Banks keep trying to make their capital ratios appear stronger, but APRA says it's a mirage

Over the past few years Australia’s major banks have consistently converted their APRA-mandated levels of capital held into some sort of “international comparison” figure higher than the stated Australian guidelines.

The uplift banks gain from such calculations appear to be an attempt to persuade investors, including short-term foreign investors who remain an important source of funding for the banks, that the banks hold more capital than the APRA guidelines suggest.

This calculation is done on the basis that APRA has a tougher regulatory framework, and thus causes heavier use of capital, than if the banks operated in another jurisdiction offshore. Crucially though, the banks don’t actually hold any more capital than they say they do, they simply re-calculate risk weights for the assets they hold – loans for example – and say that if they were operating offshore, their capital position would be higher.

Take the Commonwealth Bank, for example.

Their latest annual report shows they held 9.1% Common Equity Tier 1 capital (CET1) under APRA’s rules, down 0.2% on the June 2014 holding. But the CBA said that under an international comparison they were holding 12.7% CET1.

That’s 360 basis points or 39.5% more capital than under APRA’s rules. It implies the banks are stronger than their APRA-stated capital position says.

Interestingly it’s a position that seemed to get some support from APRA earlier this year as chairman Wayne Byers highlighted in a speech yesterday:

Our recent study that attempted to do an international capital comparison suggested the capital ratios of the major banks might, if measured on a basis more consistent with their peers, be on average around 300 basis points higher. There are plenty of caveats to this, but it provides a useful rule of thumb.

It’s the caveats that are important though and footnote 3 to the speech says:

As the study noted, APRA did not have access to the data for individual banks in the peer group. As a result, it was not possible to adjust for some country-specific differences in the application of the Basel framework. APRA was also unable, due to insufficient data, to adjust reported ratios for the impact of the capital floor (ie. the floor that limits the extent of capital benefit that banks can receive from moving from standardised risk weights to risk weights derived from internal models).

This floor is applied in almost all jurisdictions other than Australia, although not always in a consistent manner. It is possible that the floor could have a material impact on the relative positioning of Australian banks vis-à-vis their international peers.

Why the regulator would allow the banks to offer two capital figures – one real and one achieved through estimation but, by APRA’s own admission, little knowledge of the actual impact of residence in a foreign jurisdiction to the market – is difficult to fathom.

However Byers appears to have given Australia’s majors a clear indication that whatever uplifting they might want to do to their capital positions it’s their APRA CETI ratio that matters.

In his concluding remarks Byers said that “while capital comparisons across jurisdictions are useful, there is a more fundamental capital comparison that no one can afford to lose sight of. That is the comparison of Australian capital ratios against Australian minimum requirements.”

Crucially he went further noting:

For all the effort put in to providing comparable measures of capital, what ultimately counts – to investors as well as regulators – is how much capital a bank has over and above its regulatory minima.

When I convert my height from inches to centimetres, I produce a bigger number but I don’t get taller. Similarly, converting an APRA-defined capital ratio into some other (higher) measure doesn’t make a bank sounder, or create any extra capital buffer.

That’s another reason why we’re a little wary of giving too much prominence to international comparisons: if investors are interested, as they should be, in the likelihood that a regulator might intervene in the affairs of a bank, then the buffer between the locally-calculated ratio and the locally-calculated minimum is what counts.

The question for APRA now is how much longer will it allow the banks to keep producing and using these international comparisons.

Disclaimer: Greg McKenna is director of Police Bank, a Member owned bank. He has worked at both Westpac and NAB in the past.

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