The global financial crisis revealed a number of fundamental issues with
the international banking system, including that many banks had built up
excessive leverage and had a capital base that was inadequate and of
insufficient quality. Other banks also encountered problems because of how
their liquidity risk was managed. Due to the interconnectedness of global
capital markets the problems of individual banks quickly spread, resulting in far-reaching
economic ripple effects. This chapter examines one of the most significant
reforms that emerged from the crisis—the international agreement to strengthen
global capital rules and liquidity buffers collectively referred to as 'Basel
III'. As the overarching intent and features of the accord have been agreed to
at an international level and are broadly supported, this chapter has a
particular focus on how the details of Basel III will be implemented in
Overview of capital regulation and the Basel Accords
The level of capital a bank holds indicates the future ability of the
bank to grow, as well as its ability to withstand unexpected losses without
becoming insolvent. On this basis, minimum capital requirements play a key role
in the regulatory supervision of banks across jurisdictions. However, the
appropriate level of capital that a bank should be required to have to provide
a sufficient buffer against unexpected losses necessarily requires the
balancing of a number of factors:
If capital levels are too low, banks may be unable to absorb
high levels of losses. Excessively low levels of capital increase the risk of
bank failures which, in turn, may put depositors' funds at risk. If capital
levels are too high, banks may not be able to make the most efficient use of
their resources, which may constrain their ability to make credit available.
International supervisory standards are developed by the Basel Committee
on Banking Supervision (Basel Committee), which has the objective to 'enhance
understanding of key supervisory issues and improve the quality of banking
The Basel Committee does not have the authority to impose the standards it
... it formulates broad supervisory standards and
guidelines and recommends statements of best practice in the expectation that
individual authorities will take steps to implement them through detailed
arrangements—statutory or otherwise—which are best suited to their own national
systems. In this way, the Committee encourages convergence towards common
approaches and common standards without attempting detailed harmonisation of
member countries' supervisory techniques.
In Australia prudential regulation, including the implementation of the
Basel Accords, is the responsibility of the Australian Prudential Regulation
Authority (APRA). The chairman of APRA has noted that APRA generally takes a
'more conservative approach' to capital than the minimum requirements, but that
this approach has been 'widely acknowledged as an important contributing factor
in the relative success of our banking institutions in negotiating the global
financial crisis to this point'.
The first major supervisory framework proposed by the Basel Committee
was the Basel Capital Accord announced in 1988 (Basel I, also known as
the 1988 Accord).
Basel I sought to promote a standard approach across banks in different
countries. It required a minimum capital standard of eight per cent by the end
of 1992 and introduced a system of measuring credit risk.
The minimum capital ratios are based on capital in
relation to risk-weighted assets, not total assets. Basel I introduced the
classification of regulatory capital into tiers to determine minimum
- Tier 1 capital—core capital, such as ordinary shares and
equity; intended to be capable of bearing loss on a 'going-concern' basis (i.e.
capital that can be depleted without placing the bank into insolvency).
- Tier 2 capital—supplementary capital, such as
subordinate debt and preference shares. Tier 2 capital is 'made up of funding
sources that rank below a bank's depositors and other senior creditors, but in
many cases are only effective at absorbing losses when a bank is being wound
up. In this way, Tier 2 capital provides depositors with an additional layer of
loss protection after a bank's Tier 1 capital is exhausted'.
- Tier 3 capital—instruments which cover some market risks
(such as foreign currency and commodities risk) that could be allowed by
regulators to be included as regulatory capital. Tier 3 was not recognised by
APRA and is abolished internationally under Basel III.
A bank's total risk-based capital ratio is determined by the following
Under Basel I (and II) requirements, banks needed to ensure that their capital
ratio was equal to or greater than eight per cent, including a minimum of four
per cent tier 1 capital.
Although Basel I had some success in aligning the capital requirements
of banks with international operations, developments in banking markets in the
1990s made the simple approach of Basel I to measuring capital less
appropriate, as well as creating 'opportunities for regulatory arbitrage and
potential distortions in the provision and pricing of banking services'.
