Implementation of international prudential frameworks

Australia is an active member of many international policy and standard-setting bodies, including the FSB, BCBS and IAIS. Using these positions, Australia has been successful in influencing international standards to be broadly appropriate for the domestic environment.

As a global benchmark, the Basel framework is not designed to the particular circumstances of any one country. It is designed to apply a common minimum to a broad range of countries with different financial systems. A number of submissions, including from APRA, note that Australia has decided on a stricter approach to calculating capital ratios than the Basel III baseline. Further, in the case of capital requirements and the liquidity coverage ratio, APRA is implementing changes faster than a number of other countries.

Submissions raise three concerns, which are assessed in this section:

  1. More conservative capital definitions mean that Australian banks use more equity funding than overseas peers, placing Australian banks at a competitive disadvantage.
  2. Differences in capital definitions reduce transparency and make it difficult to compare capital ratios in Australia to those overseas. This can make Australian banks seem less sound than they really are.
  3. Faster implementation of Basel requirements puts Australian banks at a competitive disadvantage in overseas markets, until other jurisdictions complete their own implementation.

Preliminary assessment

Observation

Australia has implemented some aspects of global prudential frameworks earlier than a number of jurisdictions. It has also used national discretion in defining capital ratios. When combined with other aspects of the prudential framework and calculated on a consistent basis, Australian banks’ capital ratios (common equity tier 1) are around the middle of the range relative to other countries. However, differences such as those in definitions of capital do limit international comparability.

Capital requirements

Prudential frameworks have many different aspects, making it difficult to compare the relative strictness of one regime to another. Table 5.1 shows a number of these different settings for a variety of countries; in general, Australia is in line with the Basel framework minimum requirements, while a number of countries have higher requirements. On this basis, Australia’s overall framework does not seem to require excessive capital levels.

Table 5.1: Country implementation of Basel III
Common equity tier 1 capital Minimum tier 1 capital Total capital Add-on for systemically important banks Leverage ratio
BCBS 4.5% 6.0% 8.0% 1.0-3.5% (G-SIB) 3.0%
Australia 4.5% 6.0% 8.0% 1.0% TBA
European Union 4.5% 6.0% 8.0% 2.0%(a) TBA
Canada 4.5% 6.0% 8.0% 1.0% 3.0%
China 5.0% 6.0% 8.0% 1.0% 4.0%
Hong Kong 4.5% 6.0% 8.0% 1.0-3.5% (proposed) TBA
India 5.5% 7.0% 9.0% 0.2-0.8% 4.5%
Japan 4.5% 6.0% 8.0% TBA TBA
Netherlands 4.5% 6.0% 8.0% 3.0% TBA
Singapore 6.5% 8.0% 10.0% TBA TBA
Sweden 4.5% 6.0% 8.0% 5.0%(b) TBA
Switzerland 4.5% 6.0% 8.0% 1.0–6.0%(c) 4.5%
United Kingdom 4.5% 6.0% 8.0% TBA 3.0%
United States 4.5% 6.0% 8.0% TBA 5.0–6.0%

(a) This is the Other Systemically Important Institution (O-SII) buffer as set out in the Directive. Individual jurisdictions have discretion to implement a higher surcharge.

(b) Of this 5 per cent, 3 per cent is the Domestic Systemically Important Bank (D-SIB) buffer and 2 per cent is a Pillar 2 surcharge applicable to D-SIBs.

(c) A much higher capital conservation buffer of up to 8.5 per cent will also apply to systemically important banks.

Sources: APRA, BCBS, Boards of Governors of the United States Federal Reserve System, China Banking Regulatory Commission, De Nederlandsche Bank, European Banking Authority, Swiss Financial Market Supervisory Authority (FINMA), Hong Kong Monetary Authority, Japan Financial Services Agency, Monetary Authority of Singapore, Office of the Superintendent of Financial Institutions Canada, Reserve Bank of India, Sveriges Riksbank, United Kingdom Prudential Regulation Authority.

Submissions raise concerns that Australia’s approach to calculating capital ratios leads to Australian banks requiring higher levels of equity funding than international peers. In fact, banks’ actual capital ratios do not appear excessively high, including when compared to countries at a similar level of financial development (Chart 5.3).

