Stress tests and inquiries not just about banks

Three of Australia and New Zealand’s four major banks report their full year profits over the next two weeks and the fourth, Commonwealth Bank of Australia, will provide a trading update. The consensus of public forecasts is for a solid season absent of one-offs such as restructuring costs.

National Australia Bank, for example, under new chief executive Andrew Thorburnhas already flagged significant portions of its results including write-downs.

"Insubstantial testing would have seriously undermined faith in the ECB and other bodies – to the detriment of the system."

Beyond the results though, there is a looming quandary around regulators.

For the sector, revenue gains over the last six months are expected to be modest, margin pressure slightly improved with lower funding costs while bad debt charges should remain remarkably benign. Overall, banking analysts believe the banks are still on the expensive side despite recent price falls but for longer term investors the focus is more on the outlook for the sector.

On this front, revenue and capital are paramount. The former because it is an indication of earnings – and dividend – growth ahead; the latter because of the uncertainty surrounding new global regulatory measures and especially the looming Australian Financial System Inquiry report.

Of the several factors which have worked against bank share prices of late – notably the declining Australian currency, rising US interest rate expectations and geopolitical anxiety – a particular one is concerns banks will have to build up capital.

Most Australian analysts are now factoring in higher required levels of capital – beyond those already baked into the system under the Basel III regime – if for no other reason than there has been plenty of speculation about it. However this overlooks a couple of historical precedents.

The role of deciding bank capital levels resides with central banks, regulators and supervisors – in Australia the Australian Prudential Supervision Authority, the Reserve Bank and the Council of Financial Regulators.

Financial system inquiries over the decades, whether Campbell, Martin or Wallis, have looked at the structure of regulation, the institutions, the architecture. But not the regulation itself. While the current inquiry, chaired by David Murray, may well be different, it would be unprecedented for it to determine the detail of regulation such as capital levels or risk weights of assets or leverage ratios.

Yet speculation has intensified around expectations of some very concrete recommendations from the inquiry which would indeed be unprecedented.

Nevertheless, these coming bank results will be scrutinised for capital generation. To the extent capital growth, through retained earnings, is strong, the banks will balance the competing demands of shareholders wanting higher dividends and the possibility regulation will demand more be held back.

A year ago, APRA did indeed warn banks via letters to boards not to get too excited about handing back money but – at least as far as such information is known publicly – it hasn’t been as explicit of late.

The global regulatory mood has also shifted, especially in the run up to the G20gathering in Brisbane, to one where there is an acceptance that already announced measures are still playing out. The industry and many investors have argued the impact of these measures – including higher levels of capital coming in the years ahead  – needs to be properly assessed before new layers are added.

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Take the latest stress tests of European banks by the European Central Bank, the results of which were announced over the weekend. Of 130 banks tested, 25 were still short of capital. A similar test by the European Banking Authority delivered a not dissimilar outcome.

Critically though, of those banks registered as falling short, 12 have built up sufficient capital to pass since the year end calendar 2013 cut-off. The ECB reckons the remaining 13 need to raise $12 billion over the next nine months. Most of those banks were in the “periphery”, Italy and Greece – British, German and French banks did pretty well.

Overall, the ECB found Europe's banks faced a shortfall of €24 billion in capital in 2016 under the most adverse downturn scenario considered. The downturn modelled cut the common equity ratio by 260 basis points, from 11.1 per cent to 8.5 per cent after the stress test.

The ECB doesn’t see these results as static and this is where the focus on how much capital Australian banks may have to raise – as a result of Murray or something else – misses the point.

The regulators focus on capacity to generate and replenish capital as well as minimum levels. The ECB made it clear in its process: 25 banks in 10 countries failed the first round but half were able to build up buffers in the interim.

Large European banks layered on more than €200 billion since the stress tests were announced and the regulators have argued that is what they want.

APRA already has the power to change capital charges and risk weightings today. It can do so both explicitly and via its discretionary powers to shift capital levels for individual institutions.

In the previews from the broking houses of this season’s results, the consensus is the likelihood of meaningful changes to bank capital out of the Murray Inquiry is marginal nevertheless boards are likely to err on the side of caution.

That would mean no special dividends and allowing dividend reinvestment programs to bolster capital.

Judging by APRA’s own pronouncements, there is little specific guidance but there is a sense the supervisor has its eye on the gradual build-up of capital rather than measures which would require something more drastic such as a capital raisings.

Investors in Europe appear to have responded favourably to the latest stress tests but, judging by commentary, not so much because of the numbers but because the process was deemed credible and rigorous.

Make no mistake, this process was a stress test of the regulators as much as a stress test of the institutions they regulate. Another round of insubstantial testing would have seriously undermined faith in the ECB and other bodies – to the detriment of the system.

It is an interesting point for Murray and others to consider: does confidence in the financial system reside in the numbers such as capital levels (which in the financial crisis proved absolutely no guide to the survival chances of banks) or in the integrity of the system? And particularly its regulators.

One argument around the strong performance of the Australian banks both during the crisis and in its aftermath is APRA (and the other CFR members) has a reputation for being a rigorous and intrusive supervisor.

Abrogating their right to determine regulatory settings would not necessarily help faith in the financial system. It could be argued taking regulation out of the hands of those in whom the investment community has great faith may actually shake that confidence.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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