According to one observer, the Basel I framework became 'a rapidly expanding
work-in-progress as the regulators attempted to keep up with developments in
banking, finance, and financial risk management'.
3.9 In June 2004, an agreed text of the International Convergence of
Capital Measurement and Capital Standards: a Revised Framework, better
known as Basel II, was released. Basel II built on the Basel I
requirements, but focused on the capital adequacy of internationally active
banks and notably introduced a capital framework based on "three
pillars" (retained in Basel III):
- Pillar 1 (minimum capital requirements)—kept the
minimum capital ratio requirement at the eight per cent set by Basel I, but
refined the calculation to make it more closely aligned to credit, market and
operational risks—e.g. higher levels of capital for those borrowers
thought to present higher levels of credit risk;
- Pillar 2—contained principles for supervisory review of
banks' internal assessments of their overall risks;
- Pillar 3—designed to encourage greater market discipline
by improving the degree of transparency in banks' public reporting.
Basel II was implemented in Australia at the start of 2008, a similar
timeframe to that taken by the EU.
The US had not introduced the new regime before the global financial crisis commenced.
The GFC and development of Basel III
Although the origins of the global financial crisis existed before Basel
II was implemented by key countries,
the crisis highlighted various deficiencies in the framework. The regulation of
the quality of capital and the risks covered by the Basel frameworks was
particularly subject to criticism. One observer suggested that over the past 30
years 90 per cent of failed financial institutions had reported capital ratios
at or near the minimum regulatory requirements just prior to failure. In his
This raises the question of the requirement's adequacy, if
the purpose of the capital requirement is to prevent bank
insolvencies ... The main lesson of the GFC for Basel II is that bank
capital is a necessary but not sufficient requirement for a bank's
In the UK and elsewhere, the capital requirements did not mitigate the
impacts of the crisis:
In the run up to the financial crisis, the leverage of UK
banks increased significantly. The Basel II capital requirements offered no
brake on this trend because requirements were calculated on risk-weighted
assets, the value of which tended to rise during the boom. These risk-based
models systematically underestimated the risks being built up.
* * *
While capital is a necessary condition for bank resilience,
it of course is not sufficient. Northern Rock had one of the highest capital
ratios in the UK when it failed.
* * *
One of the main contributing factors to the global financial
crisis was the excessive leverage (borrowing) built up by banking systems in a
number of countries, accompanied by a gradual erosion of the level and quality
of regulatory capital held. Liquidity buffers in many global banks were also
insufficient. As a consequence, banking systems in a number of countries were
unable to cope with large trading and credit losses, particularly in structured
credit instruments, or with the massive contraction of liquidity as investors
lost confidence in the solvency and liquidity of many banking institutions.
In addition to appropriate capital rules being in place, others noted the
importance of adequate supervision by national regulators:
... my reading of the crisis was that in many
jurisdictions there might have been regulations but there was not much supervision
around the regulations ... One of the differences between the
Australian model and some of the models in other countries is that we have a
relatively 'intrusive'—I use that word in a kind way—regulator, who is
regularly in at the organisation asking questions of middle management to
senior management and the board.
Some amendments to the Basel Accords were made through Basel 2.5, which
was finalised in July 2009 and commenced from 1 January 2012.
Basel 2.5 focused on accounting for the inherent risks of securitisations,
and complex financial instruments. The changes included the introduction of
higher risk weights for resecuritisation exposures and strengthened
requirements for credit analyses of externally-rated securitisation exposures.
Amendments were also made to pillars 2 and 3. APRA advised the committee that
Basel 2.5 has so far 'had only a limited impact on ADIs in Australia, which
largely avoided higher-risk trading activities in the lead-up to and during the
global financial crisis'.
At the September 2009 G20 Leaders' Summit held in Pittsburgh, the
G20 countries agreed to develop 'by end-2010 internationally agreed rules
to improve both the quantity and quality of bank capital and to discourage excessive
Following this declaration, the Basel Committee was tasked with developing the
reform package. Initial agreement on the overall nature of the package was
reached in July 2010. G20 leaders committed to the broad elements of the
reforms at the Seoul Leaders' Summit in November 2010
and re-emphasised the commitment and the need to implement Basel III at Cannes
in November 2011.