Chart 5.3: Global distribution of banks’ actual capital ratios(a)

As at end June 2013

(a) Calculated on a consistent basis across countries by the BCBS. The sample includes 102 Group 1 banks - those with at least €3 billion in tier 1 capital and that are internationally active - from 21 BCBS countries.

Source: BCBS.

A recent BCBS review of Australia’s implementation of the Basel framework identified 27 areas in which APRA’s implementation, taking advantage of national discretions, was more conservative than the Basel baseline.49 However, Australia was also less conservative than the baseline in several areas. Similar reviews for China, Brazil and Canada identified 17, 20 and 7 areas respectively that were more conservative.50 These are not the same areas as Australia (or each other), making comparison difficult. Switzerland and Singapore were ‘super equivalent’ to the Basel framework through setting higher capital ratios rather than through stricter capital definitions. Unfortunately, these BCBS reviews currently cover only a limited number of countries.

Differences between capital ratios internationally are also driven by diversity in minimum capital requirements, leverage ratios, additional capital requirements for systemically important banks and regulator-imposed non-public capital requirements. Calculating what is required in Australia compared to other jurisdictions is therefore very difficult.

The BCBS collects data on bank capital ratios on a consistent basis among its member countries. These data show that Australian banks are roughly ‘middle of the pack’ in terms of common equity tier 1 capital ratios when calculated on this basis. Given that banks in many countries are still raising capital to meet incoming Basel standards, Australia’s prudential framework does not seem to require excessive capital levels.

International comparability

Some submissions are concerned that calculation differences make Australian banks’ capital ratios appear lower than if they had been calculated under many other jurisdictions’ implementation of the Basel rules. The exact magnitude of this difference is uncertain. It will vary by balance sheet composition and the comparator jurisdiction. Table 5.2 shows how Australian bank common equity tier 1 capital ratios change when self-calculated in an ‘internationally harmonised’ fashion — essentially, trying to adopt the Basel framework with minimal discretionary changes. These self-calculated capital ratios are higher than those calculated by the BCBS (Chart 5.3), but still fall around the middle of the range relative to other countries.

Table 5.2 Common equity tier 1 capital ratios
In 2013 bank annual reports
APRA capital ratio Self-reported internationally harmonised capital ratio Difference
ANZ 8.5% 10.8% 2.3%
CBA 8.2% 11.0% 2.8%
NAB 8.4% 10.3% 1.8%
WBC 9.1% 11.6% 2.5%
Memo: APRA submission 8.3% 10.2% 1.9%
Memo: CBA submission 8.5% 11.4% 2.9%

Sources: APRA submission to the Inquiry, CBA submission to FSI, bank annual reports.

The difficulty in calculating consistent capital ratios lends weight to claims that international investors do not make such comparisons. The differences may be to the detriment of Australian banks, as they result in reported capital ratios appearing lower than if they had been calculated in some other countries. Although some Australian banks publish internationally harmonised ratios, as in Table 5.2, they argue that investors are sceptical of their accuracy.51 In addition, where banks are issuing debt that contains ‘triggers’ based on their capital ratio, Australian banks may be seen to have less of a buffer above the trigger. This may raise the costs of issuing such instruments.

Implementation schedule

The Basel III capital ratio requirements will be fully implemented in Australia by the start of 2016, while the Liquidity Coverage Ratio (LCR) will start in full in 2015. This is sooner than in many other jurisdictions, which are phasing the new requirements in over a longer period. Submissions argue that implementing these requirements ahead of other countries places Australian banks at a competitive disadvantage during the transition.

Australia is not the only jurisdiction adopting Basel III without the extended transitional phase-in period. Other countries with strong financial systems, including Canada, New Zealand, Singapore and some of the Nordic countries, are also requiring full compliance before the end of 2019, the allowable transition period.

In addition, Australia’s major banks are well placed to meet the new capital requirements.52 This reflects both that Australian banks have been building up capital in anticipation of the incoming requirements, and that the capital requirements were not significantly higher than banks’ existing capital levels. Compared to some jurisdictions, such as particular European nations where post-GFC bank capitalisation was very low, Australia had less need to use extended phase-in periods.

