tag:theconversation.com,2011:/us/topics/bank-capitalisation-13146/articlesbank capitalisation – The Conversation2017-02-21T02:40:31Ztag:theconversation.com,2011:article/729762017-02-21T02:40:31Z2017-02-21T02:40:31ZAPRA fiddles on bank risk while Rome burns<p>Australian Prudential Regulation Authority (APRA) chairman Wayne Byers has <a href="http://www.financialstandard.com.au/news/apra-urges-banks-to-raise-capital-92155866">made it clear</a> the bank regulator will be cracking down on bank capital levels this year. </p>
<p>Bank capital reserves are a loss-absorber, designed to protect creditors if banks suffer significant losses. That protection, in turn, will – ostensibly – prevent panicked withdrawals by depositors, thereby preventing financial contagion and financial crises.</p>
<p>Byers has decided that Australian banks’ capital levels must be “unquestionably strong” in keeping with the <a href="http://fsi.gov.au/files/2014/11/FSI_Final_Report.pdf">findings of the Financial System Inquiry</a>. But how much capital equals “unquestionably strong”? We don’t know. </p>
<p>What we do know is that the inquiry handed down that finding in November 2014. More than two years have passed and only now is APRA getting a wriggle on. </p>
<p>The problem is that, <a href="http://data.imf.org/?sk=9F855EAE-C765-405E-9C9A-A9DC2C1FEE47">according to the IMF</a>, when it comes to Tier 1 bank capital, this time last year Australia was ranked 91st in the world. That puts us close to the bottom of the G20, the OECD and the G8. Our position has fluctuated, but at no time during the preceding four quarters have we risen above 60th.</p>
<p>Ranked above Australia were Swaziland, Afghanistan and even Greece. That sounds like, at best, unquestionably ordinary. Maybe even unquestionably weak. But definitely not “unquestionably strong”.</p>
<h2>The global financial crisis could’ve led to change</h2>
<p>Some argue, determinedly and erroneously, that when functioning correctly bank capital levels are almost magical things. As former US Federal Reserve chair Alan Greenspan <a href="https://www.c-span.org/video/?292886-1/2008-financial-crisis-federal-reserve-day-1-part-1">once said</a>:</p>
<blockquote>
<p>The reason I raise the capital issue so often is that … it solves every problem.</p>
</blockquote>
<p>Greenspan, as Fed chair, was ultimately responsible for the health of the US financial system. Having touted capital levels, his tenure ended just before the sub-prime disaster turned into the global financial crisis. This earned Greenspan Time Magazine’s moniker as one of the 25 people <a href="http://content.time.com/time/specials/packages/article/0,28804,1877351_1877350_1877331,00.html">most to blame for the crisis</a>.</p>
<p>However, bank capital levels were in place before the crisis hit. The Basel Committee – a sort-of UN for Reserve Bank governors and bank regulators – <a href="https://theconversation.com/is-the-basel-process-broken-you-can-bank-on-it-11488">introduced global standards</a> for bank capital as far back as 1988.</p>
<p>Back then, it set the capital level at 8%. In other words, for every $100 in liabilities, banks had to retain $8 in cash (or close to cash). But this level was simply a reflection of the average of the day. </p>
<p>Codifying the average into a global standard was an excellent trick. No-one was made to feel left out, or inadequate.</p>
<p>Then came the global financial crisis. It resulted in an output loss of somewhere between US$6 trillion and US$14 trillion <a href="https://www.dallasfed.org/research/eclett/2013/el1307.cfm">in the US alone</a>.</p>
<p>The Basel Committee said it was going to raise bank capital levels in response to the crisis. This meant it was going to do more of the thing (bolster capital levels) that had been meant to prevent such a crisis from occurring in the first place, but had failed.</p>
<h2>What now?</h2>
<p>The Basel Committee’s <a href="https://www.bloomberg.com/news/articles/2017-01-03/global-bank-regulators-delay-key-meeting-on-capital-rule-revamp">latest attempt to take action</a> on capital levels involves curbing “internal risk-based models”. These models allow banks to determine how risky their assets are, and therefore how much expensive and unusable capital they have to set aside for loss-absorption, to match the risk profile of their assets. </p>
<p>That’s like you or I determining how risky we are as borrowers, and therefore deciding how much interest we should be charged on the money we borrow.</p>
<p>European banks <a href="https://www.bloomberg.com/news/articles/2017-01-03/global-bank-regulators-delay-key-meeting-on-capital-rule-revamp">have pushed back</a> against curbing internal risk-based models. They resent not being able to have absolutely everything their own way. And the Basel Committee has proven to be a push-over.</p>
