Posted 10/02/2015 by Jaan Murphy
In December 2014, the Treasury released the final report of the Financial System Inquiry 2014 (the Murray Inquiry) which examined the Australian financial system and made 44 recommendations to the Government for its improvement.
The Murray Inquiry’s first recommendation calls for all Australian authorised deposit-taking institutions (ADIs) to increase their capital levels to the ‘top quartile of internationally active banks’ so that they will be more resilient against future shocks to the Australian financial system. In particular, Common Equity Tier 1 (CET1) capital ratios of Australia’s major banks were judged to be below the top quartile globally. The CET1 ratio is:
Common Equity Tier 1 Capital ratio = Common Equity Tier 1 Capital
Total risk-weighted assets
There is concern that increasing capital levels will place Australian banks at a competitive disadvantage if:
- an upcoming review of international best practice recommends following a different direction or
- if the higher capital requirements are applied to all ADIs, it will unnecessarily burden smaller non-internationally active banks.
Background
The Basel Committee on Banking Supervision (BCBS) is an international advisory body for global banking regulation that is made up of representatives from 28 countries. Australia is represented on the BCBS by the Reserve Bank of Australia and the Australia Prudential Regulation Authority (APRA). APRA oversees the prudential regulation of banks, building societies, credit unions and all other financial institutions operating in Australia.
Australia’s current CET1 capital ratio requirements closely follow the international best practice recommendations of the BCBS, known as Basel II and Basel III. These recommendations are intended to apply to ‘internationally active’ banks. Basel III contains the most recent CET1 capital ratio recommendations and so it supersedes Basel II in this specific area. APRA implemented the Basel II and Basel III best practice recommendations of the BCBS through Prudential Standards, which apply to all authorised deposit-taking institutions (ADIs) (not just to internationally active banks as recommended) and have the force of law.
The Murray Inquiry relied on BCBS Basel III-adjusted data to compare Australia’s CET1 capital ratios with those internationally. However, while Australia’s CET1 capital ratio calculation method closely follows the BCBS’ Basel III methodology, there are some important differences between the two that arguably mean Australia’s CET1 ratios are not comparable to those calculated by the BCBS.
How Australia’s CET1 capital ratios are calculated compared to BCBS calculations under Basel III
The Murray Inquiry based its findings on the BCBS’s September 2014 Basel III Monitoring Report which standardises the CET1 ratios of countries which have implemented Basel III. From this data, the global 75th percentile of CET1 capital ratios is 12.2%.
The BCBS’s Regulatory Consistency Assessment Programme (RCAP) reviews how closely domestic legislation of member states aligns with its minimum standards. These RCAP assessments provide insight into material gaps in domestic legislation and consequently into how consistently prudential ratios are calculated by banks and how comparable they are. The Australian RCAP report released on 17 March 2014 assessed Australia as compliant with the Basel III regulations. The RCAP report stated that in numerous areas, APRA’s regulations go beyond the minimum Basel III requirements. A list of 27 areas where APRA’s Prudential Standards are stricter than the minimum Basel III standards prescribed is available in Annex 10 of the report.
APRA has previously noted that it takes a ‘more conservative approach’ to capital in comparison to international peers. APRA is said to have implemented an ‘extremely stringent definition of capital’. In a submission to the Murray Inquiry, an experienced banking executive expanded on the implications of this:
...an Australian bank reporting its capital ratio has to show a number lower than it would if it reported on an internationally harmonized basis. This means that Australian banks are actually more highly capitalized than they appear to be.
For example in the Commonwealth Bank’s submission to the Murray Inquiry, it is stated that their CET1 ratio is 13.98% calculated on an internationally comparable basis. This ratio places CBA well into the Murray Inquiry’s determination of the global 75th percentile.
Implications of further raising CET1 capital ratio requirements
There is a strong basis for the argument that Australia’s CET1 capital ratios are not internationally comparable. As outlined, there is evidence to suggest that the CET1 capital ratios reported by Australian banks in accordance with APRA’s stricter framework are not fairly comparable to the data standardised by the BCBS to the Basel III minimums. By following the Murray Inquiry’s recommendation to raise Australian CET1 capital ratios further, it places banks at a competitive disadvantage with international peers as they will be more highly capitalised. Increasing CET1 capital ratios is expensive, particularly for smaller, non-internationally active ADIs who are more vulnerable to increases in cost base and so have more difficultly absorbing the costs of regulatory compliance than the larger ADIs.
Further, the Murray Inquiry was concluded before an expected review of the BCBS recommendations. This review may lead to changes in international practice that could, arguably, further disadvantage Australian ADIs if they are more highly capitalised and their international peers follow a different regulatory path.
* This FlagPost was prepared by Jolanta Olender, an intern from the Australian National University.