Early implementation can have a cost to the extent that it requires Australian banks to move to more expensive capital funding earlier than they might otherwise have and faster than their international peers. RBA Governor Stevens noted it is important to take advantage of the current good macroeconomic environment to build capital, as it will not last forever: “This is a reason to go faster, rather than slower, in accumulating capital to higher minima, while one can”.53

For liquidity standards, Australia arguably does not need a phase-in period because of the Committed Liquidity Facility (CLF) that was introduced to account for the low levels of Government debt in Australia. The CLF effectively allows easier compliance with the LCR and is not available in most other countries. However, banks will be required to demonstrate to APRA that they have taken ‘all reasonable steps’ to meet the LCR through their own balance sheet management, before relying on the CLF for this purpose. Moreover, the majority of global internationally active banks already meet the LCR requirement.

Policy options for consultation

Calibrate the prudential framework

The Inquiry considers it appropriate for Australia to maintain its compliance with global standards, such as the Basel framework for banking.54 There would be significant costs to Australia if it did not materially adopt the minimum standards set out in these agreements, including:

  • Australia’s reduced integration with the international financial system
  • Reduced ability to influence future global standards
  • Less international comparability
  • Australia being seen as more risky, potentially raising financial institutions’ funding costs
  • Opportunities for overseas regulators to impose more restrictive requirements on Australian financial institutions than at present, to compensate for a lack of regulatory comparability

Historically, Australia has taken a stronger approach to financial stability than required under global standards. This contributed to the robustness of the Australian financial system during the GFC, relative to North Atlantic countries, and to an international reputation for a sound system. Since then, global efforts to improve financial stability have resulted in stronger frameworks and requirements in many other countries than was previously the case — and some increase in Australia’s requirements.

Starting from the premise that, at a minimum, Australia’s prudential framework should be consistent with the global median, the Inquiry seeks stakeholder views on where Australia should aim to sit on the global financial stability spectrum given these global changes.

At one end of the spectrum, Australia may be comfortable with where the global settings have settled and see no need to go beyond this standard for its prudential framework. At the other end, Australia may want to be above the global median, particularly where there are clear Australian policy reasons for lifting the bar; for example, Australia is a capital importing nation and a stronger system may help assure international investors that Australia is a safe and attractive investment destination.

The weight of evidence suggests that having a more conservative approach to prudential requirements in the past has not placed Australian banks at a significant competitive disadvantage.

  • Historically, where the gap between Australia’s approach to capital and those in large economies such as the United States and United Kingdom was much greater, Australian banks were profitable.
  • To the extent that Australian banks are at a competitive disadvantage from being more conservative than the rest of the world, this should have decreased with Basel III, which closes the gap between requirements in Australia and those in several major markets.
  • Overseas bank branches operating in Australia do not comply with Australian capital requirements. Evidence does not suggest overseas branches are more competitive in Australia.

In addition, a growing body of work suggests that the social costs to higher bank equity funding are smaller than is often presumed. The argument is broadly that better capitalised banks are less risky, lowering the cost of wholesale debt and deposit funding.55 Further, although equity may be more privately expensive to banks, this is affected by the different tax treatment of debt and equity funding.56 Thus, from society’s perspective, which accounts for the foregone tax revenue from debt funding, equity may not be so expensive.

The Inquiry would value views on the costs, benefits and trade-offs of the following policy options or other alternatives:

  • No change to current arrangements.
  • Maintain the current calibration of Australia’s prudential framework.
  • Calibrate Australia’s prudential framework, in aggregate, to be more conservative than the global median. This does not mean that all individual aspects of the framework need to be more conservative.

The Inquiry seeks further information on the following area:

Is there any argument for calibrating Australia’s overall prudential framework to be less conservative than the global median?

International comparability of Australia’s prudential requirements

APRA’s approach to implementing parts of the Basel framework has been stricter than the international standards imply. This reflects a tailoring of the regulatory capital framework to, in APRA’s view, better reflect the capital adequacy of ADIs. The main differences are stronger definitions of capital and floors for loss given default (LGD) estimates for residential mortgage exposures under the internal ratings-based approach to credit risk. APRA does not include certain capital items allowed under Basel III that are not truly loss absorbing, as these were included to accommodate weak banking systems in some jurisdictions. Australia has imposed LGD floors as historical data on losses used to calculate risk weights may not reflect a true downturn, given Australia has not had a major recession in two decades.