<p>Australian banks have pushed back too, with a not-so-subtle threat that <a href="http://www.smh.com.au/business/banking-and-finance/apra-lifts-mortgage-capital-on-big-banks-by-billions-of-dollars-20150719-gify5r.html">customers will bear the costs</a> of higher capital levels. If Byers and APRA do what they are supposed to, and what the government told them to do <a href="http://www.afr.com/opinion/columnists/apra-to-force-big-banks-to-raise-more-capital-20170212-guaxi2">in late 2015</a>, Australia’s banks will need to raise A$15 billion or more to rectify their thin capital position.</p>
<p>That’s $15 billion not earning returns or bringing in bonuses. No wonder our bankers aren’t happy.</p>
<p>And while APRA and Byers have fiddled on this issue and effectively ignored government instructions, and Australian banks remained capital-thin, conditions have arisen that economist John Adams argues <a href="http://www.news.com.au/finance/economy/australian-economy/australia-headed-for-economic-armageddon/news-story/998390d5128ed69e8799db3de9efe52d">may result in</a> an “economic Armageddon” for Australia. </p>
<p>If that happens, guess who will be bailing out the banks? You, the taxpayer.</p><img src="https://counter.theconversation.com/content/72976/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Andrew Schmulow is affiliated with, and serves in executive capacities for, Australian Citizens Against Corruption (ACAC); the Australian Law and Economics Association (AustLEA) and the American Council on Consumer Interests (ACCI). He is the founder and CEO of Clarity Prudential Regulatory Consulting Pty Ltd. He currently consults to members of Australia's House of Representatives and the Senate of the Republic of Korea.</span></em></p>Some argue, determinedly and erroneously, that when functioning correctly bank capital levels are almost magical things.Andrew Schmulow, Senior Lecturer, Faculty of Law, The University of Western AustraliaLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/668952016-11-18T03:34:21Z2016-11-18T03:34:21ZDeutsche Bank turmoil shows risks of weakening bank capital standards<p>Deutsche Bank, a venerable 146-year-old bank whose very name symbolizes the German financial system, has recently found itself in considerable turmoil. </p>
<p>The kicker came in September when the <a href="http://www.wsj.com/articles/deutsche-bank-is-asked-to-pay-14-billion-to-resolve-u-s-probe-into-mortgage-securities-1473975404">Department of Justice slapped</a> it with a US$14 billion fine for alleged wrongdoing during the financial crisis. But Deutsche Bank was already being buffeted by a string of bad news. Its <a href="https://www.theguardian.com/business/2016/sep/26/deutsche-bank-share-price-lowest-mid-1980s">stock price has slumped</a> over the past year due to a decline in investment banking and dim prospects for its commercial banking business. </p>
<p>This has led to <a href="https://www.google.com/search?client=safari&rls=en&q=deutsche+bank+lehman+moment&ie=UTF-8&oe=UTF-8">speculation</a> about whether the German government will have to bail it out and, if it doesn’t, whether markets will soon experience another “Lehman moment” – referring to how the collapse of the U.S. investment bank sparked a global financial meltdown in 2008. </p>
<p>As I see it, these concerns obscure the much deeper problem that afflicts the European banking sector and that a bailout alone will do nothing to resolve: a lack of capital. </p>
<p>It also offers a stark warning for U.S. regulators amid talk of changes to banking rules – <a href="http://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp">especially Dodd-Frank</a> – under the new administration. While some changes to the U.S. financial system may be worthwhile, easing capital standards would be a mistake and make another financial crisis much more likely. </p>
<p>Instead, regulators on both sides of the Atlantic need to make sure there’s no question their banks are able to withstand a shock – whether a billion-dollar fine or something much more severe. </p>
<h2>Why Deutsche Bank won’t be bailed out</h2>
<p>While allowing a bank that has the size and prominence of Deutsche Bank to fail is obviously an event that could have seismic repercussions, bailing it out is not something that would be easy for the German government to do. </p>
<p><a href="http://www.cnbc.com/2016/09/30/deutsche-bank-bailout-would-be-political-suicide-for-merkel-analysts-warn.html">There are many reasons for this</a>. One is reputational. Angela Merkel, the German chancellor, has been critical of other governments (especially in Europe) for using taxpayer funds to bail out their banks.</p>
