What are the costs of Australian BASEL III implementation and what are the benefits

Charles Littrell, Executive General Manager - Annual Australian Financial Services Conference of UBS, Sydney

Today I will outline APRA's approach to balancing the likely costs and benefits of Basel III adoption in Australia. Basel III will reform both the capital and liquidity requirements applicable to Australia's authorised deposit-taking institutions, or ADIs.

Under its foundation act, APRA is required to balance financial institution and financial system safety, with efficiency, competition, contestability, and competitive neutrality. The essential concept here is balance. Safety is a remarkably useful characteristic attaching to a bank, insurance company, or super fund, but not the only important characteristic.

APRA is also required to follow the Commonwealth Government’s processes for effective regulation. APRA has for the past decade maintained a perfect compliance record with these requirements. Even if there were no explicit requirements on APRA to consult and analyse any changes to its prudential standards, we would still do so. We are confident that appropriate consultation and detailed analysis leads to a better prudential infrastructure than any other approach we could take.

We observe that supervisory use of APRA’s prudential infrastructure is made more effective by these measures. Our regulated institutions recognise that APRA’s prudential standards are formed under a robust process which not only improves but helps legitimise these standards.

The hierarchy of impact

It is possible to identify the likely influences of the Basel III reforms, and estimate the range of consequence associated with these influences.

When APRA assesses a capital or liquidity prudential standard, the hierarchy of outcomes is:

•  First, we determine which institutions will be affected;
•  Then we assess the pro forma balance sheet impacts upon affected institutions, and upon the aggregate industry;
•  Then we estimate the resultant income statement impacts. These first order effects do not assume any change in business mix by the affected ADIs.
•  At the second order, we look for impacts upon the relevant stakeholders, including customers and capital suppliers. This feeds back into potential changes in business mix and terms and conditions for ADI products.
•  Third order impacts then may flow to the broader industry or economy.

APRA routinely assesses first order impacts, with a useful degree of accuracy. For major changes we also assess second order impacts, with less accuracy possible, but often with the ability to calculate a reasonable range of outcomes. We only look at third order effects for very large changes, and at this level we are normally limited to estimating the direction of likely changes, and the resultant impacts upon safety, efficiency, and competition. Basel III is considerably more complicated than the average reform, and requires more consideration of second and third order effects, as well as the primary impacts.

When commencing this process, APRA is often looking at several potential approaches, which means that the impact analysis also looks at more than one approach. In the case of Basel III, however, we know the minimum changes, which flow from the December 2010 rules text issued by the Basel Committee.

It is APRA’s typical practice when making material and complex changes to capital, liquidity, or other quantitative prudential standards, to ask the affected industry to contribute to a Quantitative Impact Study, or QIS. For major changes such as Basel III, it is often the case that we will ask for successive QISs as the emerging standards are refined. Historically industry has proven highly cooperative and responsive to this approach. We do not require regulated entities to participate in QISs, but the great majority of these entities see the clear self-interest in doing so. We have already completed one QIS round on Basel III in 2010, and are currently undertaking a second round.

Accordingly, when forming a quantitative rule in a prudential standard, APRA is informed by a pro forma impact analysis of the prospective prudential standard’s effect not only on the industry’s position, but upon the majority of the individual institutions within that industry. We often use our statistical collections to assist in this pro forma analysis.

Basel III’s likely benefits

One frustration for safety regulators such as APRA is that costs are typically easier to estimate than benefits. Maintaining a sound banking system and a sound financial system is clearly an extraordinarily valuable proposition. The Basel III reforms fit this pattern.

We expect that Australian Basel III implementation will generate five main benefits:

1. Australian ADIs will be safer in a capital adequacy sense;
2. They will become much safer in a liquidity sense;
3. Australian depositors will be more encouraged to save than was previously the case;
4. The Australian financial sector will become less exposed to the whims of the short term international money markets; and
5. Australian ADIs will continue to be perceived internationally as subject to sound regulation, which should assist them in accessing international capital markets.

