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Bank Regulation and the Future of Banking

Wednesday 11 July 2012

John Laker, Chairman - 41st Australian Conference of Economists, Melbourne

I am pleased to join the Australian Conference of Economists 2012 and to participate in this special interest session on Bank Regulation and the Future of Banking.

Having just returned from a meeting of the Basel Committee on Banking Supervision, on which both APRA and the Reserve Bank of Australia are members, I will use my introductory remarks to provide an update on global banking reforms. This is the business APRA is in. However, our toolkit does not include a crystal ball and I leave forecasts on the future of banking to other soothsayers.

To recap, global banking reforms are aimed at improving the resilience of the global banking system by raising the quality, quantity and international consistency of bank capital and liquidity, constraining the build-up of leverage and maturity mismatches, and introducing capital buffers that can be drawn upon in difficult times. The reforms are also aimed at improving risk management and governance as well as strengthening banks’ transparency and disclosures. On a separate front are reforms, now in place, designed to align remuneration incentives with good stewardship of financial institutions.

The Basel Committee’s capital and liquidity reforms, now simply called Basel III, were endorsed by the G-20 Leaders at their Seoul Summit in November 2010 and were released, leaving a couple of areas aside, in December 2010. Those remaining areas — mainly the regulatory capital treatment of bank exposures to central counterparties — were finalised at our latest meeting and the associated rules text should be published shortly.

Implementation of the Basel III reforms is now in full swing.

Global banking reforms are not unusual. In just over twenty years, we have had the original Basel Capital Accord in 1988 and the New Basel Capital Framework (Basel II) in 2008. This time, the global reform process has some different characteristics.

The first is the role of the G-20 in providing strong global leadership of reform. The G-20 Leaders’ April 2009 Declaration, Strengthening the Financial System, established a comprehensive blueprint for global reform — of which the Basel III reforms form only a part — with an ambitious timetable. The G-20 has not wavered since.

The second is the important role played by the Financial Stability Board in achieving the G-20 agenda and timetable, by coordinating the work of the global standard-setting bodies and other organisations in the interests of global financial stability. Given its close relationship with the G-20, the Board has also provided a forum for linking reforms with the political process.

The third characteristic that is different to earlier banking reforms, and underscores the urgency of the task, is the active role the Basel Committee itself is playing in ensuring full, consistent and timely implementation of the Basel III reforms in member countries. In what its Chairman has described as a ‘significant practical and cultural shift’ in the way global standards are implemented, the Committee will be conducting onsite follow-up and thematic peer reviews of implementation, taking its assessments to the doorsteps of banks and supervisors.

Basel III capital reforms

The Committee is following a three-level approach to monitor implementation of the Basel III capital reforms. At the most basic level (Level 1), the Committee is assessing members’ progress in adopting Basel III according to the internationally agreed timetables. The publication of progress reports is intended to encourage all members to get a move on, where necessary. The most recent report showed that Australia was one of 16 of the 27 member countries (treating EU members separately) that had, by the end of March this year, published their draft Basel III regulations or standards.

The second level of review aims to ensure compliance of domestic Basel III regulations or standards with the agreed Basel III rules text. This will entail both off-site and on-site assessments of individual countries, a rigorous peer review process and public disclosure of the results. Level 2 reviews of the European Union, Japan and the United States are underway, with an APRA senior executive involved, and the results are expected to be published by the end of September 2012. Australia will be subject to a Level 2 review in due course.

The third level of the Committee’s approach aims to ensure that the Basel III reforms are delivering consistent outcomes in practice across banks and jurisdictions. This work will initially focus on the measurement of risk-weighted assets, covering both the banking book and the trading book. A variety of tools, including hypothetical/test portfolio exercises, will be used to identify areas of material inconsistencies in the calculation of risk-weighted assets across banks and jurisdictions, as well as areas of broad consistency. An APRA expert is participating in this Level 3 review process, which we see as critical to ensuring a level playing field in the application of Basel capital requirements.

