The recommendations contained in the final report of Australia’s Financial System Inquiry, published 7 December 2014, should improve the resilience of the banking system to shocks, although the implicit government support for the system is likely to decline, says Fitch Ratings. Immediate rating action is unlikely despite the changes. Increased capital requirements, a higher average mortgage risk-weight for banks using the internal ratings based (IRB) approach to calculate regulatory capital, and improvements in the resolution framework, were all recommended by the inquiry.
Australian bank capital holdings are likely to rise significantly if all recommendations are implemented. The report suggested a baseline target in the top quartile of internationally active banks, but stopped short of providing an explicit ratio. The aim would be to ensure Australian bank capital was viewed as “unquestionably strong” – given the system’s reliance on offshore funding markets, its highly concentrated nature, and the similarity in the business models of most Australian banks.
Importantly, this would apply to all banks rather than just those using IRB models. Common Equity Tier 1 (CET1) was the inquiry’s preferred method of improving capital, although it left discretion for the Australian Prudential Regulation Authority (APRA) to focus on Tier 1 or total capital ratios if it felt these were more appropriate.
The competitiveness of smaller deposit takers would improve at the expense of Australia’s major banks, which hold 80% of system assets, if the recommendation for a higher average IRB risk-weight for mortgages is adopted. Nevertheless, a gap between the two methods is likely to remain to incentivise the banks to move toward the advanced models, and the improved risk management that ensues. The inquiry states that an average IRB risk-weight of 25%-30% would appear appropriate; and that it would require about 1pp of CET1 capital, or 40%-70% of their FY14 net profit, for the majors banks to achieve this.
Fitch expects the banks to be given enough time to raise any capital required under these two recommendations through internal means, although equity market placements may be pursued to meet the targets sooner.
The development of a stronger resolution framework is likely to result in the removal of our view of implicit support for the system, resulting in Support Ratings and Support Rating Floors migrating to ‘5’ and ‘No Floor’, respectively. However, Fitch believes Australia will wait to see how global rules settle before finalising requirements. The report supports pursuing a total loss-absorbing capacity framework, in line with global moves, with loss-absorbing instruments and trigger points clearly defined. However, the inquiry notes the area is still developing and is complex, and avoids prescriptive recommendations such as the bail-in of senior creditors.
Other recommendations included retaining the four pillars policy which prevents Australia’s major banks from merging with each other; improved transparency of capital ratios relative to global minimums; improved crisis management powers for regulators, maintenance of the current deposit insurance and protection regimes; and the implementation of a leverage ratio as a backstop to deal with any inconsistencies in internal capital models. Fitch expects these measures to have a more limited impact on Australian banks relative to the three outlined above.
The inquiry had no recommendations on liquidity, noting significant regulatory requirements are being put in place at the moment. It was also neutral as to the system’s reliance on offshore funding markets, although this formed part of its recommendations on improving the resilience of the system.
The Australian government has announced a round of consultation on the recommendations, which is expected to conclude by 31 March 2015, after which it will decide which recommendations to implement. Some of the measures could be implemented by APRA under its current powers – however, Fitch believes it will wait until the government consultation period has concluded before making any changes. Some of the more complex recommendations could be delayed until after the next Commonwealth election, currently scheduled for 2016. Fitch will comment further once the government has decided which recommendations to implement.
Moody’s Investors Service says that recommendations released by Australia’s Financial System Inquiry would — if implemented — enhance the resilience of the country’s banking system.
“The recommendations would firstly enhance resilience because of the requirement of higher capital levels, particularly for the major banks,” says Ilya Serov, a Moody’s Vice President and Senior Credit Officer.
“And secondly, the recommendation to increase risk weights for residential mortgages at the larger banks using the Basel Internal Risk-Based (IRB) approach to capital management would reduce such banks’ vulnerability to any systemic crises in the Australian housing market,” adds Serov.
“This latter approach would also help regional and smaller banks, which use the Basel Standardised approach, in achieving a better competitive position relative to the major banks,” he says.
Serov was speaking on the release of a Moody’s report on the Inquiry’s recommendations released on December 7. The Moody’s report is titled, “Australia’s Financial System Inquiry’s Recommendations Are Positive, No Near-Term Ratings Implications”.
Moody’s expects the offsetting negative effects on bank profitability created by such higher capital requirements — as well as some potential for downward pressure on certain payments and superannuation management fees — to be more muted, given the major Australian banks’ strong earnings and pricing power.
In addition, the Inquiry’s recommendations regarding bank resolution suggest that the focus is on improving the loss-absorbing capacity of the banks by increasing common equity and securities with contractual bail-in provisions, and on strengthening policymakers’ crisis-resolution powers, rather than on creating a statutory creditor bail-in regime.
While improving banks’ stand-alone credit fundamentals, Moody’s notes that increasing loss-absorbing capacity could place offsetting negative pressure on the current two-notch uplift in the major banks’ ratings for senior obligations attributable to government support, since it reduces the likelihood of bank resolution taking place by way of bail-out and instead implies a higher level of burden-sharing with creditors.
The exact resolution mechanisms Australia will ultimately adopt remain to be determined. Accordingly, their impact on bank ratings would depend onthe degree to which the positive impact of higher loss-absorption capacity offsets the possible reduction in Moody’s support assumption for the banks’ senior obligations.
The Australian government expects to respond to the Inquiry’s recommendations in 2015, following consultation with the financial sector and regulatory bodies.
Moody’s believes that the recommendations need to be considered in the context of the global regulatory reform agenda undertaken by the Basel Committee for Bank Supervision (BCBS) and the Financial Stability Board (FSB), which overlap in a number of key areas. Moody’s expects implementation of the FSI policy recommendations to take several years.
Interesting. In my view the implied guarantee is not removed by Murray’s policy suggestions. It would take much more capital to fully stabilise the system to stand alone in the event that offshore funding was cut off. Yet the CRA’s are mulling removal of it from the banks’ anyway, making their cost of funds more expensive than otherwise immediately.