Bank capital blow up

In Michelangelo Antonioni’s 1960s counter-culture classic Blow-Up, a hip photographer inadvertently captures what may be evidence of a murder in the background of a picture he’s taken.

"Seen with a wide-angle lens, the data suggest certain truths. But when the focus is brought in, the picture actually becomes less clear."
Andrew Cornell, Managing Editor, BlueNotes

Apart from being an icon of the '60s, the movie is an examination of the limits of focus: from a distance, there appears to be something in the shot but the more the shot is 'blown up', the less clear it is.

A '60s cult classic might not be the first thing which springs to mind in the debate about bank capital and risk weighting, but the same phenomenon is at play. What appears to require a closer focus reaches a point where the focus loses meaning again.

The critical issue in this debate is international calculations of capital and the riskiness of assets.

Seen with a wide-angle lens, the data suggest certain truths. But when the focus is brought in, the picture actually becomes less clear.

Take capital. There is broad agreement higher levels of 'core' bank capital are desirable to act as a buffer against losses when there are economic downturns.

Australia’s Financial System Inquiry notes in its interim report that Australian banks sit about mid table on the core capital front (known as Core Equity Tier 1, or CET1).

Yet several bank submissions – including ANZ’s – argue this was a mistake. On a like-for-like basis, the Australian banking system actually sits much higher, the counter argument runs.

International comparability of bank capital has been controversial long before the Murray Inquiry. Indeed, the international scrutineers in Basel have been working for some years on measures to allow cross-border comparisons.

But no matter how desirable this is (and it is very desirable) it is in the detail that the challenge lays.

One of the problems is the supervisors and regulators themselves. In order to get countries to agree on international regulation at all, a certain amount of national discretion is allowed.

Australia’s prudential supervisor, the Australian Prudential Regulation Authority, is acknowledged to be particularly conservative. The consequence of this is the argument that capital ratios, as determined by APRA, mean Australian banks look more lightly capitalised.

This leads to claims that, if many international banks were subject to APRA’s discretion, their reported capital ratios would be lower.

The Bank for International Settlements (BIS) and Financial Stability Board (FSB) in Basel are looking at ways to harmonise the reporting, but it is impossible to be precise, due to the lack of transparency and disclosure on the national 'discretion'.

The Australian Bankers’ Association, in its submission in response to the FSI interim report, brought in PwC, an international accounting firm, to have a go at this. PwC chose a sample of banks and was criticised by some for 'cherry picking' to make the Australian banks look better.

But this ignored another complication: banks in different countries are at different stages of implementation of new global regulation. The BIS regularly provides updates on the various stages of implementation for banks in its fleet and the convoy stretches a long way.

For the PwC survey, the banks and jurisdictions considered were at a similar stage to Australia – by and large, banks which were globally or domestically systemically important (too big to fail banks) and were relatively advanced in implementing Basel III standards, while having been subjected to the BIS Regulatory Consistency Assessment Programme (RCAP).

Despite the criticism of selectivity, there is an argument that that is a better basket of banks for comparison purposes, as it allows for the varying stages of Basel III reforms by jurisdictions.

For example, American banks were excluded as most banks there are on a so-called foundation basis, their capital rules are different to Basel, and therefore don’t provide a like-with-like comparison.

Another central challenge for cross-border comparisons are risk weightings – effectively estimates of how likely loans (and other assets) are to fail and, if they do, how much they’ll cost the bank. Once again, there is local discretion in different jurisdictions.

The ABA argues the so-called “loss given default (LGD)” – how much a dud loan will end up costing – for Australia is again more conservative. The FSI agrees.  

“APRA does not include certain capital items allowed under Basel III that are not truly loss absorbing, as these were included to accommodate weak banking systems in some jurisdictions," the body says.

"Australia has imposed LGD floors as historical data on losses used to calculate risk weights may not reflect a true downturn, given Australia has not had a major recession in two decades.”

At a flat 15 per cent, Australian LGDs are tougher than the international 10-per-cent floor – that is, it is assumed less will be recovered from a dud loan and hence loss absorbency via capital needs to be higher.

Basel has been beavering away for a few years on the vexed issue of how to measure risk consistently, and hence how to deliver a risk-weighted asset measure that is comparable.

It has warned in several reports and speeches that the inconsistencies in risk weightings are a major challenge to a safer global system.

This is where the focus debate enters the existential realm worthy of Antonioni. Some argue to avoid the international discrepancies, measures such as leverage ratios should use gross figures, not risk adjusted ones, to avoid 'gaming' of the system.

Capital, meanwhile, should be measured more rigorously and any discrepancies should default to higher levels.

Yet this ignores the reality: even though there are measurement problems, some loans are riskier than others and some capital is more likely to be available in a downturn – it is the measurement in question, not the reality.

Those who argue for gross numbers and ever-higher capital are looking for meaning with the camera pulled back too far. It is true that with international data where it is today, zooming in closer doesn’t actually bring better focus.

This is the paradox the FSI must deal with, but the wrong answer would be to make a decision – either way – based on a sense of false precision. Better to do what has been shown to work, even when the data is blurred: improve supervision and enforcement, rather than add regulation.