Australia’s Big 4 CEOs have, in varying degrees, been waging a last-ditch effort to try to convince the Murray Inquiry, Treasurer Joe Hockey and APRA that they have sufficient capital to cover all eventualities that may come to pass in the Australian economy and housing market.
But the bad news, for them, seems to be there is a commonality of understanding between the Prudential Regulator, APRA, and at least the Treasurer in the run-up to the final recommendations of the Murray Inquiry later this month.
On Friday, APRA chairman Wayne Byers delivered a speech which walked the fine line between not spooking investors in the banks but still signalling that more capital is required to be held by the majors.
Right at the start of his speech, Byers cut to the heart of why banks hold capital and why, perhaps, they need more. Byers said that, “we require banks to have capital because they make their money by taking risks using other people’s money”.
Not just the depositors banks borrow from but the community at large:
As very highly leveraged institutions at the centre of the financial system, investing in risky assets and offering depositors a capital guaranteed investment, we need confidence that banks can withstand periods of reasonable stress without jeopardising the interests of the broader community (except perhaps for their own shareholders).
This is the point myself, and others, have recently raised. That is, the banks are not the economy but here to serve the economy.
Thus, the banks can no longer expect to effectively set their own capital levels via their internal ratings-based models.
As Byers says:
“All models, they are only as good as the data that feeds them. This applies both to the internal risk data, such as accurate records of LVRs, and external
economic data. The paucity of loss data in Australian experience is a particular challenge for estimating losses, especially on residential mortgages – again, this is a good dilemma to have, but still a problem for the modelers!”
That’s regulator speak for “we don’t exactly trust your models, especially given they have no actual stressed period in them”.
This is a problem, or at least a potential one if left unchecked, because Australian banks aren’t actually holding any more capital to assets now than in the past, even though their stated Tier 1 capital ratios have risen.
How can this be?
“Put simply, much of the strengthening of capital ratios relative to a decade ago is less the product of substantial growth in capital and more the product of the increasing proportion of housing loans within loan portfolios. In short, banks have de-risked rather than deleveraged,” Byers said.
This is how the “risk-based approach” has emphasised the growth of home loan lending for banks as more capital efficient than other types of lending.
So it is slighthly disengenuous of APRA and regulators around the world criticising the banks for using the regulations that they, and the BCBS in Basel, established.
But that doesn’t mean there is not a potential issue for an economy with four major banks carrying too-big-too-fail status and concentrated in home loan lending.
Which is why even though Byers says that after the stress test APRA and the majors conducted, they stayed above “the minimum CET1 capital requirement of 4.5 per cent.”
He, and APRA, believe more capital needs to be held.
Almost all banks projected that they would fall well into the capital conservation buffer range and would therefore be severely constrained on paying dividends and/or bonuses in both scenarios. For some banks, the conversion of Additional Tier 1 instruments would have been triggered as losses mounted. More generally, and even though CET1 requirements were not breached, it is unlikely that Australia would have the fully-functioning banking
system it would like in such an environment.
What’s clear from Byers’ conclusions at the end of the speech is that the banks appear to have looked at their own issues, problems, reactions and responses in isolation and not recognised the organic link within the financial system. As a result, bank plans “appeared reasonable in isolation – but may start to test the brink of market capacity when viewed in combination and context.”
Which brings the APRA chairman to the conclusion that:
the Australian banking industry appears reasonably resilient to the immediate impacts of a severe downturn impacting the housing market. That is good news. But a note of caution is also needed – this comes with a potentially significant capital cost and with question marks over the ease of the recovery. The latter aspect is just as important as the former: if the system doesn’t have sufficient resilience to quickly bounce back from shocks, it risks compounding the shocks being experienced. Our conclusion is, therefore, that there is scope to further improve the resilience of the system.
Which means more capital in the banking system, tighter lending standards and credible recovery plans, according to Byers.
What’s the Treasurer say about all this?
According to the AFR on the weekend, a spokesman said it’s now down to the Murray Inquiry and APRA.
“If Murray says the banks need more capital and APRA says the banks need more capital, then they are going to have more capital,” a “well-placed source” told Fairfax.
It seems Australia’s major banks are just going to have to get used to holding more capital. It’s likely due to competition that they, not the economy, will wear the cost.
You can read Wayne Byers full speech here
Disclaimer: Greg McKenna started his career at Westpac in 1986 as a management Trainee, he quickly moved into the dealing room and after 5 years moved on to become a broker and then fund manager before heading back to Westpac and then the NAB. He was Treasurer of Newcastle Permanent for a number of years and is now a Director of Police Bank, a member owned bank. Such a varied resume has helped Greg see both sides of the coin clearly and he comes down on the side of system stability.