APRA’s proposals for implementing the Basel III capital reforms in Australia were released in September 2011 and, after industry consultation, five draft prudential standards that will give effect to the reforms were released in March 2012. We have been consulting on these draft standards and we welcome the constructive dialogue we have had with the Australian Bankers’ Association, Abacus—Australian Mutuals and other interested parties.

There are three main elements in APRA’s approach to the Basel III capital reforms.

Firstly, APRA is proposing to adopt the Basel III definition of regulatory capital, the Basel III minimum requirements and eligibility criteria for regulatory capital instruments, and the Basel III regulatory adjustments to capital that are specified as minimum requirements, with only minor exceptions. In other words, the Basel III rules text as globally agreed. The minor exceptions relate to areas where APRA has to date taken a more conservative approach and will continue to do so. All up, APRA’s implementation of Basel III should easily withstand scrutiny under the Basel Committee’s Level 2 review process.

Secondly, APRA is proposing, for in-principle reasons, not to adopt a concessional treatment for certain items in calculating regulatory capital, a discretion available under the Basel III reforms. These items are deferred tax assets relating to ‘temporary’ (timing) differences, significant investments in the common shares of non-consolidated financial institutions, and mortgage servicing rights. APRA has never recognised these items in calculating regulatory capital and to do so now would not, in APRA’s view, be consistent with the objective of raising the quality and quantity of regulatory capital in Australia. Our consultations threw up no compelling reasons to change our in-principle views.

Thirdly, APRA has proposed an accelerated Basel III timetable in some areas. Our timetable is fully consistent with the Basel Committee’s stated view that, where they can, banking institutions should comply with the Basel III reforms as soon as possible. Our banking institutions can comply early, and they should — surely this is the time to be ‘accentuating the positive’. Our larger banks, for example, have already cleared the 2013 hurdle and should be readily able to clear the 2016 hurdle through prudent earnings retention policies.

By not adopting the concessional treatment, APRA’s more conservative approach will lead to published ‘headline’ capital ratios for our banking institutions that are lower than headline ratios of banks in jurisdictions where the discretions will be exercised. We in APRA have been well aware of this issue, which is not new. However, it is not a uniquely Australian issue. A constant complaint during the global financial crisis in a number of jurisdictions, from market participants and supervisors alike, was the difficulty they faced in undertaking detailed assessments of banks’ capital positions and making comparisons across jurisdictions, because of a lack of transparency by banks and a lack of consistency in reporting across banks and jurisdictions. The issue has therefore fallen squarely into the domain of the Basel Committee.

Since late 2011, the Committee has been consulting on a standardised disclosure template that would address concerns about the international comparability of regulatory capital ratios. That template was finalised at the most recent Committee meeting and has now been published. In Australia’s case, the template will capture the details necessary for a reconciliation between the capital positions of our banking institutions measured in terms of the Basel III rules text (presuming adoption of the concessional treatment) and APRA’s more conservative approach. No longer any excuses for the so-called ‘lazy analyst’ not looking behind headline capital ratios to discern the real strength of our banking institutions. The template comes into effect by no later than 30 June 2013, which will give APRA time to translate the disclosure requirements into its prudential standards, after consultation with industry. If it would be helpful, APRA would be prepared to consider expanding the template to simplify the reconciliation process.

Systemically important banks

The elements of the Basel III capital reforms announced in December 2010 are now virtually all in place. However, a new element in global banking reform has emerged, which is particularly relevant to countries like Australia with concentrated banking systems. That element is a framework for dealing with domestic systemically important banks (D-SIBs). At their Cannes Summit in November 2011, the G-20 Leaders, determined to make sure no financial firm is ‘too big to fail’ and that taxpayers should not bear the cost of resolution, asked the Basel Committee and the Financial Stability Board to develop such a framework. The proposed framework builds on, but differs in important respects from, the regime for global systemically important banks (G-SIBs) endorsed by the G-20 Leaders at Cannes.