A number of submissions note that these differences can create difficulties for Australian banks; for example, making them appear less well capitalised than their international peers, even where there is no real difference. A lack of transparency could prove a disadvantage in funding markets, particularly where an instrument has a trigger based on a bank’s capital ratio. However, banks can and do publish internationally harmonised capital ratios to account for the difference. One might expect sophisticated international investors to be aware of differences in regulatory approaches.

To avoid banks relying on ‘unofficial’ internationally harmonised capital ratios, which may not be seen as credible by international investors, robust, regulator-approved ratios could be published. APRA and industry are currently working to develop official reporting for this purpose. This would improve transparency at a relatively low cost.

A second option to improve transparency is to adopt the Basel framework for calculating prudential ratios, without national adjustment.57 APRA could then use its discretion to set the headline capital ratio (or other prudential tools) at the level it felt appropriate to achieve the desired level of system safety. Switzerland has taken this approach, setting a much higher headline capital ratio for its medium-sized and large banks.58 This option would also address banks’ concerns about capital ratio triggers in some types of debt instruments, such as where the debt instrument converts to equity when the official capital ratio falls below a specified threshold.

There are difficulties with such an approach. First, there is no ‘standard’ Basel framework to work off— all countries have implemented the framework in different ways, and the framework includes scope for national discretion. Second, while it would be possible for APRA to reduce its use of national discretion, this may lead to rules that are less suited to Australia’s particular circumstances. Third, allowing banks to include items in capital calculations that APRA deems to be significantly more uncertain in value, or less loss-absorbing, than current capital would increase the riskiness of the system and penalise more prudent banks that choose to hold larger portions of high-quality capital.

The Inquiry would value views on the costs, benefits and trade-offs of the following policy options or other alternatives:

  • No change to current arrangements.
  • Develop public reporting of regulator-endorsed internationally harmonised capital ratios with the specific objective of improving transparency.
  • Adopt an approach to calculating prudential ratios with a minimum of national discretion and calibrate system safety through the setting of headline requirements.

The Inquiry seeks further information on the following areas:

  • Would adopting a more internationally consistent approach to calculating capital ratios materially change Australian banks’ cost of accessing funding?
  • How would using minimal national discretion distinguish between prudent banks that hold capital as currently defined and those that rely on less loss absorbing capital?
  • How might APRA need to adjust minimum prudential requirements to ensure system safety is not altered if using minimal national discretion in calculating prudential ratios?

49 Bank for International Settlements (BIS) 2014, Regulatory Consistency Assessment Program (RCAP) Assessment of Basel III Regulations — Australia, BIS, Basel.

50 Bank for International Settlements (BIS) 2013, Regulatory Consistency Assessment Program (RCAP) Assessment of Basel III Regulations — China, BIS, Basel, BIS 2013, Regulatory Consistency Assessment Program (RCAP) Assessment of Basel III Regulations in Brazil, BIS, Basel and BIS 2014, Regulatory Consistency Assessment Program (RCAP) Assessment of Basel III Regulations — Canada, BIS, Basel.

51 Internationally harmonised capital ratios aim to recalculate the banks’ capital ratio as if the bank were subject to the ‘baseline’ Basel rules (with no national discretion applied) or subject to the rules in another specific country.

52 APRA 2013, ‘ADI Industry Risks’, APRA Insight, issue 2 notes that: “Having strengthened their capital positions over recent years in response to market expectations and in anticipation of higher Basel III requirements, all ADIs already meet this minimum requirement, with current CET1 ratios above 7 per cent”.

53 Stevens, G 2014, Financial Regulation: Some Observations, speech to Federal Reserve Bank of San Francisco’s Symposium on Asian Banking and Finance, 10 June, San Francisco.

54 Australia may adopt international standards through Government commitments, legislation, domestic standard setting, and regulator rules and guidance.

55 See for example Admati, A and Helwig, M 2013, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It, Princeton Press, Princeton NJ, and Babihuga, R and Spaltro, M 2014, Bank Funding Costs for International Banks, IMF Working Paper WP/14/71, IMF, Washington DC.

56 This difference is possibly less pronounced in Australia, however, due to the dividend imputation system — see the Funding chapter for further discussion.

57 See, for example, CBA 2014, First round submission to the Financial System Inquiry.

58 Bank for International Settlements (BIS) 2013, Regulatory Consistency Assessment Programme (RCAP): Assessment of Basel III regulations — Switzerland, BIS, Basel.