Murray stepped back on bank capital but Basel has stepped up

Looking at the top 10 stocks on the Australian stock exchange, the dominant role played by the Big Four banks in equity portfolios is clear. The top two stocks are banks: Commonwealth Bank and Westpac Banking Corp. In positions four and five are ANZ Banking Group and National Australia Bank.

"Basel is looking at narrowing the potential size of the capital advantage banks – usually big ones – can gain."
Managing Editor, Andrew Cornell

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The long-time standard bearer of the ASXBHP Billiton, the world’s biggest miner, has slipped to three. Indeed resource-related stocks as a group have slipped down the rankings as commodity prices - bulk commodities initially and now oil and copper too – have collapsed.

Remarkably, given some recent research notes from banking analysts banks rate NAB as likely to outperform as it works through legacy issues, it is possible the Big 4 might become the Top 4 on the ASX. A fifth bank, Macquarie Group, is lingering just outside the top 10.

(That’s assuming Telstra, another high yielding stock, doesn’t continue its own strong run and surpass the banks in value.)

Leaving aside stock picking, a task best left to the very brave, what is significant is the uncertainty around Australian banking stocks generated by the Financial System Inquiry seems to have dissipated.

While a volume of reports predicted significant new capital imposts on the banks out of David Murray’s FSI, the actual report delivered a more considered response, emphasising the need for Australian banks to remain among the most trusted and resilient in the world.

Yet while the threat of immediate action from the FSI may have eased, looming over the horizon from the other side of the world in Basel, Switzerland (and independent of the conniptions inflicted by the Swiss central bank) is a set of measures announced immediately before Christmas and little scrutinised over the holiday period.

These have far clearer and more present implications for bank capital than the FSI.

The FSI acknowledged the actual work of analysing and enforcing that resilience was best managed – as it is today – by the current regulators, notably the Australian Prudential Regulation Authority. APRA, it should be noted, takes its lead from Basel and current chair Wayne Byres was formally Basel’s top dog.

The market interpreted the FSI stance as “at ease”, at least as far as new capital (and consequential lower returns on equity) for the Australian banks went.

Indicative of the response was a note from industry veteran Brian Johnson from CLSA saying “despite much chest-beating heading into the release of the FSI final report … the actual FSI recommendations seem to be widely regarded as a bit of a ‘damp squib’.

“Those expecting immediate specific changes to Australian bank capital requirements were left surprised,” Johnson wrote, adding that on CLSA’s recent European investor tour many investors were bearish on Australian major banks given expectations of significant near term capital raisings, widely put at around $10 billion.

Johnson did remind investors the wording of the final report was “relative to the status quo, if implemented, unambiguously negative” and cited the FSI recommendations to “strengthen policy settings that lower the probability of failure, including setting Australian bank capital ratios such that they are unquestionably strong by being in the top quartile of internationally active banks”.

Clear in intent, vague in implementation.

Not so a series of announcements out of Basel around December 22.

The Basel Committee on Banking Supervision released a consultative document on “Revisions to the Standardised Approach for credit risk” seeking to “strengthen the existing regulatory capital standard in several ways”.

These included, a reduced reliance on external credit ratings; enhanced granularity and risk sensitivity; updated risk weight calibrations, which for purposes of this consultation are indicative risk weights and will be further informed based on the results of a quantitative impact study; more comparability with the internal ratings-based (IRB) approach with respect to the definition and treatment of similar exposures; and better clarity on the application of the standards.

The intent of these proposals, open for discussion, is to make bank risks more comparable and comprehensible. It is technical but relatively cogent stuff, covering risk weightings for both corporate and mortgage loans and other asset classes.

But it was a second announcement which has much deeper implications.

The Committee also published a consultative paper on “capital floors” which it said covered the design of a framework based on standardised approaches, setting out the proposed design of a capital floor framework based on standardised, non-internal modelled approaches.

Translated, Basel is looking at narrowing the potential size of the capital advantage banks – usually big ones – can gain by using their internal, complex risk models in comparison with banks using standardised models.

They would do this by putting a “floor” under the minimum capital which in effect may mean calling on those banks using advanced models to put in more capital.

In Australia, it is the Big Four plus Macquarie which use the advanced model.

The FSI considered the implications of the disparity on capital levels between advanced and standardised banks and looked at some measures. However these from the global bank regulator have far more significance.

According to Deloitte’s Kevin Nixon, who has spent his recent years liaising with the BIS and its regulatory agenda, “they haven’t yet put the numbers in the document but at the G20 meeting in Brisbane they floated 80 per cent” – that is the basic concept is if the risk weighting of an asset is X under the standardised approach, its risk weighting under the advanced model approach can’t be less than 80 per cent of X.

Critically, the first paper in instituting changes to the standardised approach will make that measure more sensitive – and onerous to calculate, says Nixon, now Deloitte’s financial services industry risk and regulatory leader.

“So it is a lot more labour sensitive, system sensitive and therefore more expensive than the current standardised approach,” he said, adding smaller banks will also be affected.

“This means the BCBS is instituting a link between the standardised and IRB (internal ratings based) approaches, and revising the standardised approach to make it more risk-sensitive and granular to better reflect the risk of banks’ assets.”

Regardless of the FSI – and other reviews in other nations for that matter – the BIS is forging ahead with its global campaign to make banks, particularly big ones, less risky.

They have already flagged a leverage ratio of 3 per cent, lifting the percentage of actual equity banks must hold.

This new capital floor adds some braces to that belt.

“They are introducing a second backstop to the risk-weighted capital ratio through the capital floor so no one should be in any doubt about how much benefit you can get from IRB,” Nixon says.

He reckons these proposals will change the way banks calculate capital, as well as their business and lending dynamics. For example there will no longer be a fixed capital charge on mortgages in Australia.

The final rules on capital floors are due by the end of 2015 and Nixon noted the floor can’t operate unless the new standardised approach is in place. In his opinion, Basel III was the rest of the world catching up with Australia so it didn’t affect Australian banks’ capital requirements much. However, they’ll definitely be hit by the new consultation papers.

As with all things Basel, there are lengthy lead times to consult, argue and implement these measures. But it seems certain the pressure on banks to raise capital and been pumped up a bit more.

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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