Should bank capital levels distress Australian regulators?

When banks run out of capital, the result can be devastating. Katia Christodoulou/EPA/AAP

Following its stepped up year-long review of European banks, the European Central Bank this weekend failed 25 of the 130 banks it tested on the strength of their capital buffers to protect against a downturn.

The result was seen as “good enough”, with many banks scraping through and those that didn’t, forced to again increase their capital, somewhat concentrated.

With the final report of the financial system inquiry due before the end of the year, the level of capital held by Australian banks is also up for review. ANZ bank chief Mike Smith has been insisting Australian banks are already well capitalised.

The issue of how much capital banks need gets very confused. There are three separate elements of the debate which get conflated.

Like other companies, banks hold equity capital as a buffer against bankruptcy. Banks now hold about double the amount of equity capital they held in the 2000s and hold about three times as much as they did in the 1980s.

Just what is the right amount clearly depends on the riskiness of the underlying business: risky businesses need to hold more capital to get the same degree of protection against bankruptcy as less risky businesses. By this criterion Australian banks seem well capitalised since they run quite low risk business models and have quite large capital buffers. This is clear from the chart below which compares CBA’s capital ratio with those of other large banks as measured by the standards used in different jurisdictions.

Common Equity Tier 1 ratios: CBA under various regimes

CBA 2014 annual results presentation

The second concern with capital does not relate to the potential bankruptcy of an individual bank, but rather to the resilience of a country’s banking system as a whole. Australia invests more than it saves with foreign capital inflow making up the difference. Capital flows in in a wide variety of forms: foreign direct investment, foreign portfolio investment, offshore government borrowing, offshore corporate borrowing, and borrowing by Australian banks. The figure below shows how the mix has changed over time, with a big reduction in banks’ borrowings since the financial crisis, and with government and non-financial corporations now responsible for the bulk of the borrowing.

Net capital inflow (% of GDP)

RBA Guy Debelle speech, 20 May 2014

The fact that Australian banks borrowed heavily offshore in the period 1998-2007 has created sensitivity to the funding risk they ran during the period.

When capital markets closed during the crisis, and particularly after Ireland’s ill-judged guarantee of its banks’ borrowings, there was a risk Australian banks would have to quickly cut borrowing, and hence lending, which risked creating a recession in Australia. There are many tools governments can use to reduce the risk of importing a crisis through exposure to international borrowings, but raising capital requirements seems likely to be one of the better ones.

The third issue that is often raised in Australia is the potential to use capital requirements as a tool of competition policy. There are two separate strands to this argument.

The first is that the large banks have a competitive advantage over smaller banks simply because of their size, and that the advantage could be reduced if the banks were required to hold more capital. This is simply an argument against size and could be applied in any industry, and is basically misplaced. If the banks are large because they are more efficient, or better managed, then handicapping them results in social losses. If they are large because of collusion or misbehaviour of some sort, then we already have mechanisms available through the ACCC to address them. There is simply no justification of a policy simply aimed at size.

The second is that the big banks have an advantage because their depositors, shareholders and bondholders are likely to be protected in a crisis (the too big to fail idea), that is that the government provides them with implicit insurance. The best solution to this is to take away quite explicitly any idea of government insurance for large banks. This has been the direct intention of regulators since the crisis.

Governments have a concern to see the operations of bank continue even in a crisis but not to protect shareholders or bondholders. Resolution regimes, living wills, and the compulsory conversion of bond-holders to equity holders (bail in) are all steps in the right direction.