Basel III: The journey and the destination

Wayne Byres, Executive General Manager - LaTrobe Finance and Corporate Governance Conference ‘Basel III and Beyond’, RACV Club, Melbourne

Today is an important day. Some of you might think I am referring to the fact that, under current Constitutional arrangements, our future King is getting married in a few hours time. For those of you with a mind to history, you will know is the anniversary of the day Captain Cook first set foot on the Australian continent, but that's not what I have in mind either. Today is important from a Basel III perspective because, after today, there are 100 weeks until banks have to report their first capital adequacy ratios under the new Basel III regime. The countdown begins!

The theme for this afternoon's session is 'Basel and Beyond'. But there is still plenty of work to do before we even get to Basel III, let alone worry too much about what is beyond. So today I will limit my remarks to the journey to a Basel III world, and what the destination might look like when we get there.

What is Basel III?

I'll assume everyone here knows at least a little about what Basel III involves, so I will only quickly summarise the key components:

• a substantial increase in global minimum capital requirements (effective minimum equity requirements are being increased by a factor of 3-4x in many countries);
• a considerable strengthening of the quality of capital (which has the effect of increasing the minimum requirement even further);
• the introduction of a formal corrective action regime into the capital framework (in the form of the capital conservation buffer);
• the introduction of a macro-prudential component into the framework (in the form of the countercyclical buffer);
• the addition of a simple leverage ratio as a backstop to the risk-based regime; and
• the first global liquidity and funding standards.

Put simply, Basel III is designed to make banks more resilient. The increased quality and quantity of capital, coupled with higher liquidity and more stable funding, is intended to make banks better able to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy. The GFC brought to light weaknesses in the existing regulatory regime: banks with apparently high levels of surplus capital and liquidity still found themselves seeking central bank funding and public sector capital support. Policymakers have therefore sought to comprehensively overhaul the key financial requirements placed on banks, and to put them on a much sounder footing for whenever the next crisis comes.

So there's no doubt Basel III is big and important. But what will it mean for Australian banks?

Capital

Let's start with capital. While APRA is still to finalise the full details of the new regime as it is to be applied in Australia, we certainly know the direction being taken.

As a simple rule, banks around the world will need more capital than they have held in the past to do the same level of business. In particular, they will need more equity.

Thankfully, Australian banks have built up their capital buffers substantially in recent years - indeed, the Tier 1 capital ratio of the Australian banking sector is now at a historically high level. In the first half of 2009, when the Tier 1 capital ratio of the Australian banking system was a little above 8 per cent, I gave a speech and pondered whether the aftermath of the GFC would see banks strengthen their capital ratios in the same way that they did in the aftermath of the recession in the early 1990's.[1]

With the benefit of hindsight, we can now see that they have followed a similar pattern.

What I can confidently say will be different this time around, however, is that from here capital levels will take a different path to that which they followed in the second half of the 1990s. This is because the new Basel III requirements will hold industry capital at current levels, and over time is likely to push it a little bit higher.

This chart also tells us two things about the potential impact of Basel III – one about the journey, and one about the destination:

• The first point relates to the transitional costs of shifting to the new capital regime. Until APRA's proposed prudential standards on capital are published, it is not possible to say precisely how far is the journey banks need to take to meet the new Basel III standards. But:
  • Australia has for some years implemented a number of the requirements that are now part of the Basel III regime. We already prohibit banks from counting as capital a number of balance sheet items – for example, the value of any surplus that may be residing in their staff superannuation funds - which Basel III now prohibits too. We have also adopted tighter limits on the use of non-equity capital instruments than have been applied in many other jurisdictions. We obviously supported these tighter requirements being included as part of the Basel III package, but they will have a reduced impact here.
  • Furthermore, the earlier chart tells us banks are maintaining capital ratios (measured in the conservative Australian manner) at what would historically be regarded as quite elevated levels.

Taken together, these factors – a better starting point, and less distance to travel - mean that Australian banks, and Australian ADIs more generally, are well placed to meet the new standards. As best we can tell, we aren't too far from our destination, so the cost of the journey there shouldn't be too great. We are unlikely to face the potentially large transition costs that are of more concern in some other jurisdictions.

The second point is whether, as some have claimed, the new regulatory requirements are so restrictive that, once we get to our intended destination, banks will not be able to meet in full the credit needs of the community. Banks were able to provide significant volumes of new credit and grow quite strongly in the pre-GFC period without raising substantial equity because they funded a significant part of their growing regulatory capital requirements from non-equity sources (using so-called hybrid or innovative capital instruments). While headline Tier 1 and Total capital ratios were largely unchanged for many years, the chart above showed that the net Fundamental Tier 1 capital ratio - in very simplistic terms, a regulatory version of net tangible assets - was declining for most of the pre-GFC decade. Banks have now sharply reversed this trend, and Basel III will reinforce it. In future, it will be much more difficult to fund balance sheet growth without a matching growth in equity.

