The Basel committee has been busy and has finally released a consultative document, “A framework for dealing with domestic systemically important banks” (D-SIBS). This document sets out recommendations to local regulators (APRA in Australia’s case) on how local banks, which carry the risk that if they fail, it may cause systemic failure, should be regulated for their capital requirements to significantly reduce that risk. If you are an investor in Mega Bank, which makes up about 30% of the All Ords, then this is a very important document.
So lets use the tried and true MB analysis method of quoting important parts of the document and explaining how that may apply to Australia financial system:
A D-SIB framework is best understood as taking the complementary perspective to the G (Global)-SIB regime by focusing on the impact that the distress or failure of banks (including by international banks) will have on the domestic economy. As such, it is based on the assessment conducted by the local authorities, who are best placed to evaluate the impact of failure on the local financial system and the local economy.
So APRA is front and centre in determining the D-SIB capital requirement framework, within the Assessment Methodology Principles:
Principle 1: National authorities should establish a methodology for assessing the degree to which banks are systemically important in a domestic context.
Excellent start, but will “assessing the degree” be a challenge for APRA?
Principle 2: The assessment methodology for a D-SIB should reflect the potential impact of, or externality imposed by, a bank’s failure.
For those familiar with my previous analysis you’ll recall the term “externality” which I use when referring to the implied Australian government guarantee of Mega Bank. Under this principal APRA should use a methodology, which reflects the impact of triggering the government guarantee through Mega Bank’s failure. The methodology is not one that references the probability of the externality; rather it’s about the impact of that occurring. High impact occurrences even with low probability must be taken into account.
Principle 3: The reference system for assessing the impact of failure of a D-SIB should be the domestic economy.
Australia’s banking sector makes up an inordinately large percentage of the domestic economy, therefore any impact on the domestic economy from a Mega Bank, D-SIB, failure will be significant and must form part of the system implemented to determine Mega Bank’s capital requirements.
“Principle 5: The impact of a D-SIB’s failure on the domestic economy should, in principle, be assessed having regard to bank-specific factors:
(c) Substitutability/financial institution infrastructure (including considerations related to the concentrated nature of the banking sector); and
(d) Complexity (including the additional complexities from cross-border activity).
In addition, national authorities can consider other measures/data that would inform these bank-specific indicators within each of the above factors, such as size of the domestic economy.”
Australia’s banking sector is concentrated into 4 large domestically focused banks that have around 80% of both the deposit and lending markets. The reason I coined the term Mega Bank to describe CBA, NAB, ANZ and Westpac is that primarily these banks are much more similar than different. Their interconnectedness through their sources of funds, intertwined funding books of each others secured and unsecured debt, very similar risk exposure across mortgage, other retail and business debt ensures that they all carry similar domestic systemic risk. If one arm of Mega Bank starts to wobble, the contagion is almost certain to engulf all arms. CBA, ANZ, NAB and Westpac are not just D-SIBS independently, collectively as Mega Bank, they represent a massive systemic risk to Australia if not properly capitalized without the benefit of the externality of an implied government guarantee.
Additional complexity is thrown into the situation, not because Mega Bank has exposure to offshore assets, but because a very large part of the funding book is sourced from offshore, primarily Europe and the USA. This complexity or funding risk can be uncontrollable for both Mega Bank and the Australian government. Offshore investors have funded Australia’s current account deficit through Mega Bank’s balance sheet for the last 15 or so years when the Howard government systematically pursued policies to transfer government debt to the private sector balance sheets. To a small degree this process has reversed over the last few years, nevertheless, the uncertainty of offshore investors continuing to fund Mega Bank is a risk that should have considerable impact on the capital requirements of Mega bank.
Principle 7: National authorities should publicly disclose information that provides an outline of the methodology employed to assess the systemic importance of banks in their domestic economy.
APRA does not have a great track record in this area, either for their own disclosures and the enforcement of Mega Bank disclosures under Pillar 3 disclosure requirements. APRA’s approach has been to consistently not disclose details of how it’s regulating our banks or any particular bank. The argument is that either it cannot disclose information on a specific bank that may give a competitor an edge or that such disclosure may make markets aware of a bank’s weaknesses thereby accelerating a problem. In light of the continuing issues in the global banking system, this attitude is ironic to say the least. APRA would perhaps respond that that’s why Australia has not experienced the same level of banking problems as other jurisdictions. Even though the “externaility” keeps Mega Bank afloat in global funding markets.
If APRA follows its previous path then any outline of the methodology will be pretty thin on detail. Even when the Basel committee wants to ensure that the assessment process used needs to be clearly articulated and made public so as to set up the appropriate incentives for banks to seek to reduce the systemic risk they pose to the reference system.
Principle 8: National authorities should document the methodologies and considerations used to calibrate the level of HLA (High Loss Absorbency) that the framework would require for D-SIBs in their jurisdiction. The level of HLA calibrated for D-SIBs should be informed by quantitative methodologies (where available) and country-specific factors without prejudice to the use of supervisory judgement.
I believe that Principle 8 is the most important and gets to the heart of the risk of D-SIBS. The Basel Committee are instructing national authorities, ie APRA, that once a D-SIB is indentified, ie Mega Bank, a detailed quantitative method should be used to identify the level of HLA, ie capital, that a D-SIB must carry. Specifically, “the purpose of an HLA requirement for D-SIBs is to reduce further the probability of failure compared to non-systemic institutions….”
As the research previously posted here on MB shows, Mega Bank carries a level of capital against residential mortgages that is less than 2% even with mortgage insurance. Mega Bank uses internal risk based models to determine the amount of capital which are primarily based on the historical default rate of Australian mortgages relative to loan to value ratios. The period over which Mega Bank assesses the historical default rate is primarily over a period of rising house prices fueled by the expansion of mortgage credit by Mega Bank. Thereby masking probable default levels over a more benign period. Once Mega Bank is established as a D-SIB, the IRB methodology used must become a problem.
Higher capital requirements, or the HLA, is not based on the probability of events occurring but rather the impact. APRA are being advised that they should not look at merely Mega Bank’s assessment of Australian mortgage default based on history or a rising house price market but should look at the capital requirements of the D-SIB based on what happens if house prices decrease significantly. It does not need to ask about the probability of this occurring only the impact.
Principle 9: The HLA requirement imposed on a bank should be commensurate with the degree of systemic importance, as identified under Principle 5. In the case where there are multiple D-SIB buckets in a jurisdiction, this could imply differentiated levels of HLA between D-SIB buckets.
Theoretically, Australia has four D-SIBs which make up Mega bank but as each of those are so similar and correlated, APRA perhaps need not make any meaningful differentiation as to the degree that each is systemically important.
However, if there are to be significantly higher capital requirements or HLA, for D-SIBs, will this continue or will there be an incentive to reduce systemic importance by breaking up? After all, the Basel Committee does state that the purpose of the HLA is, “to provide the appropriate incentives to banks which are subject to the HLA requirements to reduce (or at least not increase) their systemic importance over time.”
Principle 12: The HLA requirement should be met fully by Common Equity Tier 1 (CET1). In addition, national authorities should put in place any additional requirements and other policy measures they consider to be appropriate to address the risks posed by a D-SIB.
The last principle is a curious mix of a definitive requirement and piece of general advice.
If APRA follows the Basel Committee recommendations, in any reasonable manner, it’s certain that Mega Bank will require significant additional Tier 1 capital. Any shareholder of Mega Bank should be aware of the new Basel Committee framework for D-SIBs and the implications for returns and risks that this may impose in the future.
There remains the possibility of other unknown additional requirements and policy measures that could affect any investor in Mega Bank.