Bank capital – behind the headlines
Pat Brennan, Executive General Manager, Policy and Advice Division - 2019 KangaNews Debt Capital Markets Summit, Sydney
Bank capital (and liquidity) is the core of financial resilience, hence capital ratios are key indicators of financial strength. Bank boards, investors and regulators pay very close attention to these, the headline ratios and the underlying drivers, for reasons that are very obvious to this audience.
Reflecting the importance of financial strength, APRA is in the process of updating the entire prudential framework for capital in the banking industry. This began in 2014 with the Financial System Inquiry recommendation for APRA to set requirements such that Australian bank capital ratios are “unquestionably strong”, and substantial progress has been made against this objective. More recently at the end of 2017, the Basel Committee on Banking Supervision finalised most of the post-global financial crisis (GFC) reforms, finishing off in January of this year with the release of the final market risk capital framework. In 2018 APRA began the public consultation process as we sought to synthesise these two key drivers, as well as introducing a variety of features that are specific to the Australian industry.
Today I will provide an update on APRA’s approach to risk-based capital requirements, then loss-absorbing capacity (LAC), and then provide an update on what policy developments APRA is working on behind the capital headlines.
A 10-year post-GFC capital build is near completion with unquestionably strong capital ratios already attained by most banks. Stress tests undertaken by both APRA and the IMF in recent years have also found banks remaining above regulatory minimum requirements in very severe stress scenarios.
While the overall amount of capital that needs to be held by Australian banks has already been set in the unquestionably strong benchmarks announced in July 2017, the allocation of the precise amount of capital attributable to each source of risk is being worked through as part of the revisions to the capital framework. In February last year, APRA released an initial discussion paper that proposed a number of revisions to the credit risk, operational risk and market risk frameworks, including the adoption of a capital floor, which will limit the capital benefit banks that use the internal ratings-based approach (IRB) can obtain relative to those that use the standardised approaches. These proposals focus primarily on improving the risk sensitivity of the capital framework.
In August last year, APRA also released a discussion paper on improving the transparency, comparability and flexibility of the capital framework in areas where APRA’s methodology is more conservative than minimum international requirements. The proposals in that paper complement the revisions to the capital framework by seeking to ensure that the capital strength of Australian banks is appropriately understood by market participants.
APRA expects to soon release its response to revised capital requirements for credit risk and operational risk. In relation to the former, the next phase of consultation will focus on the treatment of residential mortgages for all banks, and other amendments to the standardised approach to credit risk. Later this year, APRA will release its full response to the revised credit risk requirements for the IRB approach and its response to improving transparency, comparability and flexibility. The outcome of this may lead to significant presentational and calculation changes to a number of prudential standards, although these would not affect the quantum of capital required.
This stream of work is a multi-year process and is likely to involve further rounds of consultation and quantitative impact studies to enable APRA to assess the impact and better calibrate the proposed changes. Given the need for extensive consultation, the revised prudential standards are likely to be finalised in late 2020, and are intended to commence in early 2022, consistent with the international timetable agreed at the Basel Committee.
Loss-absorbing capacity and recapitalisation
Our work on building loss-absorbing and recapitalisation capacity to deal with a bank failure or near-failure has been moving on a very different timeline to risk-based capital, and deliberately so. The 2014 Financial System Inquiry recommended introducing LAC requirements in Australia (which was consistent with APRA’s intent), adding that international practices were still emerging at that time, and APRA should follow these developments.
In November last year, APRA released the discussion paper Increasing the loss-absorbing capacity of authorised deposit-taking institutions to support orderly resolution. In this paper we proposed increasing the Total Capital Requirement of the major banks by between 4 and 5 per cent of risk-weighted assets, with the expectation this would be mostly met through the increased issuance of Tier 2 instruments. APRA intentionally proposed a simple approach of using existing, well-understood capital instruments, given they have been proven to work for their intended purpose – that is they recapitalise a bank when needed.
Whilst APRA is still considering submissions received and gathering additional information, and as such we have not yet made any decisions on the proposals, I will offer a few observations. The response we have received has been somewhat mixed. We have been given clear feedback in a number of submissions that the quantum of Tier 2 targeted, particularly at the higher end of the calibration range consulted on, will test the likely bounds of investor capacity. Submissions therefore challenged whether that calibration is sustainable over time given debt markets will continue to experience occasional periods of difficult issuance conditions. Some submissions also questioned whether there are lower cost options to achieve the same level of recapitalisation capacity, accepting these options are more complex. On the other hand we have also received feedback from some parties that using existing, proven capital instruments is a very good idea.
In the debate about what is the best form of LAC, many submissions concentrated on its form and understandably referred to the variety of international approaches that have emerged. Submissions offered informative perspectives on the relative merits of differing forms of LAC from a capacity and efficiency perspective. Few, however, reflected on the differing objectives and structures that have influenced the divergence of international approaches.