<p>Second, there is little support among German taxpayers for the bailout, so it would also be politically costly.</p>
<p>While it’s interesting to speculate about this, there are other questions that are even more pertinent. First, what is the real problem here? Why is Deutsche Bank in the mess it finds itself in? What can we do to prevent our major financial institutions from being so fragile in the future?</p>
<p>There are many factors responsible for what ails Deutsche Bank. Perhaps none figures more prominently than its capital position during and after the crisis. </p>
<h2>Who’s the riskiest of them all?</h2>
<p>Among its peer institutions, Deutsche Bank is the riskiest based on its “leverage ratio,” which essentially measures how much equity capital it has as a percentage of total assets. </p>
<p>On June 30, its leverage ratio stood at a <a href="http://www.bloomberg.com/news/articles/2016-09-20/deutsche-bank-s-low-capital-makes-it-no-1-for-risk-hoenig-says">shockingly low 2.68 percent</a>, or about half the average for the eight biggest U.S. banks, according to the Federal Deposit Insurance Corporation. That means it had only $2.68 in equity for every $100 in assets. </p>
<p>A low ratio means it has less cushion if there’s a problem. Since banks are required to mark many of their assets to market, an adverse price movement that reduces the value of its assets by just 3 percent would completely wipe out its equity. </p>
<p>We can see that the bank’s low capital is bad from at least two perspectives. One is that a 2.68 percent leverage ratio is less than what Bear Stearns had (2.78 percent) in early 2008 <a href="http://www.slate.com/articles/business/moneybox/2008/03/bear_run.html">before it collapsed</a> and had to be rescued by the U.S. government via a deal with JPMorgan Chase. </p>
<p>Another is that under the <a href="http://www.bis.org/bcbs/basel3.htm">Basel III’s capital rules</a>, banks are required to have a leverage ratio exceeding 3 percent. As an interesting contrast, U.S. bank regulators have adopted a 5 percent minimum leverage ratio for domestic banks. (One caveat is that European regulators [European Banking Authority] gave Deutsche Bank a ratio of 2.96 percent earlier this year,slightly higher than what the FDIC gave it, but still very worrisome.) </p>
<h2>The ‘doom spiral’</h2>
<p><a href="http://rfs.oxfordjournals.org/content/early/2011/02/09/rfs.hhq022">Extensive academic research</a> has revealed that a lot of bad things can happen when a bank has critically low capital. </p>
<p>One is that its internal culture gets skewed in favor of growth and excessive risk taking. Deals that can make the bank a lot of money if they pan out (but can also cost the taxpayers a lot) become more attractive. The other consequence is that there is “debt overhang” – so much debt that shareholders are unwilling to infuse any more equity into the bank since most of the benefits of the new equity will flow to the depositors and other creditors.</p>
<p>So this creates a sort of “doom spiral”: More equity is needed to rescue the bank, but excessive debt stands in the way. So the government finds itself on the horns of a dilemma, either let the bank fail or infuse taxpayer money to rescue it.</p>
<p>Finally, more highly levered banks also make a bigger contribution to systemic risk, which is the risk that the whole system will fail, as we saw during the financial crisis.</p>
<p>We see some evidence of these forces operating at Deutsche Bank. <a href="http://www.zerohedge.com/news/2016-10-08/deutsche-bank-raises-3-billion-debt-hedge-fund-explains-what-its-bail-would-look">Reports suggest</a> the bank is unlikely to raise new equity because its stock price is “too low” and trading at about 25 percent of the book value of its equity. That means the market thinks the value of the bank’s equity is worth just 25 cents when the bank’s balance sheet states it as one dollar. Put slightly differently, if Duetsche bank states its shareholders equity on its balance sheet as $100, the market will actually pay only $25 to buy it.</p>
<p>One reason for the low stock price is its dim business prospects, thanks to anemic economic growth in Europe and tighter banking regulations. The other, of course, is the aforementioned debt overhang.</p>
<p>With such low capital, it is also hardly surprising that its <a href="https://www.ft.com/content/9a018afe-3e37-11e6-9f2c-36b487ebd80a">U.S. unit failed the Federal Reserve Bank’s stress test</a> in June. The only other major bank that failed was the U.S. unit of Santander. When a bank fails a test, it is not allowed to remit dividends back to its parent company and may face harsher sanctions. In addition there is reputational damage and potential loss of customer trust, which can be very damaging to the stock price.</p>