The international perception benefit may require a bit more explanation. APRA’s firm policy is to ensure that Australia’s ADIs are held to at least the Basel minimum standards, and are seen globally to meet this test. Leaving aside considerations of government policy, which in the past three years have explicitly moved to endorsing G20, Financial Stability Board, and related initiatives including the Basel III reforms, it is good sense for Australia’s ADIs to be considered well regulated by the rest of the world. Our banking system relies upon foreign funding, and to some extent upon foreign equity. It would not be sensible to give these capital providers a ready-made excuse to abandon Australia, in the unpredictable but inevitable event of the next global financial panic.

Australia’s economic foundations are heavily commodity based, which any global survey of comparable nations will suggest is not automatically conducive to financial stability. It suits Australia well to overlay economic governance that is stronger than the developed world average, if we want to give the Australian people a fair shot at avoiding financial instability and crisis. APRA does its bit for the larger financial governance equation by ensuring that our ADIs, insurance companies, and super funds are as safe as they can reasonably be made, without impairing their efficiency and competitiveness.

In addition to Australian implementation benefits, it is worth noting that Basel III will make North Atlantic banks a lot safer than was the case up to 2007. This reduces the potential for American or European financial crises to harm Australia’s financial sector or broader economy. We get this benefit no matter what happens in Australia, so it is not included in APRA’s cost/benefit considerations.

Basel III capital impacts

The Basel III reforms will tend to increase the required quality and quantity of capital held by ADIs. It is relatively easy to calculate the change in prudentially required equity for any given ADI as a result of Basel III. There is some non-trivial accounting arithmetic involved, but at the end of the day we and the industry can develop a good sense for what will happen to the pro forma prudential requirements.

The next step is to estimate the effect that the change in the prudential minimum requirement will have on an ADI’s actual equity held. Costs and benefits flow much more for actual changes than from the theoretical changes associated with changing minimum regulatory requirements.

An ADI’s managers and board need to juggle two external capital constraints. First, the ADI needs to comply with the regulatory constraint. Second, the ADI needs to consider market constraints driven either by equity investors, or more commonly by debt providers. This last group is sometimes proxied by the ADI setting a target debt rating.

The regulatory constraint is hopefully not the binding constraint. Nearly all ADIs comfortably exceed their minimum capital requirements, nearly all the time. Market constraints, by contrast, are highly cyclical, binding quite a lot in adverse circumstances, and less so in better times.

We see here some evidence of this assertion, looking at Australian Tier 1 and core Tier 1 capital ratios over the past twenty years. The very large increase from 2008 was not driven by any change in the prudential requirements, but by bank responses to demands for more equity cover not only by debt providers, but likely by equity providers too. Reducing risk suddenly became more important in the perpetual risk/reward balancing equation. As a result, core equity ratios increased by a third, or two per cent of risk weighted assets.

The fact that the market constraint typically binds relative to the regulatory constraint opens up an intriguing possibility: what is the cost/benefit if a change in the regulatory requirement has no impact on the capital actually held by an ADI? In theory, both the cost and the direct benefit are zero, but there is a large indirect benefit from maintaining equivalence or super-equivalence with international standards.

The larger banks, which dominate the market by share of assets, lack capital positions so large that any change in the regulatory requirement won’t be noticed. It is also the case that debt and equity markets set their market capital expectations with one eye on the regulatory requirements.

Accordingly, APRA takes the view that a change in the regulatory minimum capital requirement for an industry leads to an equivalent change in the average de facto target capital position. It is worth remembering, however, that this is likely the maximum impact, and some regulatory capital requirement increases may not lead to an equivalent increase on actual balance sheets.

Do we believe Modigliani-Miller?

Let’s take the very simple example of a 1 per cent increase in an ADI’s ordinary equity to risk assets ratio. The first order effects are:

1. An increase in equity, offset by an equivalent decrease in debt, and
2. The ADI’s profits increase by the value of the interest cost saved on the debt replaced by equity.

The second order effects are that every loan made by the ADI is backed by more equity. This may or may not mean that the ADI wishes to charge a higher interest rate on loans.