This provides a hint as to the likely natural supply-side constraints on bank balance sheet growth in the future. Under Basel III, the ability to grow risk-weighted assets at a consistently higher rate than equity will be much more limited. As a result, the natural growth constraint on a bank will be its ability to build its shareholders' funds by growing its retained earnings. That is not to say banks cannot grow faster, but to do so they will need to raise (or retain) additional capital from shareholders. A simple model of the natural growth rate in shareholders' funds is:

ΔSF = (NPAT/RWA) x (RWA/Equity) x (1 – (DPR x (1 – DRR)))

where NPAT is net profit after tax, RWA is risk-weighted assets, DPR is the dividend payout ratio and DRR is the dividend reinvestment rate. In other words, the growth in equity is a function of the after-tax return on risk-weighted assets, the level of regulatory leverage, and the level of dividend distribution. This can be further simplified to:

ΔSF = RoE x (1- NDPR)

where RoE is the after tax return on equity and NDPR is the net dividend payout ratio. To take an example, assume that Australian banks earn a return on equity in the order of 15 per cent, and pay out around 60 per cent of their earnings as dividends. Under such a scenario, equity in the banking system will grow in the order of 6 per cent per annum.[2] Allowing for some dividend reinvestment, which might reduce the net payout ratio to something more in the order of 50 per cent, the natural growth rate of the industry increases to around 7½ per cent.

Of course, this is not an absolute speed limit - banks will be able to grow faster that this if they wish. But they will need to do so by either justifying to their shareholders that retaining earnings rather than paying dividends is a superior use of capital, or else periodically seek to raise new equity from existing and/or new investors.

A single digit rate of growth may seem low relative to the recent past. But the decade and a half leading up the GFC was probably unusual in that we experienced a high rate of credit demand driven, at least in part, by the community‟s adjustment to a low inflation, low interest rate environment.[3] With this demand-side adjustment to credit probably at an end, it is not unreasonable to think that bank balance sheets might grow, over the longer term, at a broadly similar rate to nominal GDP. If so, the limitations on the supply side being enforced by Basel III are unlikely to be particularly constraining.

Liquidity

Let me now turn to liquidity.

Basel III contains two basic tests banks will need to meet in the future. Although some might quibble with the use of the adjective 'basic', conceptually they are not difficult to understand.

The first is the liquidity coverage ratio (LCR). The LCR tests whether banks will be able to survive an idiosyncratic crisis for 30 days using their own resources, assuming also that (not unreasonably) markets are unsettled during this period. In its form, this is akin to the long-standing prudential requirement for large ADIs in Australia: the so-called 5 day 'name crisis' test. There are, however, some key differences:

• The time horizon of the LCR is one month rather than one week. Clearly, all else being equal this is a tougher test than is currently imposed, but it shouldn't be thought simplistically as four times tougher - the additional liquidity requirement to survive a 30 day test will depend on the maturity profile of each bank's liabilities.
• The range of assets eligible to count as liquidity under the LCR is narrower than the current prudential requirement. Most notably, Basel III has decreed that bank paper, which is the mainstay of liquid asset portfolios for most Australian banks, is not eligible as liquidity in the LCR. This reflects the experience of the GFC, where it was identified (perhaps self-evidently) that in a banking crisis bank paper may not be the most liquid asset to hold.
• The LCR is going to be an international benchmark, and come with disclosure requirements. This aspect has, in my view, not attracted a lot of attention to date. At present, only the individual bank and APRA know how much liquid asset buffer a bank holds relative to its projected outflows; in future, this will be much more transparent to competitors and counterparties, imposing considerably more market discipline.

A key problem for Australia in applying the new global liquidity standard has been the Basel Committee‟s decision to rule out bank paper as an eligible liquid asset for the LCR. Australia does not have - as we often say, for the best of reasons - sufficient government debt to meet the liquid asset needs of the Australian banking system. Nor do we have sufficient amounts of highly rated and liquid corporate debt or covered bonds. So while APRA and the RBA have been fully supportive of the international push for banks to strengthen their resilience to liquidity shocks, we have also faced the problem of being simply unable to implement the internationally agreed proposals in Australia.

In the end, APRA and the RBA were able to come up with an alternative approach which meets the spirit and intent of the new liquidity requirements. Australian banks subject to the new requirements will be able to secure a pre-committed liquidity facility with the RBA, which will provide them with a guaranteed access to cash via the ability to repo assets on demand.[4]

Importantly, this is not a free gift from the public sector: banks will need to pay a fee for this facility. The size of the fee is yet to be determined, but broadly it will be set at a level designed to ensure banks have the same price incentives to prudently limit their liquidity risks as if Australia had a sufficient volume of liquid assets.

The net result of applying the LCR in Australia is likely to be that:

• absent any behavioural change, banks will need to hold higher levels of liquid assets;
• banks will in practice be able to hold largely the same types of liquid asset portfolios they do now (including bank paper); and
• some of the yield pick-up they earn on those assets will be paid away in the form of the facility fee.