<p>Moreover, consistent with the predictions of <a href="http://www.annualreviews.org/doi/abs/10.1146/annurev-financial-110613-034531">academic research</a>, the <a href="http://www.bloomberg.com/news/articles/2016-06-30/deutsche-bank-may-be-top-contributor-to-systemic-risk-imf-says">International Monetary Fund named</a> the bank as “the most important net contributor to systemic risk.” In other words, by keeping capital that is too low from a prudential regulation standpoint, Deutsche Bank is creating risk, not only for itself but for the whole global financial system. </p>
<h2>The real concern</h2>
<p>So, the real problem for global financial stability is not whether Deutsche Bank will be bailed out. It is the question of what bank regulators are going to do to get more equity capital into banking. </p>
<p>In this regard, U.S. bank regulators have done considerably better than European (and <a href="http://www.wsj.com/articles/warning-from-tokyo-dont-let-bank-regulators-create-another-japan-1470084857">Japanese</a>) bank regulators. During the financial crisis, the U.S. government took equity stakes in banks, effectively recapitalizing them. When the shareholders of these banks repurchased the government’s stakes, private equity capital replaced taxpayer-provided capital, and the U.S. banking system ended up on a much sounder footing as a result. </p>
<p>By contrast, this did not happen in Europe. In fact, <a href="http://uk.reuters.com/article/uk-banks-leverage-idUKBREA0C0G020140113">banks in Europe lobbied</a> their bank regulators to water down the Basel III capital rules so as to avoid having to raise billions of euros in new capital. As a result, banking fragility in Europe remains considerably higher than in the U.S.</p>
<p>What should be done going forward? I think the single biggest regulatory imperative in banking is to get banks to have significantly higher capital ratios, both in the U.S. and in Europe, although the problem in Europe is more pressing. </p>
<p>And American taxpayers and bank regulators cannot afford to be smug about American banks being better capitalized than European banks. There may be lobbying of the new administration to water down capital requirements but doing so will be bad for the economy, both here and globally. Hopefully we will not repeat the mistakes made in Europe.</p>
<p>We live in a highly interconnected global financial system. European banking fragility imperils the U.S. and indeed the global financial system. Bailouts generally do not foster future financial stability; higher capital does. That’s where the answer lies.</p><img src="https://counter.theconversation.com/content/66895/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Anjan V. Thakor does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Is the financial system headed for another ‘Lehman moment’? Perhaps, but a bailout isn’t the solution. More capital is, something Trump should remember as he rewrites U.S. bank rules.Anjan V. Thakor, Professor of Finance, Washington University in St. LouisLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/447122015-07-15T20:08:19Z2015-07-15T20:08:19ZAustralian banks are strong; should we pay for them to be stronger?<p>The Australian Prudential Regulation Authority (APRA) has produced some <a href="http://www.apra.gov.au/mediareleases/pages/15_18.aspx">new estimates</a> of the capital positions of Australia’s major banks. It has done this in response to two suggestions of the <a href="http://fsi.gov.au">Financial System Inquiry</a>: first that it publish capital estimates for the banks which are consistent with international standards, and second that Australian banks should have capital levels which make them unquestionably strong (where “unquestionably strong” is taken to mean that banks should be in the top 25% of banks globally).</p>
<p>The shift to a measurement procedure based on international practice revealed the major banks are holding about 3 percentage points of capital more than the levels APRA had previously published. That is, the banks were much stronger than they appeared to be.</p>
<p>The shift to a comparable basis however also allowed a direct comparison of the Australian banks with banks offshore. The key finding is that for Australian banks to be positioned at the bottom of the top quartile (or top 25%) of their global peers for capital, they will need to increase their capital ratios by around 70 basis points (0.70%).</p>
<p>The report seems very fair. It considers each of the problems which have been pointed out with its previous measurement of capital, it considers a range of alternative measures, and it considers different ways of defining the peer group with which the Australian majors should be compared.</p>