In APRA's view, the involvement of key world leaders is a key element of Basel
III compared to its predecessor accords:
If you want to go back in time, you could perhaps call the
Basel committee a bit of a club of like-minded central bankers from around the
world. This one [Basel III] has much more of a political and G20 drive. In some
ways the Basel committee is delivering some of those G20 commitments, which is
completely appropriate because that is the committee that has the expertise in
the area. The GFC has created that additional dimension now which was not the
case in the past.
Details of Basel III
The Basel III Accord strengthens capital and liquidity requirements.
Importantly, it targets both the resilience of individual banks as well as
system-wide risks. The stated aims of the measures are to improve:
- the banking sector's ability to absorb shocks arising from
financial and economic stress, whatever the source;
- risk management and governance; and
- banks' transparency and disclosures.
The Basel III reforms contain six broad categories of measures, five of
which relate to capital and one to liquidity:
- higher regulatory capital requirements and amendments to the
definition of capital to adopt a more conservative approach to what can be
counted as regulatory capital;
- improved risk coverage through strengthened capital requirements
for complex securitisations, trading and derivative activities, and
strengthened requirements for measuring counterparty credit exposures;
- containing leverage through the introduction of a non-risk-based
leverage ratio as a 'backstop' measure to the risk-based framework;
- measures related to risk management and supervision;
- revised disclosure requirements; and
- two global minimum liquidity standards and supervisory
Capital requirements under Basel
The measures of the Basel III framework that relate to capital requirements
build on the existing tier 1 and tier 2 framework outlined in paragraph 3.5,
and the three pillars outlined in paragraph 3.9. The capital measures are
Table 3.1. The overall capital ratios are outlined in Table
Table 3.1: Summary of the Basel III capital measures
Areas of focus
Increasing the quality of capital
stronger definition of regulatory capital that will mean the predominant form
of tier 1 capital will be common equity, the highest form of loss absorbing
capital. The minimum common equity requirement will be increased from 2% to
4.5% of risk‑weighted assets.
from capital must generally be made from common equity tier 1 and available
tier 1 capital must be determined after deductions rather than before.
remaining tier 1 capital (additional tier 1 capital) 'must be comprised of
instruments that are subordinated, have fully discretionary noncumulative
dividends or coupons and have neither a maturity date nor an incentive to
that is, among other things, it must be more loss-absorbing and not have an
incentive to redeem prior to maturity.
Increasing the quantity of capital
of periods of stress, banks will need to hold a capital conservation buffer
of 2.5% (comprised of common equity tier 1) to withstand future periods of
stress. Combined with the increased common equity requirement noted above,
this brings the total common equity requirement to 7%. If capital levels of a
bank fall into the buffer range, capital distribution constraints will be
imposed that increase in severity as the buffer reduces.
regulatory capital (tier 1 capital plus tier 2 capital) must be at least 8%
of risk‑weighted assets at all times.
tier 1 capital must be at least 6% of risk-weighted assets at all times.
countercyclical buffer, varying between zero and 2.5% of risk‑weighted
assets, will be available to regulators when excess aggregate credit growth is
judged to be associated with an unacceptable build-up of system-wide risk,
such as when credit growth is occurring at a rate which, historically,
financial system stability has been undermined. The buffer will be
implemented through an extension of the capital conservation buffer and met
by common equity tier 1 capital.
non-risk-based leverage ratio will be introduced to serve as a backstop to
the risk-based capital requirement and to prevent banks building-up excessive
on and off-balance sheet leverage. A minimum tier 1 leverage ratio of 3%
of bank exposure is being tested.
number of changes to ensure that all material risks, particularly
counterparty credit risk, are captured in the pillar 1 framework. Complex
trading, derivative and securitisation activities will require more capital
and banks must determine their capital requirement for counterparty credit
risk using stressed inputs.