Of course, the qualification about behavioural change is important. It is also hopefully unrealistic, since the new standards are meant to create incentives for behavioural change. We do not expect banks will meet the new requirements simply by holding higher levels of liquid assets. In practice, between now and 2015 when the LCR is introduced, they are likely to do a combination of:

• optimise the composition of their liquid asset portfolios by altering the current mix of their liquid assets to suit the new regime;
• examine the asset side of their balance sheet to improve its liquidity;
• adjust their liability profile to lengthen its duration; and
• review their liability products to limit/remove explicit or implicit call options granted to customers.

And beyond all of this, it is important to not to lose sight of the qualitative requirements also being introduced for liquidity risk management.5 This is just as important as the numbers, although less visible. Regulators are seeking to substantially up the ante on the governance and management of liquidity risk, and in many respects these changes will be just as important as the new quantitative requirements in making banks more resilient to future funding shocks.

The other liquidity-related test in the Basel III reforms is the Net Stable Funding Ratio (NSFR). The NSFR is a longer term test on the structure of banks asset-liability mismatch.

Occasionally it is said that the NSFR is outlawing banks from fulfilling their key role in maturity transformation. This is not true. The NSFR is certainly designed to limit banks that take on large volumes of illiquid assets and attempt to fund them by equally large volumes of short-term liabilities. But there are two important features worth highlighting to anyone who thinks maturity transformation is being eliminated by Basel III:

• The new framework draws an important distinction between different types of short-term liabilities. In a strict legal sense, retail deposits, most of which are at call, have a shorter life than, say, 30 day commercial paper funding. But the NSFR recognises that there are important behavioural differences between these types of funding: retail deposits typically provide a much more stable source of funding than money raised in short-term wholesale markets. So the NSFR allows for maturity transformation using stable deposits to continue relatively unimpeded, but cracks down much more harshly on banks making excessive use of short term wholesale funding to fund illiquid long-term assets.
• The framework also recognises that it is not essential for high quality but illiquid long term assets to be entirely funded by stable liabilities. Most notably for Australian banks, the NSFR recognises that a sound funding profile for mortgage lending does not require 100 per cent stable funding, but provides that, in broad terms, only two-thirds of funding for conventional mortgage lending need be provided by stable sources (including stable, but possibly still at call, deposits).

What will it mean for Australian banks? The NSFR will continue to drive them along the path they have been taking since the onset of the GFC (see chart opposite, which is taken from the RBA Chart Pack). Compared to their current position, banks will need to continue to rebalance their funding profiles to make greater use of deposits and longer-term wholesale funding, and less use of short-term wholesale funding.

As with capital, Australian banks have not been waiting for Basel III to come along before adjusting, but have recognised the need to rebalance their funding mix regardless of Basel III. Much was made last year of the so-called 'deposit war', as banks competed aggressively for deposit funds, as well as continued to seek opportunities to lock in longer term funding. APRA will be looking to see this trend continue: while there appears to be a lull in hostilities in the deposit war just at the moment, we cannot afford to let peace break out just yet!

Banks will also want to scrutinise the asset side of their balance sheet, with the NSFR providing additional encouragement to distribute rather than hold longer term illiquid positions. Banks have never had a large incentive to assist in the development of a corporate bond market in Australia, but the NSFR may help them along this path.

What is still up for debate is the extent of balance sheet rebalancing needed. The Basel Committee has quite deliberately taken a cautious path to the implementation of the NSFR – it does into come into force until 2018 – to provide further time for analysis and, if necessary, refinement to deal with unintended consequences. It is still possible that the NSFR could be further refined if the Committee considers that it is not producing sensible outcomes. But the fact that banks are being forced to change their profiles is definitely an intended consequence of the reforms. And the best way to manage the transition is to start early.

Concluding Remarks

A Basel III world will look quite different to that which existed before the GFC. This is intentional: Basel III is designed to create incentives for banks to change their behaviour. The fact that banks will hold higher levels of higher quality capital, hold more liquidity, and maintain more stable funding profiles is a quite deliberate drive by regulators to make the banking system more resilient than it proved to be in the midst of the last crisis.

Of course, not all change will be the Basel Committee's doing: many of the characteristics of the new world are being driven by the marketplace, as much as being a response to regulation. The fact that Australian banks are already clearly well advanced on the journey to a Basel III world, even though some of the deadlines to get there are some way off, is evidence of this.

But what Basel III will do is put a floor under these market expectations, so that the cycles that we have seen in the past in bank capital ratios are less likely to occur in the future. In the years prior to the GFC, the market placed too much pressure on banks to demonstrate financial efficiency, and too little to demonstrate financial sufficiency. Basel III cannot guarantee against further crises or bank failure, but it will make banks more resilient by ensuring they maintain much higher levels of financial sufficiency in future. Given the costs of financial insufficiency that the GFC has demonstrated, we believe the journey to the new world is one worth taking.

Thank you.