<p>The report is also careful to point out that the data are difficult to interpret and subject to a lot of uncertainties. APRA is also very careful to say that its findings would not be translated directly into policy and should not be interpreted as so being.</p>
<p>The bottom line conclusion however, is stronger: </p>
<blockquote>
<p>“Based on the best information currently available, APRA’s view is that the Australian major banks are likely to need to increase their capital ratios by at least 200 basis points [2%], relative to their position in June 2014, to be comfortably positioned in the fourth quartile over the medium- to long-term.”</p>
</blockquote>
<h2>Shifting goal posts</h2>
<p>There are a number of reasons for the higher level. Two are quite straightforward: the global benchmark is drifting higher as more countries are lifting the expectations for their banks, and more regulatory changes are in process which is likely to lift the target levels.</p>
<p>The other important observation is that the 2 percentage point lift would move the Australian banks “comfortably” into the top quartile rather than to the bottom of the top quartile. Obviously it is not “comfortably” for the banks, the shareholders or their borrowers, but perhaps “comfortably” for the regulators.</p>
<p>There are big issues being skated over here. Do we need our banks to be in the safest 25% of global banks, which might require them to hold 0.75% or 1.0% of extra capital; or do we need them to be comfortably in the top quartile which might require them to hold 2.0% of extra capital?</p>
<p>It is easy for the regulator to float the idea of requiring banks to hold an extra two percentage points of capital, but there is a cost involved. It is a proposition which requires some form of cost analysis, and hopefully we will get one when APRA produces its regulatory impact statement.</p><img src="https://counter.theconversation.com/content/44712/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Rodney Maddock does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Global regulators are requiring banks to hold more capital, so how high should Australia aim?Rodney Maddock, Vice Chancellor's Fellow at Victoria University and Adjunct Professor of Economics, Monash UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/350152014-12-07T05:55:42Z2014-12-07T05:55:42ZA call for capital: Murray report pushes for higher banking standards<figure><img src="https://images.theconversation.com/files/66468/original/image-20141207-8664-ubbxdi.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">David Murray and Treasurer Joe Hockey have released the final report of the Financial System Inquiry.</span> <span class="attribution"><span class="source">AAP/Britta Campion</span></span></figcaption></figure><p>To increase the resilience of the Australian financial system the Big Four banks will be asked to carry larger capital buffers under recommendations made in the final report of the <a href="http://fsi.gov.au/">Financial System Inquiry</a>. The inquiry, led by former Commonwealth Bank chief executive David Murray, calls for change in Australia’s financial system to make it more resilient, efficient and equitable.</p>
<p>The report is a comprehensive and carefully written reflection of the large number of submissions the inquiry received over the past year. It also recognises Australia is not immune from future financial crises.</p>
<p>The report proposes major changes to the banking system likely to increase competition in the sector. These changes include narrowing the gap for mortgage lending requirements between institutions. The result will even the playing field between the Big Four banks and smaller financial institutions. </p>
<p>Borrowers in the small and medium business community, who have found it hard to secure finance, may also be pleased with the proposed revision of the relative treatment of home loans compared to corporate loans.</p>
<h2>A push to increase the capital buffers of banks</h2>
<p>The inquiry suggests increasing the level of capital all banks are required to hold to “unquestionably strong” levels. In particular, core Tier 1 capital should be increased. This may impact on profit margins and dividends for bank shareholders.</p>
<p>Most importantly, the inquiry distinguishes between buffers and hard minimums for capital. Capital buffers can be run down if needed and are important to ensure bank resilience during stress periods. Insufficient capital buffers trigger restrictions on dividends and bonus payments, whereas a breach of hard minimum capital levels triggers bank liquidation.</p>