standards for supervisory reviews (pillar 2) and public disclosures by banks
Table 3.2: Minimum capital ratio requirements under Basel III
% of RWA
Common equity tier 1 capital
plus conservation buffer
needed, an additional countercyclical buffer to be met by common equity
tier 1 capital
Tier 1 capital
tier 1 capital
plus conservation buffer
capital (tier 1 + tier 2)
capital plus conservation buffer
Liquidity measures under Basel III
The liquidity reforms are comprised of quantitative and qualitative
requirements. The quantitative requirements are global minimum liquidity
standards that will be introduced to make banks more resilient to potential
short-term disruptions in their ability to access funding and to address
liquidity mismatches on banks' balance sheets. Two standards will be
- Liquidity coverage ratio (LCR)—the LCR is intended to
improve short-term liquidity coverage. It will require banks to have sufficient
high-quality liquid assets to withstand a stressed funding scenario that is
specified by supervisors (based on the stock of high quality liquid assets and
the capacity of these assets to cover expected cash outflows over the 30 day
- Net stable funding ratio (NSFR)—the NSFR is a longer-term
structural ratio intended to encourage banks to use stable funding sources
(i.e. reduce their dependency on short-term wholesale funding). The NSFR
The qualitative requirements are measures designed to strengthen
governance and risk management of liquidity risk in banks.
Views on Basel III and its overall impact
APRA commenced consultation on the implementation of Basel III in
December 2010 by advising the ADIs of its support of the reforms.
In September 2011 it released a consultation paper on the capital reforms,
followed by a discussion paper on the liquidity reforms in November. On 30
March 2012, APRA released its response to the submissions on the capital
reforms. On 28 September 2012, APRA released the final prudential and
reporting standards for most aspects of the capital reforms. The remaining
standards were published on 13 November 2012.
Evidence received from the major banks and their representative
organisations acknowledged their overall support for the intent of Basel III
and instead focused on specific aspects of how Basel III will be implemented in
We agree with the broad thrust of the Basel III regulations.
We agree with the idea around international harmonisation. We do not want
Australia and Australian banks to be again affected by lax banking practices
elsewhere in the world when we feel we run a prudent system here in Australia
and a very well regulated and well supervised system.
* * *
We are putting Basel III in place and we are largely
willingly putting in Basel III in place. We have had some technical issues and
we have a disagreement with APRA, which is fine, because APRA gets the final
say, about the pace at which some of those changes have been made. As I have
said several times, we absolutely need to learn from the lessons of overseas,
but just because banks and bankers and regulators failed in some other
jurisdictions and therefore need major overhaul to their regulatory systems
does not mean that that is the appropriate situation for Australia.
Westpac submits that the liquidity reforms, rather than the changes to
capital requirements, are more likely to impact Australian banks by 'increasing
the cost of, whilst constraining the capacity for, credit provision by the
The LCR will require that a greater proportion of deposits
and other liabilities are held in the form of high quality liquid assets, which
by definition therefore means a reduced lending capacity for a given deposit
base. The NSFR will require that lending activity is supported to a greater
extent by more stable funding, in general directing liability raising
activities towards retail deposits and long term wholesale funding. The price
impact has been readily apparent to all observers, particularly in the retail
deposit space, but price alone may not be sufficient to address the capacity of
the market to supply stable funding to support credit growth.
At a public hearing, a Westpac representative further explained their
bank's concern about the costs associated with the liquidity measures:
The rules will work by stating if you have high-risk
deposits, online deposits and the like, you have to keep a certain percentage
of that in liquid assets to cover in case something goes wrong. Let us say we
have $100 of online deposits. Under the rules you have to keep $30 of that in
highly liquid government securities and the like. The cost comes from the rule
stating that for the $100 you have as a deposit, and let us say you are paying
five per cent, on the $30 of liquid securities you have you are probably
earning half a per cent less than that because it is in highly liquid
government securities. The cost is the difference between what you have on the
deposit side and the low government yield on the other side, so the 50‑point
difference which is what the drag is. If you have that drag then other assets,
other forms of borrowing, are going to have to pay for that gap. That is where
the cost comes in.
