It is with some vindication that I am able to inform MB readers of a forthcoming investigation by the Basel Committee on the progress of the implementation of Basel III reforms on a country by country basis. The investigation will extend to include the calculation of risk-weighted assets in both the banking book and the trading book. Details can be obtained from the Basel website and were posted on 3 April even though some action has been going on for months.
Wayne Byres, the Basel committee’s new secretary-general, iss quoted in Risk Magazine:
A stricter approach to the modeling of bank capital is “high likely”, as a result of concerns that risk-weighted asset numbers are too divergent. ‘Banks are likely to have less freedom to calculate their own regulatory capital requirements after the Basel Committee on Banking Supervision completes its probe of modeling choices at different institutions.
I have written numerous posts highlighting the inadequacy of Mega Bank’s (our big four banks) IRB methodologies under Basel II and the lack of transparency required under Pillar 3 which has resulted in Mega Bank’s minimum capital requirements being 1.6% on residential mortgages or 1.95% including LMI. The global issues around the calculation of risk weighted assets commenced being highlighted also by a number of bank spokespeople in the middle of 2011, mainly in the USA. These concerns have been now recognized by the Basel Committee with a formal investigative process beginning in 2012.
The Basel Committee has said that the investigation will prioritise the global SIFIs so Mega Bank is not top of the list. Nevertheless Australia can expect a visit to investigate the IRB methodologies of Mega Bank probably within the next year. What does this mean for Australia and every Australian?
If history is any guide, the wool can be pulled and nothing will change. Readers might recall that in January the IMF released a stress test report on Mega Bank. The MSM and many commentators interpreted that report as indicating the strength of Mega Bank in a stressed scenario similar but less severe than Ireland. Under the IMF scenario Mega Bank would have around 5% Tier 1 capital but no provisions left under such a stress. Commentators apparently thought that indicated superior strength, whilst the detail of how much capital Mega Bank would need under that stress to stop becoming a zombie bank at that point was ignored. If you do the calculations, it’s around $100Bn of additional Tier 1 capital give or take a few $10Bn. Mega Bank, APRA and the RBA wore the IMF report as if it was a badge of honour and not a strong warning signal. Will history repeat itself with the Basel committee investigation?
With a little help perhaps the Basel Commitee investigation into Mega Bank will be different and capital inadequacies will be either recognized or debated openly and accepted as adequate. Firstly let’s turn to another quote from the Basel committee’s new secretary-general, again from Risk Magazine.
Such variations could be the result of differences in business models and risk profiles, or they could reflect a deliberate attempt to minimise capital requirements. The Basel Committee’s RWA investigation will try to separate one from the other, says Byres – but the result could be a reduction in modeling flexibility.
This represents a powerful recognition from a senior global “regulator” that some banks could be minimizing their capital requirements by deliberately gaming the system. Mega Bank may be in for a shock that the game is no longer about models that minimize capital requirements and therefore increase return on that capital whilst passing the risk to the taxpayer. It’s (from the proposed APS 110):
…about ensuring that the bank maintains an appropriate level and quality of capital commensurate with the type, amount and concentration of risks to which the bank is exposed from its activities having regard to any prospective changes in the bank’s risk profile and capital holdings.
Clearly, the proposed changes by APRA to APS 110 which I detailed in my last post are connected to the debate going on within the Basel Commitee and the up coming investigation into all banks’ including Mega Bank’s IRB methodologies and assumptions. BTW, it’s been remiss of me not to mention that the new secretary general of the Basel Commitee appointed in January, the aforementioned Mr Byres, was previously executive general manager of the diversified institutions division at the Australian Prudential Regulation Authority.
APRA is changing the rules that Mega Bank must follow on how and who’s responsible for maintaining adequate capital. This changing of the rules calls into question the current IRB methodology for residential mortgages and how its been determined and used to date. Conveniently the Basel Committee, under the direction of a former APRA employee but not APRA, will now question the methodology. The Basel Committee review will cover all assets and include operational and liquidity risks. However, as residential mortgages are well in excess of 50% of Mega Bank’s assets and enjoy such a favourable capital treatment over other assets classes, we should expect that a primary focus will be on the IRB method used for mortgages.