<p>On the face of it, this is a proposal that would be hard to argue against. However, risks do exist. The implementation of such rules can be challenging and implementation will need to be handled carefully in Australia. That is because banks compete with non-bank financial institutions and with institutions outside Australia. </p>
<p>Capital increases for Australian banks may exceed the global Basel standards and trigger capital arbitrage, that is a “horse race” to transfer of risk to non-banks or overseas. However, the inquiry mitigates such concerns by emphasising that Australia should not deviate from these standards “unless there are specific domestic circumstances”.</p>
<p>To date, the costs and benefits of capital regulation have been unclear. Banks have many stakeholders, including financiers in the form of shareholders, bondholders and depositors. Through explicit and implicit governmental bank guarantees, Australian taxpayers are also stakeholders. </p>
<p>What needs to be understood is that financial resilience generally implies lower levels of risk, and lower risk generally means lower returns. The magnitude of this future risk return trade-off and impact on lending activity is unclear and further impact studies for Australia are needed. The inquiry recommends longer transition periods allowing such analysis.</p>
<h2>Measuring risk</h2>
<p>The inquiry notes the internal risk weighting models used by large banks often predict lower levels of risk – thus requiring lower capital levels – than the standardised approach used by small and medium banks. As a consequence, major financial institutions only have to <a href="http://www.abc.net.au/news/2014-12-07/financial-system-inquiry-murray-report-banks-hold-more-capital/5949404">set aside less than half the capital of regional banks, mutual banks and credit unions</a>.</p>
<p>Internal ratings-based models are calibrated to the low default experience in Australia. This is attributed to Australia’s extended period of economic growth since 1983, careful underwriting and regulation, as well as prudent monetary and fiscal policies. </p>
<p>In comparison, the standardised approach is based on average risk levels in a large number of leading economies. The approach reflects the economic downturns experienced globally in recent decades. </p>
<p>The inquiry suggests the gap between the risk weights for residential mortgages should be reduced. New Zealand has recently implemented such changes by increasing asset correlations, a measure for systematic risk, from 15% to 21% for high loan-to-value loans.</p>
<h2>Impact on bank concentration</h2>
<p>The implied increase in equity between small and large banks may increase long term competitiveness in the sector.</p>
<p>The following charts compare the market share of the Big Four, Medium Five (AMP, Bendigo & Adelaide Bank, Suncorp, Bank of Queensland and Macquarie Bank) and other banks.</p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/66274/original/image-20141204-3619-db25ko.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/66274/original/image-20141204-3619-db25ko.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=391&fit=crop&dpr=1 600w, https://images.theconversation.com/files/66274/original/image-20141204-3619-db25ko.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=391&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/66274/original/image-20141204-3619-db25ko.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=391&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/66274/original/image-20141204-3619-db25ko.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=491&fit=crop&dpr=1 754w, https://images.theconversation.com/files/66274/original/image-20141204-3619-db25ko.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=491&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/66274/original/image-20141204-3619-db25ko.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=491&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">Total resident assets (absolute, in $ million), source: Australian Prudential Regulation Authority.</span>
</figcaption>