If we believe the Modigliani-Miller theorem, then capital structure doesn’t matter, and a lender should therefore be indifferent to the proportion of debt and equity in his or her balance sheet. But anybody who spends time with bankers knows that they are passionately interested in debt and equity composition. So we can set "zero" as the lower bound of second order interest rate effects for Miller- Modigliani true believers, among which I do not count myself. I note that although the Modigliani-Miller theorem was published in the late 1950s, the idea that an increasing equity requirement does not impose a cost still has passionate and well respected modern adherents. To take one example, Anat Admati of the Stanford Business School, with several colleagues, is evolving a working paper with the intriguing title: "…Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive"[1] This paper is a good summary of the arguments in favour of increasing bank capital requirements, on the grounds, among other things, that banks have too successfully imposed the cost of insufficient capital upon society at large.

Those who completely disbelieve in Modigliani-Miller, again a group in which I do not count myself, would think of the bank acting as a monopolist, against a high and fixed target return on equity. Let’s say that the banker wants an 18 per cent return on equity, which is 25 per cent pretax. Let’s also assume that the funding value of equity replacing debt is 5 per cent pretax. This generates a banker who wants 20 per cent pretax on each increment of equity. So every 1 per cent increase in the equity ratio would generate a 20 basis point increase in the loan rate.

But note that I stipulated a 1 per cent increase in the ratio of equity to risk assets, not accounting book assets. The notional 20 basis point increase needs to be multiplied by the ratio of risk assets to book assets, or for any given loan simply by the risk asset weighting. For home loans, which under internal ratings approaches have about a 20 per cent risk weight, the maximum impact in price is only 4 basis points, 20 per cent of twenty basis points. Across the larger banks, the average ratio of risk assets to book assets is around 50 per cent, so the maximum monopolist rate increase reduces from 20 to 10 basis points for the average loan.

There is also the consideration that I let the banker price like a monopolist, and let the banker use an aspirational return on equity. If I neither completely believe nor completely disbelieve Modigliani-Miller, what is the reasonable middle ground?

Something like an assumption that banks will try to maximise their aspirational returns, but will be partially defeated in this aspiration by competition, and by the fact that higher capital ratios produce at least some reduction in the necessary return on equity.

As a reasonable candidate for this middle ground, let’s consider the median total shareholder return of the last ten years, comprising capital appreciation and dividends on ordinary shares, rather than the banker’s target ROE. Using ASX figures for the 8 largest listed banks, in Australia this is about 8 per cent.

If we recast the previous calculations using an 8 per cent expected shareholder return, then we find that the interest rate increase for a 100 per cent risk weighted loan would be about half the previous figure. After adjusting for risk weightings, the average rate increase from a one per cent lift in the equity to risk assets level is 5 basis points, and for home loans perhaps 2 basis points.

Through this example, we arrive at a range of second order effects: increasing the required Core Equity Tier I ratio by 1 percentage point leads to an increase in lending rates of zero to 10 basis points once competitive equilibrium is established, with a reasonable estimate of 5 basis points. This means that an ADI with a weighted lending interest rate of 8 per cent would increase the average rate to 8.05 per cent.

Put another way, in this simple example we see that a reasonably substantial increase in an ADI’s capital protection, say from a 7 to an 8 per cent core Tier I ratio, leads to a much smaller proportionate increase in the ADI’s lending rate.

We can then briefly consider the third order impacts of this example. What would be the effect on the Australian economy of lending rates increasing by 5 basis points, and home lending rates by 2 basis points? Very likely, any effects would be too small to observe in the actual economy.

There are professional researchers who look at these issues in considerably more detail. Those interested in this topic might like to look at a May 2011 IMF working paper2 by Cosimano and Hakura. For a broad range of mostly North Atlantic countries, this paper estimates that large bank equity to asset ratios will increase 1.3 per cent due to the Basel III reforms. This is projected to generate a 16 basis point increase in lending rates, and over the long term slightly over a 1 per cent reduction in total lending. This paper usefully cites several other recent works in the area. The most authoritative public sector analysis, produced late in 2010 by the Bank for International Settlements3, estimates that after many years of transition, the median effect of a 1 per cent increase in bank capital ratios would include a 12 basis point increase in lending spreads, a one to two per cent reduction in aggregate borrowing, and a 0.1 to 0.2 per cent decrease in GDP.

In summary, the second and third order impacts from Australian Basel III capital reforms are likely to include a small increase in lending rates, and a very small decrease in total lending, balanced by an improvement in ADI and financial system safety.

