The explicit agenda of Australia’s regulatory agencies is that the risks made evident by the global financial crisis in other parts of the world must be addressed by reforms to the regulation and supervision of Australia’s financial system, notwithstanding that Australian banks and other authorised deposit-taking institutions (ADIs) have fared considerably better than banks in other parts of the world.

The stated aim is that future Australian governments and taxpayers should not be compelled to provide guarantees or a public sector injection of capital (or equivalent support) to Australian ADIs to ensure their continued viability.

The cost of doing so has been made clear in a number of recent speeches. In July, the Deputy Governor of the Reserve Bank of Australia (RBA) said:1

“In the wake of this experience [the global financial crisis], it is not surprising that regulators and, to some extent the financial institutions themselves, have sought to address the various problems. Capital ratios are being increased, and the quality of capital is being improved. Maturity transformation is being reduced. And banks are holding more liquid assets. These changes are occurring not just because of new regulations, but also because they are being demanded by the marketplace.

Together, these various changes are increasing the cost of financial intermediation conducted across the balance sheets of banks. In effect, the choice that our societies are making – partly through our regulators – is to pay more for financial intermediation and, perhaps, to have less of it. The benefit that we hope to receive from paying this higher price is a safer and a more stable financial system.”

Basel III capital and liquidity initiatives

Although reforms are also occurring in other areas (e.g. insurance, superannuation, derivatives and the provision of financial advice), for ADIs much of the current scope and pace of reform is dictated by the Basel III capital and liquidity initiatives published by the Basel Committee on Banking Supervision (BCBS). Basel III increases the quantity and quality of capital required of a bank in six ways by:

  1. increasing the headline required percentages (i.e. the numerator of the capital ratio);
  2. increasing the capital required for certain classes of asset (i.e. the denominator of the capital ratio): certain securitisations, trading book exposures and counterparty credit risk changes (including strong incentives for the central clearing of derivative contracts);
  3. restricting dividends and discretionary distributions where common equity capital levels fall below prescribed minimum levels (the Capital Conservation Buffer);
  4. requiring additional common equity capital to be held when authorities judge that excessive credit growth in comparison to gross domestic product is resulting in an unacceptable build-up of systemic risk (the Countercyclical Buffer);
  5. imposing a fallback total leverage ratio (the Leverage Ratio); and
  6. increasing the items that are deducted from the calculation of required capital.

The implementation of the Basel III capital reforms in Australia

As a member of the BCBS, the Australian Prudential Regulation Authority (APRA) fully supports these initiatives and published the first set of final prudential and reporting standards to implement the Basel III capital reforms at the end of September 2012. The standards are:2

  • Prudential Standard APS 001 Definitions
  • Prudential Standard APS 110 Capital Adequacy
  • Prudential Standard APS 111 Capital Adequacy: Measurement of Capital
  • Prudential Standard APS 222 Associations with Related Entities
  • Reporting Standard ARS 110.0 Capital Adequacy
  • Reporting Standard ARS 111.0 Fair Values

Consistent with APRA’s regulatory approach these standards apply to all Australian ADIs, not just Australian banks. APRA’s proposals in relation to the implementation of the Basel III capital reforms in Australia were first released in September 2011, and after industry consultation, draft prudential standards were released in March 2012. The final prudential standards published in September 2012 are consistent with the draft prudential standards. However, they are not the final word on the implementation of the Basel III capital reforms, as further prudential and reporting standards (including new counterparty credit risk requirements) are expected to be released in November 2012.

The final prudential standards published in September 2012 reflect the main elements of APRA’s approach to the implementation of the Basel III capital reforms.3 APRA has adopted the Basel III definition of regulatory capital, the Basel III minimum requirements and eligibility criteria for regulatory capital instruments, and the Basel III regulatory adjustments to capital that are specified as minimum requirements, with only minor exceptions. However, for ‘in-principle’ reasons, APRA has not allowed any concessional treatment for certain items in calculating regulatory capital, a discretion which is available under the Basel III reforms.4 Finally, APRA has accelerated the Basel III timetable for implementation of the capital reforms, which will become effective from 1 January 2013, with transition largely completed by 2016.

APRA has summarized the key features of the Basel III capital reforms that will apply to Australian ADIs in the following terms:5

  • common equity is the predominant form of Tier 1 capital;6
  • most deductions from capital are to be from Common Equity Tier 1 capital;
  • an increase in the minimum amounts of capital that ADIs must hold against the risks they face: Common Equity Tier 1 capital must be at least 4.5 per cent of risk-weighted assets and the Tier 1 capital ratio at least 6 per cent, an increase of 2.5 and 2.0 per cent, respectively, over the existing minima;
  • a Capital Conservation Buffer of 2.5 per cent that places increasing constraints on capital distributions where an ADI’s capital level falls within the buffer range;
  • a Countercyclical Buffer of up to 2.5 per cent that will apply when excessive credit growth and other indicators point to a system-wide build-up of risk; and
  • a simple, transparent leverage ratio to help contain the build-up of leverage in the banking system. The leverage ratio is yet to be prescribed in the prudential standards.