</figure>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/66275/original/image-20141204-3645-1rxiyjz.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/66275/original/image-20141204-3645-1rxiyjz.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=391&fit=crop&dpr=1 600w, https://images.theconversation.com/files/66275/original/image-20141204-3645-1rxiyjz.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=391&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/66275/original/image-20141204-3645-1rxiyjz.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=391&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/66275/original/image-20141204-3645-1rxiyjz.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=491&fit=crop&dpr=1 754w, https://images.theconversation.com/files/66275/original/image-20141204-3645-1rxiyjz.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=491&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/66275/original/image-20141204-3645-1rxiyjz.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=491&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">Total resident assets (relative, in %), source: Australian Prudential Regulation Authority.</span>
</figcaption>
</figure>
<p>Basel II and the internal ratings-based approach were implemented in 2008, around the time of the global financial crisis. The charts show the Big Four have since increased their market share, while all other banks have lost market share. This may also be attributed to the ability of the Big Four to better access funding.</p>
<p><a href="http://www.afr.com/f/free/blogs/christopher_joye/why_banking_big_nine_would_be_win_dyeWmAUsMltyZYqnBhWBkN">The emergence of a “big nine” set of banks has been predicted</a> with these changes. A less concentrated banking system could decrease the systemic risk of individual banks and provide a more competitive banking system with lower fees for consumers. </p>
<h2>Mortgage concentration continues to be a concern</h2>
<p>Capital rules aim to protect banks from realised financial losses. It is also worth considering ways to avoid large bank losses in the first place. This may include prudent monetary policy to avoid asset bubbles and asset diversification.</p>
<p><a href="http://www.imf.org">According to the International Monetary Fund</a>, asset diversification is a major challenge for Australian banks where 62.7% of total loans relate to mortgages, 9.7% to commercial real estate loans and most of the remainder to small and medium sized company loans often secured by real estate. </p>
<p>Australian banks have a much higher exposure to mortgage loans to other developed economies. <a href="https://theconversation.com/australian-banks-are-too-exposed-to-mortgages-but-what-if-the-world-was-flat-31000">Hence, mortgage lending has been identified as systemic risk</a> to the industry and is addressed in detail in the report.</p>
<p>Much of the growth in total bank assets, shown above, has been in mortgage loans. Meanwhile small and medium-sized companies currently find it hard to secure finance. Increased internal ratings-based risk weights for residential mortgages may mean that more credit will be made available to businesses.</p>
<p>Beyond these proposals, <a href="https://theconversation.com/australian-banks-are-too-exposed-to-mortgages-but-what-if-the-world-was-flat-31000">other ways</a> to diversify asset portfolios exist. Securitised mortgages could be replaced with investments in other asset classes and geographies. For this to occur, transparency and global financial integration will be important.</p>
<h2>The legacy</h2>
<p>Previous inquiries, such as the Campbell Inquiry in 1981 and the Wallis Inquiry in 1997, laid the foundation for an internationally competitive financial industry. Those inquiries led to the deregulation of the industry and the creation of the Australian Prudential Regulation Authority.</p>
<p>It is early days yet, but this inquiry is also likely to have a major impact on the Australian financial system. The system is likely to become more efficient because of increased transparency and lower fees. It is likely to become more equitable from reduced discrimination among institutions and also more resilient.</p>
<p>However, Australia has not experienced real economic stress since 1983 and the current state of affairs is unlikely to persist. The resilience of the Australian financial system will need to be monitored, re-assessed and market parameters re-weighted as the economic environment changes over time.</p><img src="https://counter.theconversation.com/content/35015/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Harry Scheule does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>To increase the resilience of the Australian financial system the Big Four banks will be asked to carry larger capital buffers under recommendations made in the final report of the Financial System Inquiry…Harry Scheule, Associate Professor, Finance, UTS Business School, University of Technology SydneyLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/334052014-10-27T03:28:26Z2014-10-27T03:28:26ZShould bank capital levels distress Australian regulators?<p>Following its stepped up year-long <a href="https://www.ecb.europa.eu/press/pr/date/2014/html/pr141026.en.html">review</a> 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.</p>
