Casualties of the externality


Now that all the hype over the RBA’s rate cut and Mega Bank’s reduction in mortgage rates has died down. Its time to recap on the only campaign in Australian media focused on Mega Bank’s balance sheet and urging bankers to follow regulatory rules and responsibilities. Whatever situation Mega Bank may be faced with politically it has a responsibility and is liable to follow the rules of the regulators who represent all Australians.

Unfortunately, added to the mix are certain regulatory shortcomings which need addressing but these shortcomings are not there to be exploited by Mega Bank in order to transfer risk to the Australian taxpayer.

My purpose of outlining a number of very technical regulatory requirements and the position of Mega Bank’s balance sheet, is to be able to establish the facts and where the Bank may be failing in its duties, responsibilities and liabilities and therefore misrepresenting the real risk position. The reader can make up their own mind on culpability. So what have we established?


Mega Bank uses a methodology based on the internal risk based approach of Basel II and III to calculate risk weighted assets and therefore minimum capital requirements. The methodology results in Mega Bank only having 1.6% capital on total residential mortgages or around 2% if mortgage insurance is included. In the face of Australia having the least affordable housing in the world and a weakening housing market, this does seem an extraordinarily low capital requirement compared to other asset classes.

Nevertheless under Basel Pillar 3 disclosure requirements, Mega Bank should “make high quality and timely disclosures of information on its risk profile, risk management and capital adequacy to contribute to the transparency of financial markets and to enhance market discipline “ I am quoting APS 330 which also includes the detailed disclosure requirements for the IRB methodologies on page 13 Table 6. No analyst, except perhaps those working for Mega Bank or APRA, would say that the Pillar 3 disclosures of all arms of Mega Bank as released to the ASX and on their websites satisfies the general and detailed requirements of APS 330. This is a wholesale failing of the system that significantly affects, shareholders, wholesale lenders, depositors and the tax payer from understanding what risks they carry.

I’ve also outlined how the recent structure of Australian covered bond issuance is deeply flawed with the shape of Mega Bank’s balance sheet put squarely into the hands of the credit rating agencies with little thought to unsecured lenders or depositors. The importance of this regulatory lapse is highlighted by the fact that whilst the APRA approved IRB methodologies only require 1.6% minimum capital the CRAs requires more than 20% overcollateralization of residential mortgages to achieve AAA ratings. Covered bond issuance by Mega Bank continues to significantly weaken the already thin capitalization levels that support unsecured lenders.


Its at this point in my discussions with those with vested interests that I get the so what look, “but Mega Bank has an implied government guarantee”. Or as one commentator, Smokester, put it, “the externality”. An expression I’ve now heard and read several times with the meaning that although such an implied guarantee exists it’s outside the bank’s control and therefore can be taken advantage of but carries no responsibility. Just another form of, losses are for the taxpayer and gains for the banks, but in a jargon which makes it acceptable. With no apologies to those who disagree, it is not acceptable.

I also have praised APRA in a previous post on the new APS 110, where it is proposed that directors and senior management are more responsible for ensuring that an ADI has adequate capital. Adequate capital must also be determined by forward looking possible risk scenarios which after stress testing should leave an ADI in a position to be able to continue to operate. This is a very significant change for Mega Bank’s directors and senior management. I’d be concerned that although the IRB methodologies produced very low minimum capital requirement for residential mortgages. Australia is looking down the barrel of falling credit demand and availability, and declining house prices. Are those directors meeting their capital responsibilities in these circumstances?

Maybe the “externality” is the get out card. The directors and management of Mega Bank know it’s a fact, although its never mentioned. APRA and the Government know it’s a fact and is relied upon heavily by lenders and other stakeholders, although it’s never mentioned. Just because it’s not mentioned does not mean a judge may not decide that directors should not take it into account in their capital decisions. After all, look at the benefits to the politico-housing complex.


