Unquestionably weak: Why Aussie banks need $75bn (to start with)

APRA’s Wayne Byers gave a speech on 5 April which sought to set the agenda for the future state of the bank capital in Australia. Whilst clearly the agenda is that bank capital is to increase, I found the speech misleading on the current state of major bank capital and therefore grossly misleads the market in how much extra capital is actually required to ensure that the major banks are unquestionably strong and therefore are most unlikely to call on taxpayer support.

The recommendation of David Murray’s Financial System Inquiry (FSI) and as accepted by the Federal Government was that unquestionably strong was when the major banks capital or CET1 Ratios are in the top 25% of international peers.

As reported on MB, Morgan Stanley doesn’t think it’s very much but has MS done enough homework?

My contention which I and others have had for quite some time is that both the banks and APRA misrepresent how strong the major banks are compared to international peers and that we have a long way to go to get to the FSI definition of “unquestionably strong”.

According to Mr Byers and APRA our collective banks core capital or CET1 ratios are as follows:

On the 31st December 2016 APRA are saying that the major banks CET1 ratio looks to be about 9.6%. Now how does that compare to international peers?

According to the Basel Committee (BCBS) Basel III Monitoring Report, February 2017 on page 42, the median CET1 ratio of Group 1 banks that includes Australia’s major banks, is 12.1% and the start of the top quartile (25%) is a healthy 13.8% as at 30 June 2016. These ratios are directly comparable to APRA’s 9.6% for the major banks as per Chart 3.

But Mr Byers and APRA represent the comparison as follows:


The Following is the explanation:

“Chart 4 shows the interquartile range of CET1 capital ratios for large internationally-active banks. The range has risen pretty steadily, with no sign of levelling off just yet. This accumulation of capital must surely slow soon, but given many banks are still building capital we expect the trend to go on a bit further before it does so. The dot shows where the major banks collectively sat in June 2014, and the arrow represents what we estimated, at that time, would be required to be comfortably in the top quartile over the longer term”.

Does anyone know what this means? I’m not sure exactly but there are couple of points that I can explain. Where the dotted line sits looks to be the 13.8% as referenced from the BCBS report as the point where a bank crosses into the top 25%. However, where the dot sits as representing Australia’s major banks is nearly 12% for the CET1 ratio. Where does that number come from? APRA’s own calculation as outlined in Chart 3 is 9.6%, which totally contradicts the comparison in Chart 4 by a massive of 2.4%! Mr Byers refers in his speech of a difference of 2% for the major banks to be in the top quartile when it’s more like 4.2%.

Neither Mr Byers nor APRA provide any explanation to this obvious contradiction. Nor did they provide a clear reference for where the information came from. The reference to the Bank of international Settlements (BIS) is a bit obscure. However, it could only have come from the BCBS (a part of the BIS) report that I have referenced and linked above. I cannot help but think that this whole issue has been deliberately obfuscated, even though this may be the single most important issue that the Australian banking system has to deal with. Recall that the FSI recommended that the major banks should be in the top quartile of CET1 ratio and that on behalf of the people of Australia, the Federal Government accepted that recommendation.

I may be able to throw some light on the issue. For quite some time (2008) the major banks that use Internal Risk Based methods to calculate risk weighted assets and capital have represented that when comparing their capital or CET1 ratios that adjustments need to be made, obviously in their favour, when comparing to international peers. Consequently, perhaps the difference between the actual reported CET1 ratio of 9.6% and the comparison in Chart 4 above of 12% is due to assumed adjustments. These representations are to a degree supported by non-independent papers from the Australian Bankers Association, PwC and APRA itself.

I and a number of others have specifically debunked these claims on many occasions. The whole thing defies logic because there is no information on bank IRB calculations which allow for there to be a direct comparison of models. The Basel II regime was actually designed so that international peer comparisons can be made with the Pillar 1, 2 and 3 regime. No room here to go into details but put simply, Pillar 1 are minimum requirements which a local regulator can differ from but the underlying models or calculations are not disclosed, and Pillar 2 which are also non-disclosed local regulator adjustments for local conditions. Under these circumstances its simply not possible to do a line by line comparison or adjustments when comparing banks in other jurisdiction and these would not be accepted internationally anyway.