<p>The result was seen as <a href="http://online.wsj.com/articles/europes-good-enough-bank-stress-tests-heard-on-the-street-1414345314">“good enough”</a>, with many banks scraping through and those that didn’t, forced to again increase their capital, somewhat concentrated.</p>
<p>With the final report of the <a href="http://fsi.gov.au/">financial system inquiry</a> 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 <a href="http://www.smh.com.au/business/anz-chief-mike-smith-tells-b20-meeting-banks-have-to-reearn-trust-20140722-3cdn8.html">insisting</a> Australian banks are already well capitalised.</p>
<p>The issue of how much capital banks need gets very confused. There are three separate elements of the debate which get conflated.</p>
<p>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.</p>
<p>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.</p>
<p><strong>Common Equity Tier 1 ratios: CBA under various regimes</strong></p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/62814/original/d25dz24p-1414376555.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/62814/original/d25dz24p-1414376555.png?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=372&fit=crop&dpr=1 600w, https://images.theconversation.com/files/62814/original/d25dz24p-1414376555.png?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=372&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/62814/original/d25dz24p-1414376555.png?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=372&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/62814/original/d25dz24p-1414376555.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=467&fit=crop&dpr=1 754w, https://images.theconversation.com/files/62814/original/d25dz24p-1414376555.png?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=467&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/62814/original/d25dz24p-1414376555.png?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=467&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption"></span>
<span class="attribution"><span class="source">CBA 2014 annual results presentation</span></span>
</figcaption>
</figure>
<p>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.</p>
<p><strong>Net capital inflow (% of GDP)</strong></p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/62815/original/mzs53fft-1414376680.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/62815/original/mzs53fft-1414376680.png?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=220&fit=crop&dpr=1 600w, https://images.theconversation.com/files/62815/original/mzs53fft-1414376680.png?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=220&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/62815/original/mzs53fft-1414376680.png?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=220&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/62815/original/mzs53fft-1414376680.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=277&fit=crop&dpr=1 754w, https://images.theconversation.com/files/62815/original/mzs53fft-1414376680.png?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=277&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/62815/original/mzs53fft-1414376680.png?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=277&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption"></span>
<span class="attribution"><span class="source">RBA Guy Debelle speech, 20 May 2014</span></span>
</figcaption>
</figure>
<p>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.</p>
<p>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.</p>
<p>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.</p>
<p>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.</p>
<p>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. </p>
<p>Governments have a concern to see the operations of bank continue even in a crisis but not to protect shareholders or bondholders. Resolution regimes, <a href="http://www.smh.com.au/business/banks-warn-living-wills-come-at-a-cost-20120708-21pek.html">living wills</a>, and the compulsory conversion of bond-holders to equity holders <a href="http://www.economist.com/blogs/economist-explains/2013/04/economist-explains-2">(bail in)</a> are all steps in the right direction.</p><img src="https://counter.theconversation.com/content/33405/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Rodney Maddock has received funding in the past from a range of financial institutions. None is current.</span></em></p>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…Rodney Maddock, Vice Chancellor's Fellow at Victoria University and Adjunct Professor of Economics, Monash UniversityLicensed as Creative Commons – attribution, no derivatives.