In a general sense, there are other possible risks. The Deputy Governor
of the RBA, Phillip Lowe, recently noted concern that current efforts to
tighten regulation could actually create new risks through increased 'shadow
banking' as activities are pushed off banks' balance sheets. Further, the means
by which banks respond to increased costs of financial intermediation, partly
contributed to by new regulatory requirements, could also be of concern if
lower returns on equity increase the incentive for banks to take on new risks,
or lead to cost-cutting in risk‑management areas at banks.
Academics held a broad range of views about the implementation of Basel
III in Australia. Professor Moosa questioned the need to implement Basel III at
all, describing the Basel Accords as having a 'miserable history' and arguing
that financial regulation 'should be a domestic issue, tailor-made for the
domestic economic conditions and financial environment'.
Professor Milind Sathye raised a number of possible consequences. Some of these
included increased cost of bank funds (with the possibility of this being
passed onto their customers), the heightened need to preserve capital impacting
the allocation of capital to different lending categories, such as small
business lending, depending on rates of delinquency and an impact on the
mortgage loan market due to higher risk weights for securitisation.
Professor Kevin Davis noted that the capital reforms, while piecemeal, were a
response to particular identified problems. On the liquidity measures the
professor was less enthusiastic:
To some extent the requirement for a minimum liquidity
coverage ratio which says that banks have to hold a certain amount of
government securities ignores the fact that, if we do have a liquidity crisis,
the central bank has to step in and provide liquidity facilities and, in doing
that, it will accept either government securities or private sector securities
in repurchase agreements—taking an effective haircut off the collateral to make
sure that the central bank does not have an exposure to default.
A similar sort of issue arises with the net stable funding
ratio. What that is doing is effectively reducing the ability of banks to
undertake liquidity transformation—borrow short and lend long—which, from all
economic textbooks, is one of the major economic functions that the banks carry
out. So one has to be a bit careful about the extent to which that reduces the
ability of banks to do the real functions that are key to them.
Impact on the Australian economy
Accompanying the initial announcement of Basel III, the subsequent
release of details about the reforms, and the early stages of its
implementation are some concerns about the impact it will have on the economic
output of particular countries. In Australia, however, the impact on economic
output may be different. Australian banks are already well-capitalised,
particularly the non-major ADIs. APRA notes that because the transition process
to Basel III has not yet begun it is difficult to assess what impact it will
although the ABA points out that banks 'have been anticipating the changes in
prudential requirements as a result of Basel III', including the need to expand
their stable funding.
At a global level, the Basel Committee considers that the effects of
Basel III on the banking sector and the broader economy will potentially have a
'modest impact' on economic growth.
Domestically, the RBA considers that the imposition is not going to be
Although Basel III may prove to have some economic cost, the chairman of APRA
recently expressed his view—shared by the Basel Committee and many others—that
the economic benefits of Basel III should be '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.
Of course, Basel III will not make the international banking system
It will provide a more secure banking system worldwide,
yes—no doubt. Will it prevent future financial problems? I do not know that
anything can prevent future financial problems. We are dealing with an industry
which is dealing with risk, and everything prudent and appropriate and
farsighted that we can do to ensure that we never have another experience like
the GFC needs to be done, recognising that all of that comes at a cost and that
we need to balance that.
To some extent, while the economic cost of Basel III to Australia and
the international economy more broadly is debatable, at this point in time it
is essentially an academic discussion. As the Basel III reforms encompass the
largest international banking sectors and have the backing of the G20, Australia
has little flexibility regarding the broad reforms. However, how the reforms
are implemented domestically is an issue that is worthy of scrutiny and
discussion. This point was well articulated by Professor Davis:
If we did not follow the Basel Accord and the rest of the
world is doing so, our financial sector would suffer in terms of its image in
the rest of the world. There is much more emphasis now through things like the
Financial Stability Board and their peer assessments of countries on how well
or how closely various countries are following the international agendas. So,
in a sense, we are stuck with that as a constraint within which we operate ... We
cannot deviate too much, but we need to ask the question as to how they fit
best into the structure of the Australian financial sector, particularly
because our banks were not heavily engaged in the trading activities and so on
previously but they might in the future.