Safety vs. efficiency in Basel III capital reform

Let’s assume for our current purposes that the net effect is that Australian’s bank capital ratios expressed in ordinary equity are 8 per cent rather than 7 per cent, as a result of Basel III. This is an example, not a prediction.

It would be fair to assert that between two banks otherwise identical, but differing only between a 7 and an 8 per cent equity capital ratio, that the latter bank would be modestly but appreciably safer.

Accordingly, APRA views the Basel III capital reforms as likely to produce moderately safer Australian banks, at minimal cost expressed in terms of higher lending rates and lower borrowings. It is arguable that the major Australian effect will be that we simply maintain our place among the A-league of countries applying the accepted minimum international standards, and therefore continue to have sound access to international capital markets.

There are also large but unpriced second and third order effects associated with a sound banking system. The fact that Australia’s financial sector boards and managers have been generally sensible for the last century, and the public sector has also performed competently, means that we take it more or less for granted that Australia enjoys financial stability. Our last serious banking sector crisis was in the 1890s. How many countries could make a comparable claim?

APRA’s Basel III approach is consistent with its generally conservative approach to supervision and regulation. Conservatism and proactive supervision goes in and out of fashion, but it seems to generate better long term effects than leaving financial stability to market forces. Basel III, along with everything else we do, is part of a larger strategy designed to minimise the risk that Australians will eventually suffer a financial crisis.

What about liquidity?

It is important to separate the cost of liquidity from the simple cost of money. In this slide we see that wholesale spreads have increased quite a lot in recent years, from what in hindsight appears to be an unsustainably low base prior to the global financial crisis. This change is good for depositors, bad for borrowers, and hasn’t got a lot to do with regulatory changes. In this slide we see some changes in bank costs of funds, as estimated by the RBA. As with all borrowers, banks were probably getting too good a deal up to 2007. Then in the global financial crisis all borrowers were forced to pay up, and now this paying up has moderated. It seems the case, however, that the cost of money, particularly longer term money, has settled at a higher rate than was the case pre 2007. This is probably a healthy outcome, albeit with material transition issues to consider.

In this slide we see that Australia’s banks have already materially changed the composition of their liabilities, with more retail funding and less short term wholesale funding. Again, a healthy change, and only incidentally related to regulation. Banks and capital markets have worked out that hot funding is far less useful than was assumed up to 2007, and we see some of the results here.

Given that banks have already come a long way on liquidity, what more will need to happen? Broadly speaking, the Basel III liquidity reforms will produce two improvements. First, banks will need to demonstrate their ability to survive liquidity adversity for thirty days, rather than the current benchmark of 5 business days. Second, bank funding will become more stable, measured against a one year benchmark. In Basel III jargon, these requirements are the Liquidity Coverage Ratio or LCR, and the Net Stable Funding Ratio or NSFR.

Before proceeding further on liquidity, I should note that it is APRA’s intent to only apply the LCR requirements to ADIs where we require them to model their liquidity net outflows, not ADIs using the much simpler minimum liquidity holdings (MLH) rule under our current liquidity prudential standard. Broadly, this means that banks will be impacted by the LCR, and credit unions and building societies will continue with a system that is nearly identical to the current rules.

Given that the NSFR’s composition has yet to be refined, and is not due for implementation until 2018, I will focus upon cost/benefit for the LCR.

The LCR’s general approach is that banks will calculate their stressed net outflows over 30 days, and must hold high quality liquid assets at all times to cover this projected net outflow. The dominant liquid asset in most countries will be sovereign bonds, with other high quality bonds also featuring.

In Australia’s case, and for good reasons, there are clearly insufficient government bonds and other non-bank high quality bonds to meet the LCR for Australian dollar denominated outflows. The Basel Committee acknowledged this arithmetic reality by including a provision for alternative arrangements in jurisdictions that lack ample bond availability. APRA and the RBA have already announced our joint intention to facilitate Australian LCR compliance, via an RBA-provided collateralised line of credit.

The costs of LCR compliance will include the need to reduce the 30 day net outflows, which is largely a matter of terming out debt. Given that widening spreads with tenor now seem a permanent part of the landscape, terming out will cost the banks some money in net interest margin terms. Banks will also need to offer attractive deposit products, valuing depositors for their liquidity provision. Higher deposit rates for domestic depositors have no net cost or benefit. If a bank is simply facilitating a change in terms of trade which increases both lending and deposit rates, this is less costly than a bank widening its spread between deposits and loans.

