Comment: no easy answers on capital comparisons

The international capital comparison study released by the Australian Prudential Regulation Authority yesterday spells out the difficulties involved in making any capital adequacy comparisons between Australia's four major banks and their international peers. These difficulties extend not only to definitions and determinations of capital and risk weighted assets but also to which international banks should make up a peer group.

There is general agreement with the Financial System Inquiry's recommendation that Australia's authorised deposit-taking institutions should have "unquestionably strong" capital ratios and that, in the case of the four major banks, this requirement should place them in the top quartile of their international peers.

The problem is measurement. APRA had to determine its own international peer group against which comparisons could be made. It came up with a group of 63 international banks after finding that it could not use the 98 banks classified as Group 1 banks by the Basel Committee on Banking Supervision because they are not named.
    
Then there are four different measures of capital adequacy to consider: common equity tier one capital, tier one capital, total capital, and leverage. There is no international standard that is used.

CET1 capital is the purest measure of capital and the most commonly referred to for comparison purposes. Leverage, as it will be applied to authorised deposit-taking institutions, is yet to be defined by APRA.

Focusing on the CET1 ratios of the four major banks as at the end of June 2014, APRA concludes that the ratios could actually be understated by 300 basis points relative to the peer group selected - CET1 could be understated by 100 bps and risk weighted assets could be overstated by as much as 200 bps.

The latter would seem a very controversial finding considering the raging debate about the risk weighting that should be applied to residential mortgages.

Any excitement from the surprising finding that the CET1 ratios of the four major banks could be understated by as much as 300 bps is, however, promptly quelled by the observation that this still doesn't get them into the top quartile. To get them into the top quartile, APRA estimates that the ratios would need to increase by a further 70 bps.

This equates to about an extra A$10 billion of CET1 capital, which seems manageable but it doesn't end there. If the four major banks are to make the top quartile on all four measures of capital adequacy, APRA concludes that much more will be required.

APRA's conservative estimate is that another 200 bps will need to be added to the major banks CET1 ratios. This is another $20 billion roughly, on top of the first $10 billion.

That isn't too bad considering some of the amounts that have been speculated, but wait - there's more.

As APRA notes, the international peer group selected for the four major banks is not going to stand still, waiting for our banks to catch up. These banks are continuing to build their capital levels, driven by the requirements of their own regulators.

However, APRA is not going to tie the major banks to top quartile positioning, it is simply going to use this as a guide. And it is not going to say yet what it expects from the major banks or other ADIs in terms of capital increases.

APRA will be guided by the final determinations of the BCBS in this area, which are not expected before the end of this year. APRA appears loath to move ahead of the BCBS, unlike regulators in some other advanced countries around the world.

In the meantime, APRA's formal response to the recommendations of the FSI is expected soonish. A key response will be the one to the recommendation that the gap be closed between the risk weights applied to residential mortgages by the four major banks using the internal ratings-based method, and the standardised approach used by all other ADIs.

As noted by the FSI, the IRB approach allows an average risk weight of 18 per cent to be applied to residential mortgages by the major banks but the standardised approach requires an average risk weight of 39 per cent. This puts smaller ADIs at a significant competitive disadvantage.

While the smaller ADIs have understandably argued that a lower average risk weight should be applied to all, the FSI clearly recommended against this and argued for a floor to be applied to the risk weights that can be used under the IRB method.

If the risk weighting of residential mortgages increases through the introduction of a floor under the IRB approach, yet more capital will be required.