APRA Has Just Shaken The Foundations Of The Way Australian Banks Report Their Exposures

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APRA chairman Wayne Byers has hit the ground running since taking over from the retired John Laker.

This week in what is likely to be seen as a landmark speech in Australian prudential regulation, Byers said that efforts to strengthen confidence in bank capital reporting are, “being undermined somewhat by an increasing lack of faith in the use of internal models by the largest banks to calculate risk-weighted assets”.

That is a shot aimed directly at the big banks both in Australia and around the world.

But he didn’t stop there:

Capital ratios are the cornerstone of any analysis of bank financial health, for investors as much as regulators. While Basel III has done much to ensure the numerator of the capital ratio is a genuine measure of a bank’s capacity to absorb loss, doubts about the reliability of risk measurement in the denominator mean that the resulting ratios lack credibility as a reliable measure of financial strength. So as it stands, the future of internal models in the regulatory framework is somewhat in the balance.

It’s a concern that segued nicely into a change of tack in capital reporting announced yesterday by APRA.

APRA’s released details of a proposed new approach that will require Australia’s “Internal Ratings Based Approach” banks, the majors and Macquarie Bank, to disclose the raw leverage on their balance sheet.

This is a big move and will shake the very foundations of the way banks report capital because banks of all shapes and sizes, both in Australia and around the globe, generally report capital on the basis of risk weighted assets.

APRA says it:

proposes that a locally incorporated ADI, with approval from APRA to use an internal ratings-based approach to credit risk under the risk-based capital adequacy framework, be required to disclose certain quantitative and qualitative information about its leverage ratio, calculated in accordance with the proposed methodology set out in draft APS 110.

There is no minimum leverage ratio requirement proposed by APRA at this stage; any decision on implementation of a minimum leverage requirement will only be taken by APRA once the Basel Committee on Banking Supervision agrees a minimum international standard.

The important change here is that when declaring its capital a bank issues a ratio of Tier 1 capital to “risk weighted” assets assets (loans are assets on bank balance sheet). Under this process, the face value of the assets is reduced by a factor associated with the “risk’ as either mandated by APRA or calculated by the financial institution under the internal ratings-based approach.

It’s all a bit arcane. But what it means is that the capital position the banks declare is much higher than the one they would declare if the total face value of their assets was taken into account, not just the “risk weighted” value of these assets.

There is nothing wrong with that as the face value of most loans – given the high degree of collateral backing such loans – is hardly ever at risk.

However, what APRA is now proposing under these changes to APS 110 and APS 330 is that banks have to expressly report their leverage.

That means that the bank will need to calculate the ratio of its Tier 1 capital divided by their assets – on and off balance sheet – based not on risk weights but face value.

All banks are leveraged, it’s part of the way they do business and the role they play in the financial system, but this move is likely to shine a light on the real leverage in Australian banking in a way that the debate about how banks calculate capital never has.

At risk from the requirement to publish leverage ratios along with the usual capital adequacy calculations is a chance for a wholesale change in analyst and investor behaviour. rather than focus on the banks preferred “risk adjusted” risk these key external stakeholders may now concentrate on these simpler leverage ratios, as a measure of bank risk, rather than the established capital calculations.

That could mean higher funding costs for more levered institutions and for the Australian banking system as a whole.

No doubt, however, Wayne Byers’ stunningly aggressive comments this week also highlights the push by APRA and the Murray Inquiry for the majors to hold more capital is both continuing and enduring.

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