APRA’s assessment is that as the banking system moves towards the 2015 LCR introduction, it will not be feasible for the system as a whole, or for any major bank individually, to improve its liquidity so much that the RBA collateralised facility will not be necessary. We intend to work with the banks to minimise the use of this facility, but "minimal" will not equate to "zero".

Under the terms of the collateralised facility, the banking system can hold banking assets to meet their liquidity needs, which by definition will cost zero on a net basis. The cost for this aspect of the LCR will arise through the RBA line of credit. Given that the facility fee for this line has not yet been decided, I am unable to provide a range of basis point estimates today for costs. It would be fair to say, however, that our preliminary calculations indicate that the total cost of LCR compliance will not be great, in the context of the banking sector already going some way towards repairing what we now know was an insufficiently liquid position up to 2007.

In late 2009 the CBA’s chief executive, who was also chair of the Australian Bankers Association at the time, commented that in his view the emerging liquidity rules would result in a rate rise of 4 to 7 basis points. After a year and a half of Basel III rules development, APRA’s view is that this initial estimate remains reasonable. There will clearly be some cost associated with LCR compliance, but not such a large cost that the terms of trade between lenders and borrowers, or the overall shape of Australia’s balance sheets, should change materially.

Benefits of the Basel III liquidity reforms

Now let us look at the benefits of liquidity reform. As with capital reform, there is a large benefit associated with keeping Australia in the global "A" league, with continuing sound access to international capital markets. There is also an indirect benefit in that the rest of the world’s banks will also become stronger in liquidity terms, which means that the next financial crisis is hopefully less traumatic than the 2008 version.

Unlike capital reform, however, where APRA’s current capital regime weathered the global financial crisis, there is a clear need to enshrine stronger liquidity management practices. In late 2008, Australia’s banks were sounder by a considerable margin than their North Atlantic peers in capital and asset quality terms, but they were not spared from the freezing of global funding markets.

Australia’s banks have already progressed some way in strengthening liquidity risk management, and APRA looks forward to working with industry in this regard. We need to be prepared for the day when the world’s capital markets decide that they are less happy than is currently the case to lend to Australian names. Until 2008 few people understood just how easily the international markets could close to Australia. We know now that these markets are considerably less robust than we previously thought, and accordingly we need considerably more protection against their failing to fund Australian banks, for either rational or irrational reasons.

What about shareholders?

An analysis of shareholder impacts is absent from the above commentary. Earnings will slightly increase, return on book equity will slightly decrease, and the risk of catastrophe will moderately decrease. It is impossible to say what the net effect of these changes will bring to the share price. APRA’s starting position is that the likely effects are small, with zero a reasonable central estimate.

Summary — Basel III costs and benefits

In closing, I repeat the point that the calculations I have provided here are illustrations, not predictions. We have a considerable body of work in front of us before APRA will have the facts to hand to produce the requisite regulatory impact calculations. On the other hand, we already know that the broad impacts will be:

1. First, that Australia’s banking system will end up with more capital of somewhat higher quality than would otherwise be the case;
2. Second, that Australia’s banking system will become a lot more resistant to liquidity risk than was the case until 2008;
3. Third, that at least in Australia much of the industry’s capital and liquidity strengthening will be driven by market expectations, not regulatory requirements;
4. Fourth, as a result of the Basel III reforms, ADIs will pass on some capital and liquidity costs to borrowers, and some liquidity benefits to depositors;
5. Fifth, that there are substantial benefits associated with Australia at least meeting the Basel III global minimum requirements, and APRA remains confident that our local adjustments will effectively balance safety with efficiency and competition; and finally
6. The net calculation of costs and benefits flowing from the Basel III reforms will be decidedly positive, as will be the case in the rest of the world. Relative to the North Atlantic countries, these calculations will be somewhat muted in Australia by the need for relatively less reform, and therefore relatively lower identified costs and benefits.

In sum, APRA is confident that the Basel III reforms will prove worthwhile in Australia, and among our other efforts, we intend to produce regulatory impact cost-benefit analyses that demonstrate the range of calculations backing this confidence.

Thank you for your attention.