The focus of global policymakers on systemically important banks reflects concerns about the ‘negative externalities’ or adverse side effects that the distress or failure of such banks can cause. As the Basel Committee has put it, drawing on some basic economic theory, individual banks in maximising their private benefits may rationally choose outcomes that, from a system-wide viewpoint, are suboptimal because they do not take these negative externalities into account. These externalities include the impact of the distress or failure of a systemically important bank on other financial institutions and on the real economy, and the substantial public sector support that might be needed to deal with the problem. Such adverse side effects were writ large in a number of jurisdictions during the crisis.

In addition, the moral hazard costs associated with direct support and implicit government guarantees for banking institutions perceived to be ‘too big to fail’ may amplify risk-taking by these institutions, reduce market discipline, create competitive distortions and further increase the probability of distress in the future.

The response of global policymakers to the ‘too big to fail’ issue has involved two complementary approaches. The first is embodied in the G-SIB regime. This focuses on large, internationally active banks with significant cross-border operations, and it assesses the negative externalities of the distress or failure of such banks from a global perspective — that is, making no distinctions about individual jurisdictions. The broad aim of the G-SIB regime is to:

  • reduce the probability of failure of G-SIBs by increasing their ability to absorb losses as a going-concern, by way of a capital surcharge above the Basel III minimum; and
  • reduce the impact of failure of G-SIBs by improving global recovery and resolution frameworks. I would note, in passing, that APRA’s current work on living wills draws on this latter initiative.

The additional loss absorbency required for banks determined under the Basel Committee’s methodology to be G-SIBs ranges from one per cent to 2.5 per cent Common Equity Tier 1 (CET1) depending on a bank’s systemic importance, with an empty bucket of 3.5 per cent CET1 as a means of discouraging banks from becoming even more systemically important. The Financial Stability Board announced the initial group of 29 G-SIBs last November and, as we know, no Australian bank was on that list.

The proposed D-SIB framework takes the complementary perspective of the individual jurisdiction. It focuses on the impact that the distress or failure of banks (including international banks) will have on the domestic economy. It recognises that there are many banks that are not significant at the global level but could, if they were to come under stress, have an important impact on their domestic financial system and economy compared to non-systemic institutions.

The Basel Committee has just released a consultative document on its proposed framework for dealing with D-SIBs. The framework is different from the prescriptive approach in the G-SIB framework and, naturally, provides greater scope for national discretion. Hence, there are no agreed ‘buckets’ into which to fit different D-SIBs. Rather, there is a minimum set of 12 principles that would give effect to the requirement that D-SIBs should have higher loss absorbency.

There are three key features of the principles to which I would draw your attention:

  • national authorities should establish a methodology for assessing the degree to which banks are systemically important in a domestic context;
  • national authorities should publicly disclose information that provides an outline of the methodology employed; and
  • the higher loss absorbency requirement imposed on a bank should be commensurate with its systemic importance and should be fully met by CET1.

Until this proposed framework has been subject to consultation and has been endorsed by the G-20 Leaders, there is nothing more I wish to say on the topic of D-SIBs. Other than to note that the consultative document makes the key point that other policy tools, particularly more intensive supervision, can also play an important role in dealing with D-SIBs. APRA could not agree more. Our risk-rating process — what we call our PAIRS/SOARS framework — has been in place since 2002 and is geared towards earlier supervisory intervention for APRA-regulated institutions with higher impact, measured in terms of their balance sheet size.

Basel III liquidity reforms

Alongside its Basel III capital reforms, the Basel Committee in December 2010 released its rules text for a new global liquidity framework, intended to promote stronger liquidity buffers to ensure that banking systems are more resilient to liquidity stresses. The centrepiece of the Basel III liquidity reforms are two new global standards — the Liquidity Coverage Ratio, aimed at strengthening the short-term resilience of banks, and the Net Stable Funding Ratio, aimed at promoting longer-term resilience by requiring banking institutions to fund their activities with more stable sources of funding. The Liquidity Coverage Ratio will be introduced on 1 January 2015 and the Net Stable Funding Ratio from 1 January 2018.

APRA released a discussion paper and draft prudential standard setting out its proposals for implementation of the Basel III liquidity reforms in November 2011.