Implementation of Basel III in Australia
As noted above, while the ADIs are broadly supportive of Basel III, some
issues regarding the approach to implementing Basel III in Australia and
certain unique characteristics of Australia's financial system that would
impact its implementation were noted. These included the:
- implementation timetable in Australia compared to other
- treatment of certain capital instruments;
- treatment of mutual ADIs;
- consequences of limited sovereign debt;
- definition of a 'basic deposit product'; and
- application of the countercyclical capital buffer.
These issues will be discussed in the following paragraphs.
The implementation timetable in
Globally, Basel III is required to be fully implemented by 1 January
2019, with a transition to the arrangements commencing in January 2013.
Within this broad timetable, different aspects of the reforms have different
minimum implementation dates. In Australia, APRA will follow aspects of this
timetable but has announced an 'accelerated' timetable for some key elements of
- the revised Basel III minimum requirements for minimum common
equity tier 1 capital of 4.5 per cent will commence on 1 January 2013,
rather than the Basel Committee's timetable of 1 January 2015; and
- the capital conservation buffer will be introduced in full on 1
January 2016, rather than being phased in between 1 January 2016 and 1 January
2019 as proposed by the Basel Committee's timetable.
APRA has indicated that in 2015 it will advise whether a countercyclical
buffer will apply from 2016 and whether transitional arrangements are required.
APRA also advised that the Basel Committee has not finalised measures to
address counterparty credit risk and to enhance disclosure requirements, but
that APRA will consult on the implementation of these measures in Australia
once they have been finalised.
APRA will follow the Basel Committee's timetable for the liquidity reforms (LCR
to be introduced on 1 January 2015 after an observation period which began in
2011 and the NSFR introduced from 1 January 2018).
Impact of the accelerated
Since Basel I, Australian banks have consistently held capital well
above the minimum requirements.
APRA submits that the larger banks currently have a common equity tier 1
capital ratio well above the minimum that Basel III would require to be phased
in by January 2015 (see Figure 3.1). Accordingly, APRA has used these results
to support its accelerated implementation timetable. APRA argues:
The larger banks already meet the 2013 target and need take
no action. APRA believes that they will be readily able to meet the 2016 target
through prudent earnings retention policies. The accelerated timetable is
unlikely to impose any burden on smaller ADIs, given their current high capital
ratios and generally lower level of regulatory adjustments.
Figure 3.1: Actual capital v Basel III minimum
capital requirements, selected larger banks (end June 2011)
Source: APRA, Submission 55,
The ABA, however, argued that Australia 'should not put itself at a
competitive disadvantage by implementing ahead of its major trading partners'.
Doing so, in its view:
... could put pressure on the prices that banks are able
to offer households and business. Additionally, these costs may come at a time
of heightened uncertainty in international money markets. It has been argued
that the costs of accessing wholesale funding for Australian banks will reduce
as they hold more capital and become less risky. The current reality is banks
are being asked to raise additional capital in an environment where capital is
becoming increasingly difficult and more expensive to obtain.
The ABA also raised issues about the likelihood of other jurisdictions implementing
Basel III in the near future, and questioned the benefits of Australia being so
out of step with those countries:
Mr Münchenburg: ... I understand APRA's argument,
which is that the banks can get there. It is a very good way of sending a
signal to the rest of the world about how well capitalised banks in Australia
are if we comply with the Basel III capital requirements early. Our concern is
when we look around the rest of the world we do not see the same levels of
enthusiasm for implementing Basel III as we see here in Australia. A number of
jurisdictions are less well advanced with developing their regulation than we
are, including most notably the US which is yet to release—
CHAIR: It has not even implemented Basel II properly yet, has
Mr Münchenburg: Indeed. And it is yet to indicate in any
clear way how it proposes to implement Basel III whilst maintaining that it
will. Again, the issue for us is one of balance. We are not disputing the need
to move to Basel III. Our own banks would not want to be not Basel III
compliant because, when they go out to raise funds overseas, that is a box that
investors would want to see very firmly ticked.