On the face of it the major banks are short 4.2% on CET1 ratio if they are going to be “unquestionably strong”. CET1 is based on risk weighted assets. What happens when we compare ratios on non-risk weighted assets?

Mr Byers produced this chart.

Note with Chart 6 that there is no source on the data and or an explanation of the use of Tier 1 capital ratio rather than CET1. According to the BCBS report previously cited and on page 42, we can say the Tier 1 ratios are generally about 1% above CET1 ratios but could be a lot more. So looking at Chart 6, the use of Tier 1 ratio and how that compares to Chart 3 is not explained and makes the whole situation difficult to understand.

Chart 6 also contains a representation of total ADIs’ Shareholders equity to total assets. Note there is no breaking out the major banks. Firstly it is very significant that since 2007 this ratio has only increased from 6% to 6.5% when the Tier 1 ratio has increased from around 8% to 12%. Risk weighted assets have decreased relative to assets even as the balance sheets have grown immensely.

Referring back to the BCBS report previously cited, we can compare with international Group 1 bank peers via the Leverage Ratio. The LR is specifically defined as per here. In the absence of definitions supplied by APRA, I can only estimate that the LR would normally be much lower than a ratio referred to as “Shareholders equity to total assets”. On page 49 of the BCBS report, to be in the top quartile of Group 1 banks the LR would need to exceed 7.0% for “unquestionably strong”. So the only thing we can conclude with certainty is that Australia’s major banks are not in the top 25% for their Leverage Ratios. APRA has the data on LRs, so why were they not used and compared to international peers in Mr Byers’ speech?

So what does Mr Byers say about APRA’s responsibility to ensure that the major banks are “unquestionably strong” and in the top quartile or 25%?

“In thinking about the concept of ‘unquestionably strong’, there are three basic ways to do that:

  • relative measures: the FSI adopted a relative approach in suggesting that unquestionably strong regulatory capital ratios would be positioned in the top quartile of international peers. We have said on a number of occasions that we do not intend to tie ourselves mechanically to some particular percentile, but top quartile positioning is a useful sense check which we can certainly use to guide our policy-making………………”

Note the bolded words, a clear indication of the accountability of APRA. There is no accountability. In the face of the FSI recommendation and the acceptance of that recommendation by the Federal Government on behalf of the people of Australia, APRA says quite clearly that they are not bound to follow the will of the people.

If you want evidence of how important capital requirements are to the major banks and the mortgage market, we need look no further than Chart 7 from Mr Byers’ speech.

Note the vertical line in 2008 when the major banks started using their Internal Risk Based models to calculate risk weighted assets. From that point capital requirements for mortgage loans decreased significantly with a corresponding large increase in housing loans as a proportion of the lending book.

Assuming that APRA grows some balls and enforces the will of the people to ensure that their major bank masters are unquestionably strong, what’s the capital shortfall?

The major banks have assets of around $2835Bn according to APRA’s February 2017 Banking Statistics. This translates to $1344 of risk weighted assets using an average risk weight of 48% as per Chart 7 above. Multiply that by the 4.2% shortfall. Let’s go with a rounded $60Bn plus the amount from changing the risk weights of mortgages as calculated by Morgan Stanley in the report cited above of $12.5Bn to $16Bn. Let’s call it all $75Bn to be on the safe side.

The $75Bn requirement is without any stress in the mortgage market and a changing of risk perception in capital models, but it is what’s required to ensure our banking system is unquestionably strong, and for taxpayer risk to be minimised and bankers held accountable.
If you want something to get angry about, get angry about this. It’s a planned conspiracy between major banks and APRA to minimise major banks capital, and deceive the taxpayer and market, for the benefit of bankers and regulators at the cost of taxpayers.

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