The most significant IRB methodology input change, in my opinion, is the need to take account of prospective changes in the bank’s risk profile and capital holdings. This is done primarily by stress testing and scenario analysis relating to potential risk exposures and available capital resources. Will the application of proper stress testing analysis give a different result for Mega Bank’s risk weighted assets and therefore minimum capital requirements? Based on the Mega Bank’s current capital holdings against residential mortgages and the results of the IMF stress test I previously referred to, one would think a definite yes, but how will the Basel Committee investigation apply stress testing methodology?
Fortunately we can answer that question because the Basel Comm has a guideline to which we can refer. “Principle 1 For Banks” with some explanation almost says it all:
Stress testing should form an integral part of the overall governance and risk management culture of the bank. Stress testing should be actionable, with the results from stress testing analyses impacting decision making at the appropriate management level, including strategic business decisions of the board and senior management. Board and senior management involvement in the stress testing programme is essential for its effective operation.
Followed up by:
Stress testing should form an integral part of the internal capital adequacy assessment process (ICAAP), which requires banks to undertake rigorous, forward-looking stress testing that identifies severe events or changes in market conditions that could adversely impact the bank.
And Principle 8:
Stress testing programmes should cover a range of scenarios, including forward-looking scenarios, and aim to take into account system-wide interactions and feedback effects.
And what should a Supervisor/Regulator/APRA do as per Principle 19?:
Under Pillar 2 (supervisory review process) of the Basel II framework, supervisors should examine a bank’s stress testing results as part of a supervisory review of both the bank’s internal capital assessment and its liquidity risk management. In particular, supervisors should consider the results of forward-looking stress testing for assessing the adequacy of capital and liquidity.
The Principles outlined herein represent a selection that point to the type of scrutiny that Mega Bank should be under to justify its current IRB methodologies for residential mortgages. Will this scrutiny be carried out in a transparent and appropriate manner and will it result in meaningful change?
On the one side we have an Australian housing market which is close to the most unaffordable in the world with mortgage debt at 100% of GDP also close to the highest of any country, yet Mega Bank calculates its minimum capital requirements at 1.6% on residential mortgages which undoubtedly would be close to the lowest of any bank in the world. Faced with these facts a local regulator, APRA, has just introduced significantly greater responsibility for directors and management to maintain adequate capital with a strong emphasis on stress testing for future potential risks. Plus, a Basel Committee investigation into Mega bank’s IRB methodologies for calculating minimum capital where the committee’s secretary general, former APRA employee, acknowledges that some banks may be gaming the Basel II IRB approach rules. Surely, the result the Basel Committee assessment is a foregone conclusion?
Sadly, no. On the other side, however, we have an equally formidable opponent. Do not underestimate the politco-housing complex. The smoke screens will be built and a whitewash is on the cards. Australia has a history of painting a very rosy picture of our financial system and housing market in the face of significant known risk factors. Deny the risks and maintain the meme that Mega bank and house prices are strong and will remain so. Which side will APRA take? Mr Wayne Byers’ position could be very useful either way.
Fortunately there is something that independent concerned parties can do. The following is an extract from the rules of the Basel investigative/assessment team.
Domestic banking regulators and supervisors are expected to be the key counterparts of the assessment team during the on-site reviews, but meetings with other relevant parties (including the finance ministry or treasury, industry representatives, accounting representatives, analysts) may also take place to ensure that the assessment team collects a broad range of views and develops a sound understanding of local regulatory requirements. If scheduled, meetings with the private sector are expected to take place without the participation of representatives of the domestic authorities.
I for one will be contacting the Basel team, finding out when they’ll be in Australia and arranging for them to have available the relevant excellent analysis that the MB bloggers and others have presented to the Australian public over the last 15 months. Lack of credible information must not be an issue for the Basel Commitee investigators.