The problem with this defence of course is that not all Australians are members of the politico-housing complex or are heavily invested in housing. In fact every day less and less Australians are joining the circus. Unfortunately as the system stands the non members are meant to pay for the sins of the members

There is, however, a much greater distortion in Australia’s banking system which, whilst the opposite of ”the externality” argument, actually allows it to play out. The credit rating agencies do not consider the implied government guarantee of Mega Bank to be an externality not to be mentioned. Rather, it’s a factor front and centre in their credit opinions which allows Mega Bank to receive a rating which is at least 2 notches above where it should be. The CRA’s direct acceptance of the implied guarantee gives legitimacy to the externality that neither Mega Bank, APRA or the Government will directly admit.

Whilst a CRA can give any credit opinion it want, I’d argue that giving direct credit to the “externality” is in the interests of Mega Bank but not its lenders which rely on the credit rating. Firstly, where did the 2 notches up come from? If there is a guarantee then why not assign a AAA rating as per the Australian government? If it can’t be relied upon, then how can it be taken into account? What is the probability of the government ensuring that unsecured lenders will be paid if insolvency occurs? These are questions to which the CRAs should provide answers, otherwise I see the same type of conflicts of interest that the CRAs have been accused of during the US sub-prime debacle. A less conflicted approach would be to have a headline credit rating without the implied guarantee with a rating supplement for those investors willing to believe the rating upgrade for the guarantee.


The fundamental problem with “the externality” effect is that it allows Mega Bank to hold low capital levels whilst at the same time raising debt at low levels relative to where the cost should be without its effect. This allows a large expansion of mortgage credit without the need to raise extra capital. Mortgage growth could generate its own minimum capital requirements each year in the recent boom years. A classic requirement in generating asset bubbles with little to no impairment to credit growth. At the very least, “the externality” should have been paid for even if in the form of capital to protect the taxpayer.

Whilst I make all these points, establish the facts and at least question the system, there are many who believe that “so what, the system has worked well for Australia and many have benefitted. That’s life”. “There are winners and losers, isn’t that normal business?”

There is nothing normal about the situation we find ourselves in. This is about a generation building a life style on the proceeds of debt and the valuations of assets based on air to support it. The only thing that sustains the pseudo wealth creation is the slow and steady transference of that debt to younger generations assisted by our government through “the externality”. The debt must also increase to create the same lifestyle for and to attract those younger generations. Shear weight of the numbers required, means that at some point there are not enough entrants in the game to sustain it. This is a generational battle that can only end sadly for most. It cannot be termed as the luck of the draw or accident of birth benefit for the select ones.


One of the largest problems we are faced with is that the majority of Australians currently believe they are the beneficiaries of the system called the politico-housing complex. Whilst I’ve pointed out how failures in our financial system and “the externality” have allowed this complex to thrive, why care when you think it works for you? As taxpayers and beneficiaries of the politico-housing complex, support is given to” the externality” because it delivers in spades in driving up wealth through increased house prices.

At least it has until recently, but if you know what’s good for you, Ms Taxpayer, you will take notice as there will be very few winners when the game ends.

Every day now and I’d say for at least the last year the ranks of those doing well out of the politico housing complex are reducing with those carrying the burden increasing. This weight of numbers, as mentioned above, will gradually shift not just the debate and the political will but must see a rebalancing of housing wealth whether fast or slow.


I’ll take the liberty and use some very rounded numbers to make my point. Everyone who bought a house in the last year is well behind in cashflow compared to renting and likely to be well behind in the value of equity they have in their house. That’s about 0.5M borrowers out of around 5M borrowers who are not benefitting from the politico-housing complex or from supporting “the externality”. Let’s assume that the slow melt continues, or indeed that there is simply no real increase in house prices over the next 5 years. During that time with absolute certainty the balance between those benefitting and those supporting shifts dramatically. However, at that point the beneficiaries become targets as no generation with the balance of power will wear the burden.

It is inevitable that the balance must shift. By deduction, flat house prices or a slow melt over 5 years cannot be a viable outcome. Half a million borrowers bearing the burden now will not turn into 2.5 million carrying the burden and allowing the Boomers to cash out. The majority of Gen X, Gen Y and immigrants are not that stupid. Are they?