercyclical buffer in its prudential capital regime. Broadly speaking, the application of the buffer would have the following main elements:
- APRA will continuously review the need for the countercyclical buffer, in consultation with the Reserve Bank of Australia (RBA);
- in addition to macroeconomic indicators of excessive credit growth such as the credit-to-gross domestic product (GDP) gap28, APRA’s review will be informed by input from the supervisory visits it conducts
Basel III reforms propose putting the RBA squarely at the front of controlling credit growth and systemic risk by being able to provide economic scenarios which add to Mega Bank’s capital requirements. Basel III reforms are to apply from January 2013, but what was stopping the RBA in assisting APRA with the Basel II advanced methodologies being proposed by Mega Bank? The RBA boffins would have more than enough ability to assist APRA in applying data performance adjustments which take account of enough cycles to determine a more risk averse PD over time.
The power of APRA and the RBA working together to ensure systemic risk doesn’t sit on Mega Bank’s balance sheet or in the hands of taxpayers is built into the system already. Although Basel III reforms will ensure that there is a focus on this power, its to our great detriment that it has not been used.