NAB raised similar concerns given the current European crisis:
CHAIR: Basel III seems to have been pretty well accepted. Do
you think there is a risk that other countries will not go through with it?
Mr Joiner: I am waiting for Europe to say that it is
unaffordable at this pace ... You come back to this industry
profitability point. If you are like we are—we have 15 per cent or 16 per cent
return on equity—when we need to recapitalise, we go to the market and we raise
it from shareholders. If you are like the German banks or the UK banks and you
have no or negligible return on equity, you cannot go and recapitalise in the
markets. The only way to comply with Basel III is to sell assets, stop writing
loans and shrink your balance sheet until your ratios are good. But that
destroys the economy around you and you get into a negative spiral. There is no
clear evidence of it, but I have always had the view that, at some point,
Europe is going to say, 'This is not the right time to do this.'
CHAIR: Given that the US has traditionally been slow on this—
Mr Joiner: The US, at the end of the day, rarely does
anything which is bad for business. 
As the implementation of Basel III in Australia should make it clearer
to international investors that Australian banks are well-capitalised, there is
a possibility that early adoption would mean that banks could raise funds from
international wholesale markets at a lower cost. APRA's chairman has argued:
Surely, given the recurring global market turbulence, nothing
could be more positive for the competitive standing of ADIs in Australia, or
for investor confidence in these institutions, than being early in displaying
the Basel III equivalent of the Heart Foundation's Tick ... for the
health of their capital position.
Whether these advantages would eventuate was an issue pursued by the
committee with the ABA. Its CEO acknowledged 'that is an argument'; however:
... I understand from my discussions with the banks that
it does not quite work in the sense of you are well advanced with Basel III so
therefore we will give you an extra tick. It is more the case you will be
penalised if there was no evidence that you were going to be Basel III
compliant. It is well known that the Australian banks are well capitalised. It
is well known around the world that Australia, Canada and a few other
jurisdictions came through the GFC relatively unscathed. It is easy to
overstate the extent to which early adoption of Basel III gives a
competitive edge or a price edge in raising money internationally.
Treasury dismissed arguments regarding the possible impact on the banks'
international competitiveness if Australia implements elements of Basel III
earlier than other jurisdictions:
We cannot be concerned about what other countries do. We have
to make sure that this trade-off on stability and competition ensures that we
have got the best prudential requirements we can have that suit our
circumstances. I think that is what APRA is seeking to achieve. There are
other countries in Europe that have higher capital requirements on their banks
so APRA is well apprised of the issues.
Other observers also consider there will be little practical impact. Professor
Davis described the likely impact of earlier implementation as 'next to
nothing'. In addition to the fact that the major Australian banks are already
holding capital at levels near the Basel III minimum requirements, and that the
capital levels of smaller ADIs are above the threshold, Professor Davis noted
the benefits from Australia's dividend imputation tax system:
The argument that would be posed as to why that might reduce
international competitiveness would be the standard argument that says that the
more equity you have to use, the higher will be your total cost of funding. If
I put my academic's hat on again ... I could refer to a whole lot of
theory that says that there are only certain situations in which equity is
actually more expensive than debt. The standard argument is that as a bank gets
more levered, then yes, they are using more deposits or debt—which looks
cheaper—but the cost of their equity is going to go up. Shareholders are going
to demand a higher return because of a higher risk.
