If you have been following the debate about bank capital in recent months, you could be forgiven for thinking there is only one issue: how much capital should banks have to hold on account of their residential property lending activities? This has certainly been APRA's main focus during that time. However, the Financial System Inquiry's recommendations on bank capital delved into other areas as well – and they have potentially more far-reaching consequences.

In last month's Unravelled, I said that, in order to understand APRA's capital requirements for banks, you need to understand three things:

  • the different types of capital that count as prudential capital;
  • the capital ratios that apply under those requirements; and
  • how those ratios apply to the circumstances of a particular bank.

The Financial System Inquiry made significant recommendations about each of these matters.

Capital that counts as prudential capital

Recommendation 3 concerns 'loss absorbing and recapitalisation capacity'. To my mind, it is the most interesting of the Inquiry's recommendations for fostering 'resilience'. If adopted and implemented, it is likely to have significant implications for the capital-raising activities of the banks.

Unfortunately, the recommendation is expressed in language that seems calculated to destroy, or at least deflect, your interest. So take a deep breath before you read it:

Implement a framework for minimum loss absorbing and recapitalisation capacity in line with emerging international practice, sufficient to facilitate the orderly resolution of Australian authorised deposit-taking institutions and minimise taxpayer support.

What is this about? It is not about reducing the probability of bank failure – other recommendations (discussed below) are aimed at that. Instead, it is about reducing the cost of bank failure. Specifically, it is about maximising the extent to which those costs are borne by the failed bank's shareholders and creditors, rather than by taxpayers.

In other words, recommendation 3 is seeking to address 'too-big-to-fail'. (By the way, am I the only one who finds the Inquiry's references to some banks being 'perceived' to be too-big-to-fail a little disingenuous?)

The Inquiry says Australia does not currently have requirements for loss absorbing and recapitalisation capacity. In order to understand recommendation 3 it is important to test this statement.

In last month's Unravelled, I identified the requirements on banks to hold certain amounts of Common Equity Tier 1 Capital, Additional Tier 1 Capital and Tier 2 Capital. I also said Common Equity Tier 1 Capital is the highest quality because it is the best able to absorb losses, with ordinary share capital being the prime example. Doesn't this mean we already have requirements for loss absorbing capacity at least? It does.

But it seems recommendation 3 is aimed at refining, and probably expanding, those requirements. Most significantly, it could result in the creation of a new class of capital instrument sitting between Tier 2 Capital (on the one hand) and senior unsecured debt (on the other). That said, as the Inquiry notes, Additional Tier 1 and Tier 2 instruments with conversion and write-off features already exist and investors already hold them.

In practical terms, the recommendation seems to be about ensuring the creditor hierarchy is clear, with clear layers of subordination between classes, and about ensuring the mechanisms and triggers under which creditors will absorb losses are also clear. The Inquiry also refers to ensuring eligible instruments are 'held by investors who can credibly be exposed to loss'. It is not possible to know whether this is a reference to contagion risk or a comment on the suitability of such instruments for retail investors. Would you like a hybrid security with that, sir?

Capital ratios

Recommendation 1 is, by comparison, much less Delphic:

Set capital standards such that Australian authorised deposit-taking institution capital ratios are unquestionably strong.

Set capital standards such that Australian authorised deposit-taking institution capital ratios are unquestionably strong.

There is not a lot for me to say here. The Inquiry and the banks disagreed on where Australian capital ratios sit relative to capital ratios elsewhere. The Inquiry thinks Australian ratios should be increased. An increase would seem to be consistent with international trends. The main question here seems to be not so much 'if' ratios will be increased but rather 'when' (and 'by how much'). The other question is whether the Government will express any views - or simply leaves it to APRA to make a call.

Applying the ratios

Recommendation 2 is about residential property lending:

Raise the average internal ratings-based (IRB) mortgage risk weight to narrow the difference between average mortgage risk weights for authorised deposit-taking institutions using IRB risk-weight models and those using standardised risk weights

The 'big four' domestic banks and Macquarie are accredited as 'IRB model' while the rest are 'standardised'. The lower the 'risk weight' for an asset, the less capital the bank has to hold. In the case of IRB model banks, the average risk weight for residential mortgages is about half the average that applies to standardised banks.

The Inquiry wants that gap to be narrowed. It does not support lowering the risk weight for standardised banks and so the recommendation is to raise it for IRB model banks.

APRA has been very active in this area in recent times. In November 2014, it released Prudential Practice Guide APG 223 Residential Mortgage Lending, in which it noted that residential mortgage lending constitutes the largest credit exposure in the Australia banking system and, for many ADIs, over half of their total credit exposures.

In December 2014, APRA wrote to all ADIs about 'reinforcing sound residential mortgage lending practices'. In that letter, it noted that, in the first half of 2015, it will 'reflect any concerns through changes' to capital requirements at the individual ADI level. Put simply, if APRA doesn't like what it sees unfolding in a particular bank's residential mortgage books, it may require the bank to hold more capital as a consequence.

The Inquiry's recommendations on bank capital were system-wide recommendations. The action that APRA is flagging is institution-specific action. Further, any institution-specific action is unlikely to become public, because of APRA's non-disclosure requirements. This has resulted in a side-debate about disclosure and transparency and about the way in which APRA does its work. In his recent testimony before the House of Representatives Economics Committee, APRA Chairman Mr Wayne Byers said:

I am not in any way trying to dismiss the importance of disclosure and transparency, but disclosure and transparency are not an end in themselves. They are means in which you will hopefully generate good outcomes for the community ... I think our track record shows that a lot of the time operating behind the scenes, getting things fixed and allowing things to move on relatively seamlessly has been in the community's interests.

Bank capital in 2015 promises to be very interesting, no matter how much (or little) we get to see of what APRA does.