APRA to banks: be chaste but not yet

While acknowledging the study was undertaken in response to a recommendation out of David Murray's Financial System Inquiry – that APRA should “set capital standards such that Australian authorised deposit-taking institution [ADI] capital ratios are unquestionably strong" – APRA noted Australian banks were well capitalised but not in the top quartile under most measures. The top quartile being where the FSI wanted them to be.

APRA's keystone statement was “the results of the study will inform, but will not ultimately determine, APRA's approach for setting 'unquestionably strong' capital adequacy requirements. APRA regards the top quartile positioning as a useful 'sense check' of the strength of the Australian framework, but does not intend to tightly tie Australian requirements to a benchmark based on the capital adequacy ratios of international banks".

The Australian dimension to this debate aside, it is critical to appreciate that, internationally, not only are goal posts moving in this debate but no one can decide whether they should be a rectangle, a hoop, a couple of struts with a cross bar or even four poles of two different sizes.

Further, the debate over appropriate capital is running in parallel with a couple of other regulatory reforms out of Basel, notably on the measurement of risk weighted assets, the use of internal models to measure credit risk, and leverage ratios. About none of which is there international agreement – beyond the desire for banking systems to be unquestionably strong.

The Institute of International Finance's (an international financial institution industry body) latest monthly regulatory update has the following items on regulatory capital:

Risk-weighted asset consistency – being undertaken by the IIF's RWA Task Force; IIF Response to IOSCO Alternatives to the use of Credit Ratings to Assess Creditworthiness; Credit Risk Standardised Approach; Interest Rate Risk in the Banking Book; Fundamental Review of the Trading Book.

Furthermore, capital ratios are not, of themselves, guarantees of safer banks. Leaving aside that many banks which failed in the financial crisis were actually well capitalised but had insufficient liquidity, raising the risk weighting on certain assets would actually lower relative capital in the process.

APRA acknowledges this when addressing another issue raised by the FSI, the risk weights applied to mortgages by those banks using the more sophisticated internal rating models, so called IRB banks.

“To the extent that APRA increases IRB risk weights, and the major banks respond by increasing their actual capital levels to maintain their existing capital ratios, it will improve their position relative to international peers and contribute to closing the gap to the fourth quartile," APRA said.

What that means is if mortgage risk weights are raised, banks will have to hold more capital for each loan. But absent any other measures, capital measures would go down – not because the banks are less safe but because the denominator in the calculation, risk weighted assets (RWAs) , is higher.

APRA assumes – and regulator assumptions are typically polite demands – banks would in fact respond by raising more capital.

But beyond the particular situation with APRA and Australian banks, the study emphasises the complexity of the task facing global regulators if they want to harmonise regulatory requirements and make meaningful comparisons.

APRA notes there varied national discretions in implementing the global Basel capital adequacy framework by different jurisdictions, including Australia. Furthermore, the determination of an appropriate international peer group is not straightforward and there are different measures of capital adequacy that can be used for any comparison.

“As a result, there is no internationally-harmonised capital ratio that provides a definitive measure of capital adequacy for the purposes of international comparisons," APRA says.

However, using what APRA considered a reasonable comparison of core Common Equity Tier 1 (CET1) capital, the authority found Australian major banks would, on average, be in the order of 300 basis points higher on their capital measures as of the end of June 2014.

“With some caveats, other measures of risk-based capital would increase by a similar magnitude. In broad terms, this is accounted for by: around 100 basis points in differences due to APRA's definition of capital; and around 200 basis points due to differences in the calculation of risk-weighted assets (RWAs)," APRA said.

So APRA concluded Australia's major banks would need to “increase their capital adequacy ratios by at least 200 basis points, relative to their position in June 2014, to be comfortably positioned in the top quartile of their international peers over the medium- to long-term, as recommended by the FSI".

Even that estimate though was qualified by APRA: positioning CET1 capital ratios at the bottom of the fourth quartile would require a smaller increase of around 70 basis points in CET1 capital ratios, according the authority.

“(And) to simultaneously achieve a position in the fourth quartile for all four measures of capital adequacy, the increase in the capital ratios of the major banks would need to be significantly larger, albeit that there are more substantial caveats on the ability to accurately measure the relative positioning of Australian banks using measures other than CET1," APRA says.

That's why it is right to look at the substance of what APRA is saying – and indeed has said quite consistently in this debate – rather than just feed numbers into a spreadsheet.

The final numbers, and the timing of their implementation, are going to shift with APRA's own studies, what Basel determines and how other international regulators respond. And of course how global banks respond because comparisons such as “top quartile" are relative.

APRA's key message is this: it is “committed to ensuring" the strengthening of capital adequacy as a result of the FSI or Basel or its own judgements “occurs in an orderly manner".

“Australian Authorised Deposit Taking Institutions should, provided they take sensible opportunities to accumulate capital, be well placed to accommodate any strengthening to capital adequacy requirements that APRA implements over the next few years," APRA says.