The big lie in APRA’s stress test results

Let’s close one case of deception and move to the next.

The case for closure, I am pleased to say, is that APRA has finally dealt the death knell to the misleading reporting of the Majors, aka MegaBank, as to their “real” levels of capital.

The new deception however is no less worrying with our prudential regulator giving the impression that Australian banking, were it to suffer the acute stresses seen in other jurisdictions during the GFC, would be in good shape.

This new deception is equally designed to keep you and I blind to what the taxpayer is supporting in the Australian financial system.

Let’s look at closure first.

The case of closure is the long campaign to bring attention to the misleading reporting of the major banks when they represent within investor reports, the media and submissions to inquiries that their capital ratios when harmonised with international banks are actually much higher.

The point of these deceptions has been to indicate that the majors are strongly capitalised and that APRA and the FSI should keep capital requirements where they are.

But recently as others have joined our cause , both the FSI and APRA have stated that these capital harmonisation calculations produced by Mega Bank are, put simply,bunkum!

In his speech on Friday 7 November, Wayne Byers the new Chairman of APRA categorically debunked the claims when he said:

International comparisons are fraught with difficulty as data is not always available to properly compare ‘apples with apples’. And there are a multitude of ratios – eg, CET1, Total capital and leverage. However, APRA’s assessment, which incorporates the Basel Committee’s monitoring data and our own estimates of the necessary adjustments to risk-weighted assets, is that the largest Australian banks are broadly in the middle of third quartile (ie above the median) of their peers when it comes to the all-important CET1 ratio.

These banks would, however, rank lower on other measures.

That’s well below where Mega Bank, aided in their deception by the ABA and PwC in submissions to the Murray Inquiry placed themselves.

So, I applaud APRA and Wayne Byers for their new approach.

But, it’s now over to ASIC and its Chairman to bring those to account who engaged in this misrepresentation. The actions were only designed to increase returns on equity upon which management bonuses depend whilst passing the risk to both shareholders and taxpayers. Despite the seriousness of the matter I won’t be holding my breath on any action from ASIC.

But this is where an old deception gives way to a fresh one and it’s sad to have to say that, the deliberate deception continues.

Within the results of APRA’s stress tests on the 13 top Australian banks (ADIs) is a deception of breath taking degree.

The stress tests results were released in the aforementioned speech by Wayne Byers, “Seeking Strength in Adversity”. Besides the fact that details of the stress tests on a bank level were not released as they were in both Europe and the USA, the results are deliberately fashioned to give the appearance that the system passed the stresses in good shape.

This is not my read on the results.

In very simple terms, APRA says that the Scenario A stress tests show a decrease in the CET1 (tier 1 equity) ratio across the system of 3.1% moving from 8.9% to 5.8% which is well above the current minimum of 4.5%. Similar results were obtained in Scenario B. As the stresses were designed to be severe, on the face of it these appear to be excellent results designed to reassure taxpayers and the market that everything is hunky doory.

There is something about these results which doesn’t sit right with me.

APRA says that the stress tests produced losses of $170Bn over 5 years. Yet the system only has capital (CET1) of about $203Bn currently. Granted the banks would be earning net income on many parts of their portfolio during the crisis. Nevertheless and as we’ve seen overseas, all sorts of other consequences appear in a crisis and which detrimentally effect a banks earning capacity and so some fairly aggressive assumptions must have been made to tick off on banks being well capitalized when losses over the stress period almost equal the amount of capital on their balance sheets to absorb losses today.

Another curious but unsurprising result comes from the housing sector.

As Mr Byers himself states, housing was a major focus for the stress tests with total losses of $49Bn in Scenario A and $57Bn in Scenario B. Well how did the banks fair when only housing is looked at? Its not reported directly but I suppose APRA couldn’t help but report something, so how about this little gem?

As an aside, the stress test results can also give us a perspective on the relative levels of capital required by different regulatory approaches. This was not the purpose of the test, but it is topical given the FSI’s focus on the issue. The loss rates on residential mortgages in the scenarios did demonstrate that banks using the IRB approach tended to generate, on average, lower loss rates than banks using the Standardised approach. However, regulatory capital for housing held by Standardised banks was (just) sufficient to cover the losses incurred during the stress period; that was not the case for IRB banks (although strict comparison between these specific stress scenarios and regulatory capital requirements needs a degree of caution, given differences in time periods and modelling methodology between the stress test and the capital framework).

That is as close to a regulator saying fail as you can probably get without spooking investors and depositors in the system by saying FAIL!!!

In summary, Mega Bank’s capital allocated to cover mortgage risk was insufficient in total to meet losses under the stress scenarios. Doesn’t this amount to a non-validation of the IRB (internal risk based) models, and if so why are they not being changed?

But the deception continues and I also have the unfortunate task of informing you that our Mr Byers and APRA are parties to that deception.

As I pointed out above APRA’s results say that across the system that after the stress test scenario a CET1 of 5.8% is achieved. However, that’s not exactly the case, is it Mr Byers? Without explaining how the CET1 is calculated before and after the stress, its deceptive to make the comparison directly.

The APRA results clearly assume that when calculating CET1 after the stress that the calculation of risk weighted assets (RWAs) is the same even for Mega Bank which uses IRB models, otherwise APRA could not get the glowing results they report.

But that’s not how the rules work is it Mr Byers?

Under the Basel rules for calculating RWAs, under a scenario, say, where housing prices drop and defaults rise then the models must be recalibrated to account for these significant performance changes which would result in large increases of RWAs for the major banks. The result of which would be much lower CET1 ratios, more than likely much lower than minimum requirements.

This is the biggest fault with Basel II IRB models which are based on past loan performance. Its not just being able to cover losses it’s the huge amount of extra capital that needs to be raised to cover model recalibration, otherwise Mega Bank is out of business or provided with large taxpayer support.

APRA should be very clear about what they are presenting to the Australian public. To not be clear that the CET1 ratios presented as representing the system after the stresses are based on present calibrations and not the future requirements, is highly deceptive.

The Australian taxpayer which now props up the Australian banking system deserves more from its regulator.

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