Now is a good time to reflect that in many jurisdictions the chosen LAC approach was in direct response to their own, painful, lived experience through the GFC; with the reality of “Too Big to Fail” meaning authorities were faced with no choice but to bail-out troubled banks. In some jurisdictions this has led to a stated policy approach with the express, singular objective to never again require taxpayers to fund a bank bail-out. On the other hand, in other jurisdictions, including Australia, the objective is to protect the community from the potentially devastating broader impacts of financial crises. This is done firstly by reducing the probability of failure; and secondly by establishing sufficient recapitalisation capacity such that, should a failure or near-failure occur, the overall cost is minimised. This is consistent with the Financial System Inquiry recommendation that stated recapitalisation capacity should be “sufficient to facilitate the orderly resolution of Australian authorised deposit-taking institutions and minimise taxpayer support.”
These differing objectives guide policy choices. Differing legislative and regulatory frameworks, and institutional and corporate structures, around the globe also guide choices and have played a role in influencing the divergence of approaches adopted.
So for now we are thinking through options and gathering additional information. APRA would still prefer a solution that is on the side of simplicity, though at the same time we clearly want to arrive at an approach that will work over time.
Whenever APRA consults on a policy we undertake a genuine consultation process and, for major policy such as this, it is an extensive process and all submissions are carefully considered. In this case we have benefitted from a high level of engagement with a broad range of stakeholders, broader than is usually the case for APRA consultations, reflecting this is new territory. At this point I cannot say when we will make public our findings from the consultation, but given some years ago we intentionally adopted the position of a follower of international developments, we are now motivated to work through the considerations as swiftly as possible.
Following finalisation of the LAC framework APRA will build out other aspects of the prudential framework for recovery and resolution.
And now, what is behind the headlines?
Without diminishing their importance, there is plenty that capital ratios do not tell you. They don’t tell you how well a bank is run: if its approach to risk management is sound, whether there is good governance, and whether stakeholder interests are appropriately balanced. Capital is no panacea as financial strength alone cannot adequately mitigate against poor risk management or weak governance. These are fundamental concerns for a prudential regulator. Capital standards, including unquestionably strong benchmarks, are set on the basis of at least sound risk management and governance being in place, and so APRA has an ongoing supervisory and policy focus on non-financial risks and drivers.
Cyber-risk, remuneration, accountability, governance, risk management, recovery and resolution – these will naturally become the greater part of APRA’s policy focus for the forthcoming years. We are not lowering policy intensity on financial risk and capital, but we are complementing and adding to this by strengthening the prudential framework for non-financial risk.
Here is a quick overview of what to expect:
Late last year, APRA released the final version of Prudential Standard CPS 234 Information security, which provides a clear set of requirements and expectations covering information security, including cyber risk. We will very shortly be supplementing this with a detailed practice guide.
In the next quarter we will release for consultation an updated prudential standard on remuneration. This follows the April 2018 Information Paper Remuneration practices at large financial institutions, which reported on a thematic review APRA conducted where we found that practices were not as robust as they should be. We have also learnt a great deal from the CBA Prudential Inquiry and of course the Royal Commission. The new standard will be stronger and be primarily focused on outcomes. This will include that performance assessment must reflect consideration of all relevant contributions to performance, including risk management; banks will need to be transparent with APRA on how remuneration decisions are made; and variable remuneration must be truly variable in practice.
We will also have a significant focus on governance and accountability. An extension of the Banking Executive Accountability Regime (BEAR) to cover other prudentially regulated industries has been a consideration since BEAR was first envisaged – APRA has consistently supported this extension as the prudential principles of BEAR apply equally across industries. Following the Royal Commission, the BEAR extension will go even further, with a parallel conduct accountability regime to be administered by ASIC. This is an important development and APRA and ASIC will work closely to ensure the parallel regimes work optimally. APRA will refresh its Governance and Fit and Proper standards to not only more closely complement the accountability regime, but to strengthen standards more generally; again this will be in light of what we have learned through our supervisory activity, through the CBA Prudential Inquiry and the findings of the Royal Commission.
In the sphere of risk management, APRA will in the near future release for consultation a materially updated Prudential Standard APS 220 Credit Quality that we will also rename to Credit Risk Management. Given credit is the most material risk of the Australian banking sector we expect this will get plenty of attention. On a slightly longer time frame, we are developing an overarching operational risk standard and will consider changes to Prudential Standards CPS 220 Risk Management as our work of non-financial risk progresses.
In conclusion, APRA has a comprehensive policy agenda both on bank capital and non-financial risk. On the latter, this will draw on our supervisory experience, the CBA prudential inquiry, the findings of the Royal Commission and international developments. The Australian banking system is well capitalised and APRA is supplementing that financial strength by ensuring strong risk management and sound governance practices are in place across the full spectrum of risks that banks face.
 APRA normally uses the term Australian Deposit-taking Institutions (ADIs) to refer to authorised participants in the banking industry and this includes banks, building societies and credit unions. For ease of reference and considering the international audience being addressed, in this speech “bank” should be read as referring to all ADIs.