We can show these changes in tabular form as follows:7

Click here to see table.

A higher price for reform

The question which arises is what is the higher price to be paid for the safer and more stable financial system which the regulators hope will flow from the Basel III and other reforms?

The RBA believes that there will be an increase in the cost of financial intermediation and a broad implication of this increase is that there is likely to be less financial intermediation, particularly across the balance sheets of banks.8 No doubt part of this increased cost will be attributable to an expected increase in the cost of raising Additional Tier 1 and Tier 2 capital – what price will investors demand for the increased risks associated with the new requirements for (a) in the case of Additional Tier 1 capital only, loss absorption conversion or write-off if the issuing ADI’s Level 1 or Level 2 Common Equity Tier 1 capital ratio falls to or below 5.125 per cent of total risk-weighted assets?, and (b) in both cases, loss absorption conversion or write-off at the point of non-viability? Conversion must be into the ordinary shares of the ADI or its parent entity (which must be listed at the time of issue). These requirements raise obvious difficulties for mutual entities which have not yet been resolved.

However, APRA has stated that:9

“The implementation of the Basel III capital reforms in Australia, in broad terms, is likely to generate very small increases in lending interest rates. Increased rates could over time result in a very slight decrease in GDP growth compared to what GDP would have been otherwise. For these potential costs, Australia is more likely to retain one of the world’s soundest banking systems. This seems an eminently sensible trade-off.

The Basel III capital reforms are an important but far from the only part of APRA’s approach to encouraging a safe banking system. APRA’s strategy includes conservative regulation, starting with but extending beyond minimum standards set globally, and assertive and where necessary intrusive supervision. Furthermore, APRA’s supervision is founded upon the principle that larger and more systemically significant institutions will receive closer attention upon earlier signs of any financial distress.”

The extent of any increase in the cost of financial intermediation which can be attributable to Basel III capital reforms is difficult to assess, particularly because of the impact of other factors, some of which are driven by regulatory change, but others of which are being driven by ADIs themselves as they review their risk management practices or are being demanded by the marketplace.

Other regulatory changes will also have an impact. These include:

  1. finalisation of the remaining prudential and reporting standards to implement the Basel III capital reforms;
  2. the implementation of the Basel III liquidity reforms;
  3. the implementation of the G-20 endorsed new international standard for crisis management arrangements published by the Financial Stability Board (FSB);10
  4. the additional capital reforms and prudential framework to be applied to domestic systemically important financial institutions (SIFIs) – although none of Australia’s banks have been designated by the FSB as a global SIFI, the BCBS has developed a framework for the prudential supervision of domestic SIFIs which is awaiting endorsement by the G-20 leaders and is expected to result in higher loss absorbency (Common Equity Tier 1 capital) requirements for domestic SIFIs;
  5. the new requirements for resolution and recovery planning (“living wills”) by ADIs; and
  6. the new prudential framework for conglomerate groups expected to be implemented from 1 January 2014.

However, in our view, the real price is not to be found in the cost of financial intermediation, but elsewhere.

First, if Basel III makes it too costly or difficult to do business, ADIs might try to transfer or cede business to other sources of credit: to capital market investors, to other, but different prudentially regulated entities, such as life insurers or to other non-bank credit providers, so called “shadow banks”. The FSB, BCBS and APRA are all alive to the risks of a growth in shadow banks. That risk might be pre-empted, either by extending prudential regulation to some non-bank credit providers, or by quarantining (or ring-fencing) the activities of ADIs from them, although there are no current proposals in Australia to do so. If business is transferred or ceded to other sources of credit outside Australia, the inconsistent implementation of Basel III in different parts of the world is likely to exacerbate the problem. The problem of interconnectedness highlighted by the global financial crisis is unlikely to diminish with the passing of time.

Second, would be any failure to anticipate novel, toxic asset classes. The history of banking crises is marked by a period of excessive growth in assets that are imagined by bankers and regulators to be safer than they are, for example:

  • in the 1890s in Australia it was real estate lending;
  • in the 1980s it was lending to Latin American countries on the premise that countries do not default on their loans, an experience that might yet be repeated in Europe; and
  • in the early 2000s it was misplaced faith in mortgage-backed and other securities based on their triple AAA rating.

A free market economy cannot ban risky investment and regulators may prove no better judge than private capital in identifying risk. Assuming that some consensus exists as to riskiness, based on the tenor of the asset, its complexity, or liquidity or the nature of counterparties, it is reasonable to ask to what extent ADIs should hold those assets or whether regulation should encourage those assets to be held elsewhere in the financial system. That other place is the capital market or other non-bank investment vehicles.

However, if that is to work, those alternative sources of capital and takers of risk have to be substantive pools of funds, independent of the banking sector. Absent such independent pools of funds, risk which appears to be held in the capital market or in or other non-bank investment vehicles may come back to the banking sector through a number of channels.

This is how Basel III can be outflanked or frustrated. Once again the scarcity of the true independent, domestic capital market end investor is a source of danger and the more that can be done to promote investment of that kind, the better.