Leverage, risk, culture and Australian bank capital

Today's response by the Australian government to last year's Financial System Inquiry (FSI) will intensify the scrutiny even more with the government re-emphasising the Australian Prudential Regulation Authority (APRA) should “take additional steps to ensure our banks have unquestionably strong capita ratios” and continue “to ensure our banks have appropriate total loss-absorbing capacity and leverage ratios in place”.

"Stress testing, raising margins on repo funding, and supervisory guidance garnered greater support compared to capital, liquidity, or credit-based tools."
William Dudley, President of Federal Reserve Bank of New York

The market – and indeed most observers – believe global bank capital ratios will continue to rise as regulators move to implement changes already announced and further enhance financial system resilience.

The questions though are when and by how much?

Capital costs money. Equity in itself has a price but for investors there are the collateral questions of whether dividend payouts will shrink as more capital is retained for regulatory purposes and whether bank returns on equity in Australia - with current management targets around 16 per cent - are sustainable.

Asked these questions last week, Westpac chief executive Brian Hartzer and chief financial officer Peter King reasonably answered they can only respond to set regulation or at least clear signals from regulators.

The market clearly believes more capital will be necessary. As CLSA analyst Brian Johnson wrote after the Westpac announcement “this is a Schwarzenegger capital raising - they'll be back!"

Meanwhile, the global regulator, the Basel Committee on Banking Supervision, has a number of potential twists in mind including a review of banks' own advanced risk models, standardised credit weightings, operating risk, market risk and leverage. All of which could reshape the levels of capital needed and none of which are settled.

That doesn't stop some commentators and analysts leaping on one particular theme and spread-sheeting it to come up with a fixed figure for future raisings.

The regulators themselves are not so prescriptive. In Australia, APRA chairman Wayne Byres has been careful in recent speeches to set directions rather than precise numbers while emphasising the regulatory agenda has more than just capital in mind. Culture and remuneration, for example, are critical in making institutions "unquestionably strong". The government’s FSI response cemented APRA’s central role in building financial system resilience.

In the US, in a roundtable of Federal Reserve governors considering how to manage the risk of a commercial property melt-down, the regulators emphasised the uncertainty around when and what to use as tools – they considered capital, leverage ratios, counter-cyclical buffers, liquidity, net stable funding ratios, credit tools, stress testing and supervisory guidance.

“It was noteworthy that in the discussion there was no agreement as to what instruments should be emphasised and the ordering in which they should be used relative to monetary policy," New York Fed President William Dudley said.

“Among the available macro-prudential tools, stress testing, raising margins on repo funding, and supervisory guidance garnered greater support compared to capital, liquidity, or credit-based tools."

In the UK, Paul Fisher, the Bank of England's risk specialist and 2IC at the Prudential Regulation Authority (PRA), gave a very comprehensive run down of the regulatory landscape and horizon in a speech at the American International University in London.

Running the gamut of current, proposed and debated regulation, Fisher concluded with the salient caution “it will take at least until 2019 until most of the measures outlined in this lecture are broadly in force, with some taking longer. And no system should be static, since regulation will need to evolve alongside the business".

From the UK supervisor's perspective, “the strategy is to deliver a resilient financial sector by seeking: an appropriate quantity and quality of capital; effective risk management; robust business models and sound governance, including clear accountability of a firm's management".

Fisher made several key points, just as applicable in Australia (and the region) as the UK. Local regulators and supervisors will implement global rules with some discretion but in keeping with the global agenda. Capital is “arguably the single most important objective of a prudential regulator" in order to provide a buffer for pronounced stress and a backstop if a wind-up is necessary.

“That will mean that the cost of required capital to support banking activity could be higher than it was previously. However, this is not certain," he said. “By making firms safer, it is possible that the required risk premia in bank capital and funding instruments will be lower, and hence the effect on the overall cost of funding is uncertain."

Fisher also bought into the leverage debate. Some believe a simple leverage ratio, of total assets (not weighted for risk) measured against capital, is a more desirable measure. Others argue ignoring the different risk profile of assets is simplistic – even granted the uncertainty in comparing risk weightings at different organisations.

“The degree of leverage has historically been a much better indicator of likely firm failure (although we can't be sure that correlation will survive if firms start to manage to a constraint!)," Fisher noted, warning the RWA and leverage approaches in themselves generate different incentives for firms.

Under RWAs the incentive can be to expand the balance sheet with assets that carry low risk weights. Under a leverage ratio, the incentive can be to limit balance sheet size but choose riskier assets.

“Ideally, the two measures would work in tandem to ensure sufficient capital to support both balance sheet size and risk taking," he concluded – which is both sensible and imprecise for those wanting to build capital forecasts into their spreadsheets.

And like APRA's Byres, Fisher emphasised the critical importance of culture, governance, board structure and remuneration – less tangible factors which tend to be ignored.

The Australian government's response to the FSI is of course of great import here as it will feed into the approach of all the members of the Australian Council of Financial Regulators, including APRA.

But what happens on the other side of the world is still paramount. All regulatory roads lead to Basel. When one wants to know what Caesar is thinking, one needs to be in Rome and JCP Investment Partners head of financials Matt Wilson has just been touring the banking equivalent of the empire.

“The regulators are very clear and consistent," he says.

In a note to client, Wilson wrote “the re-regulation cycle is far from complete. It was clear that liquidity, capital and governance are paramount".

Critically Wilson believes core equity tier one (CET1) targets for capital continue to rise and total capital pay-out ratios are likely to settle at around 50 per cent – down around 30 per cent on where they are now.

But equally he too heard the drum beat around the critical importance of governance.

“Remuneration rules have been tightened to ensure remuneration practices are consistent with effective risk management, while (key performance indicators) KPI's such as return on equity are discouraged," he wrote.

The message from Rome then capital is critical but behaviour is key.