This new global liquidity framework is, to be sure, an untested one and the Basel Committee is determined to get it right. Hence, the Committee is using the lead-in periods before implementation as observation periods, monitoring the implications of the two standards for financial markets, credit extension and economic growth, and addressing unintended consequences as necessary. Monitoring is covering some general issues, such as the impact of the standards on smaller institutions versus larger and on retail versus wholesale business activities, as well as some specific technical issues, such as the treatment of liquidity lines to non-financial corporates, eligibility criteria for high-quality liquid assets and the treatment of term deposits. Discussions on these technical issues are now an important item on the Committee’s meeting agenda and good progress is being made.

In contrast to the capital reforms, then, the detailed elements of the Basel III liquidity reforms are not yet in place. Inevitably, market concerns about the quality of sovereign debt in some jurisdictions have led to speculation about the direction of these reforms. Ignore the speculation! There is a strong commitment to the new global liquidity framework by global policymakers. And, of course, under the Liquidity Coverage Ratio, liquidity stresses are intended to be addressed as much by extending the maturity of liabilities as by building up high-quality liquid asset portfolios.

This latter point is especially relevant for Australia, which does not have sufficient high-quality liquid assets (particularly sovereign debt) for inclusion in liquidity buffers. As we know, Australia has chosen to adopt an alternative treatment available to it in the new global liquidity framework. Under this treatment, any shortfall between a banking institution’s holdings of high-quality liquid assets and its Liquidity Coverage Ratio requirement will be able to be met through a Committed Liquidity Facility with the Reserve Bank of Australia, for a fee. The availability of such a Facility must, however, be balanced against the overriding objective of the new global liquidity framework of reducing the recourse of banking institutions to their central bank at the first signs of stress. Moral hazard problems can abound in this area as well as with D-SIBs. Accordingly, APRA will want to be assured that banking institutions have taken all reasonable steps towards meeting their Liquidity Coverage Ratio requirements through their own balance sheet management, before relying on the Facility. The lengthening of tenors in wholesale funding that has been taking place is a step in the right direction, but there is further to go.

A final note

No discussion of global banking reform, even introductory remarks, would be complete without acknowledgment that higher quality and quantity of bank capital and liquidity comes at a cost to banking institutions and, potentially, to economic activity. The costs to banks, which are largely private costs, are generally measured in terms of reduced profitability from, on the assets side, holding larger portfolios of lower-income-earning liquid assets and, on the liabilities side, from replacing debt with more expensive equity and lengthening funding profiles. To the extent that banks seek to recoup their reduced profitability through increasing their lending rates, investment and consumption — and consequently output — are lower than they would otherwise be.

The fall in output represents the economic costs of the Basel III reforms.

The economic benefits of the reforms are seen from a longer-term perspective, in the form of higher output that would be enjoyed from a reduction in the frequency and severity of banking crises. The economic benefits of a safe banking system accrue as both private and public benefits. As the world is being painfully reminded, the losses in output during a crisis and in subsequent years are substantial, and some of the losses may be permanent. In the United Kingdom, as just one example, the cumulative loss of output since the crisis began is likely to be at least 25 per cent of annual GDP already, and the eventual loss could be a multiple of this.

The Basel Committee’s comprehensive analysis at the global level of whether the economic benefits of Basel III outweigh the costs found a strong case in the affirmative. APRA is now performing a similar calculus at the domestic level for its Regulation Impact Statement, prior to finalising the Basel III reforms in Australia. The work is nearing completing and we will begin to discuss it publicly soon. Suffice to say that APRA has reached a similar strong conclusion — the economic benefits to the Australian community of a safer banking system clearly outweigh, in our judgment, the economic costs of the reforms.

The Australian Prudential Regulation Authority (APRA) is the prudential regulator of the financial services industry. It oversees banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, private health insurers, friendly societies, and most members of the superannuation industry. APRA currently supervises institutions holding $6 trillion in assets for Australian depositors, policyholders and superannuation fund members.