Murray was right to support the principles of regulation not set the letter

There’s been a major financial system review produced, concerns linger around a housing bubble, consumer confidence is fragile, the banking sector is dominated by a group of majors and the resource economy is making a slow transition to other growth drivers.

Click image to zoom Tap image to zoom

I’m talking of course of Canada where Reserve Bank governor Stephen Poloz has just delivered a Financial System Review (FSR). Meanwhile, the Financial Time’s Lex column took time to analyse the superior performance of Canada’s Big Five when compared with their US-rivals in recent years.

"The Australian system must operate along international lines."

According to Lex, Canada’s pillars “reported double-digit earnings growth, dividend yields twice as big as their US rivals and returns on equity at around 20 per cent, a level that is a distant memory for Wall Street”.

Like Australia, Canada’s banks performed relatively well in the financial crisis through good management, supervision, a resource-strong economy and simple business models. They’ve maintained that form, delivering well for shareholders.

But Poloz noted “in this FSR, we discuss three important financial system vulnerabilities: high household indebtedness; imbalances in the housing market; and increased investor risk taking”.

He went on “fortunately, Canada's economy is showing the first signs of a broadening recovery. Non-energy exports have been responding to stronger U.S. growth and exchange rate depreciation, investment spending appears to be picking up, and we have seen pockets of new job creation”.

Poloz conceded the weakness in oil and other commodity prices was a potential risk and his expectation of a soft landing for housing hinged on stronger growth, employment and incomes.

As Lex noted “it is unclear how much the Canadian banks are exposed to the oil sector. Bankers say it is less than 15 per cent of their capital markets earnings, but given the many small, local companies that operate in the energy sector, analysts say that the number may be higher”.

The – not for the first time – remarkably coincident fortunes of the Australian and Canadian economies and financial systems shouldn’t be extrapolated too far but they remind us Australia is part of the global economy and David Murray’s Financial System Inquiry must take account of and complement global forces.

This is perhaps one of the lesser appreciated principles which have informed the final recommendations of the inquiry.

For all the cheer leaders of radical change and specific regulatory imposts, the FSI recognised its role was not to usurp that of the Australian Prudential Regulation Authority or indeed other regulators who have won Australia a valuable – literally – reputation for sound governance.

Whether on specific levels of capital or the risk weighting of assets, the FSI deferred to APRA which in turn is participating in a global discussion of these fundamentals.

Indeed, it would have been ironic if in arguing Australian banks, as capital importers, needed to have regard for the sensitivities of offshore investors the FSI had introduced a new order of Australian exceptionalism.

Central to the argument Australia’s financial system must be attractive to international providers of capital is that the Australian system must operate along international lines. Recent years have demonstrated those investors trust APRA to both regulate and enforce at the top end of global standards.

That the former top regulator from the Bank for International Settlements, Wayne Byres, is now chairman of APRA reinforces that view.

As far as banking regulation goes, the critical work needed in the immediate future is for the international community to come to some consensus on the measurement of capital and risk weighting.

This is no easy matter. That an international firm such as PwC was prepared to put its name on analysis undertaken for the Australian Bankers’ Association and that analysis was disputed by the FSI is simply one symptom of the complexity.

Brad Carr from the Institute of International Finance argues for maintaining the current direction of risk weighting in a new contribution to BlueNotes but the essential point is not all loans carry the same risk so any measure of assets – a bank’s loans – needs to capture that difference.

Again, if Australia were to head in a direction where the price of risk in the system – effectively the interest rate on loans and capital set aside for their potential failure - didn’t reflect the underlying threat then once again we would be undermining the confidence of investors.

As Carr points out, under the first wave of standardised risk weightings, all corporate loans were rated the same, mortgages were half as risky and central governments had no risk. We now know (and indeed did then) that doesn’t remotely reflect reality.

Nor is it true that the same loan made by different institutions has the same risk to investors. This is because of concentrations – a bank operating in fewer geographies across a narrower product range is riskier through an economic cycle than a more geographically and customer diverse bank.

While the FSI recognised that it argued the balance had swung too far towards the stability of the system – which penalises smaller banks – and against competition which is enhanced by risk weighting loans at similar weights regardless of the riskiness of the institution making them.

Again, this is a complex debate but it is also one which APRA has the powers to act upon most notably through special and secret capital buffers it applies.

Over the last week the response of investors to the Australian FSI has been to initially buy banks as the recommendations were not as punitive on capital as expected then to pull back as some analysts continued to argue banks would have to act quickly to raise new capital, hurting existing shareholders.

But complicating that analysis was the impact of the currency. Australian banks are not only internally sensitive to the currency but foreign investors, like any investor, are interested in money in the pocket. If the Australian dollar falls sharply against foreign currencies there are a number of very large, foreign investors who will sell banks because their value in those foreign currencies falls.

In Canada, as Lex argued, banks are buffeted by global forces, both there and here the impact of falling commodity prices and currencies.

The FSI can afford to look through these macroeconomic forces to ask what should Australia do to not skew the confidence of capital providers to the downside. The headline answer was make sure Australian banks have capital levels near the top of the international ranks.

But the more profound point is Australia’s system needs to be transparent, in the hands of a trusted set of regulators, not dependant on the idiosyncracies of governments or even major reviews. The most telling point is that to be attractive to international investors we don’t need particular levels of capital or attitudes to RWAs but we consistency with global regimes.

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

editor's picks

15 Dec 2014

Risk weighted assets: a journey of improvement

Brad Carr | Director, Institute of International Finance

Among the various issues highlighted by the Financial System Inquiry (FSI) was the calculation of banks’ risk-weighted assets (RWA). As the basis for banks’ regulatory capital requirements, this is a central measure in investors’ assessment of a bank’s balance sheet strength, as well as influencing bank pricing and shareholders’ returns.

10 Dec 2014

Adding exams would give Murray report extra marks

Amanda Gome | Former head of digital and social media, ANZ

ANZ welcomes recommendations from David Murray’s year-long review into the financial services industry to lift education, training and competency standards for financial advisers.