The critical thing in the case of the Australian banks that
distinguishes them from banks in almost every other country in the world is
that we have a dividend imputation tax system. One of the big incentives for
companies and banks to use debt and deposits is the tax deductibility of
interest. Then the problem they face is that when they pay dividends, the
dividends are effectively taxed twice under a classic tax system. We do not
have that. We have a situation, with dividend imputation, whereby—to the extent
that the tax is paid at the company or the bank level—when shareholders receive
the dividends they get tax credits, if they are Australian shareholders. So any
sort of tax induced costs, which is one of the main effects to the Australian
banks, is pretty small, I think. Again, that is a debatable issue, because some
people would say that the tax credits—the franking credits—are not worth much;
others would say they are worth a lot. It is an empirical question, but it is
certainly not as significant an effect for Australian banks under the
imputation tax system as it would be for banks in other countries under the
classical tax system.
The committee recognises that prudential regulation necessitates an
appropriate balance between stability and competition being found. However, it
does not accept the argument put forward by Treasury that Australia should not
be concerned about the prudential regulation in place in other countries. Given
the implications for the competitiveness of Australia's banking sector and the
possible consequential effects on the price of credit and the economy,
Australian policymakers need to take into account what other countries are
doing when developing prudential standards and making an informed decision on
where the appropriate balance lies.
Domestic regulatory discretion
exercised in Australia
Overview of APRA's intent
As acknowledged and supported by Treasury, APRA has continuously taken a
conservative approach to implementing the Basel Accords.
While the Basel Committee gave national regulators the discretion to provide
limited recognition of certain items for calculations of common equity tier 1,
such as investments in the common shares of non‑consolidated financial
institutions (other banking or insurance wealth management businesses) and
certain deferred tax assets, APRA is not proposing to change its current
policies to allow banks to include these.
Accordingly, such items would need to be deducted in full from common equity
tier 1 capital.
In addition, the CBA identified two other key areas where APRA's
proposals differ from the approach taken by overseas regulators—namely that
APRA takes a more conservative approach:
- in calculating the amount of capital required to be held against
- to the amount of capital required for interest rate risk within
the banking book.
On the liquidity reforms, APRA is proposing that all ADIs meet the
qualitative requirements, but that only the larger ADIs will need to meet the
new LCR and NSFR requirements. APRA is intending to implement the Basel III
liquidity rules with only minor modifications to address unique aspects of
Australia's financial system, such as the volume of retirement savings in
self-managed superannuation funds.
Treatment of investments in
non-consolidated financial institutions
The concessional arrangements for investments in non-consolidated
financial institutions that the Basel rules allow national regulators to
implement, but which were not endorsed by APRA, was a specific issue commonly
raised by financial institutions. An APRA official explained how this decision
would impact banks with wealth management arms:
There are always exceptions to the rule, but the core rule is
that if a bank has an investment in such a business it is normally 100 per cent
deducted from capital. What will happen under Basel III is that the deduction
will be from the common equity proportion of capital as opposed to being spread
across a broader set of capital. So the impact of the deduction will be more
conservative, but the size of the deduction will be the same.
APRA is of the view that such arrangements 'would represent a double use
of capital, which does not strike us as prudent', while the concession for
deferred tax assets 'allows an asset that is unlikely to exist in the case of a
failed or severely troubled institution, and again, this does not strike us as
Another APRA official further explained the guiding rationale behind this
Effectively, what we are saying is that if a bank is invested
in these sorts of businesses then the shareholders are invested in it, not
exposing the depositors to the potential risk. That is the important reason why
we have always gone for the deduction element, to stop there being depositor
exposure, which is after all our primary function protecting the interests of
the depositors themselves.
The ABA and the CBA argued that the divergences between APRA's Basel III
proposals and the minimum Basel III requirements will result in Australian
banks reporting lower capital ratios than their international peers. The ABA
claimed that this will mean 'Australian banks will appear less
capitalised than their peers':
While in theory perfect information and adequate capacity
allows for (overseas) investors to fully analyse the differences between APRA's
approach and that undertaken by overseas jurisdictions, what happens in the
real world can be quite different.
The CBA argues that, even with a common disclosure template being
proposed by the Basel Committee, investors will need to undertake more detailed
analysis in order to accurately compare bank capital ratios. A CBA executive
advised that the difference between how capital is reported under APRA
requirements compared to the international approach results in more than a two
per cent difference in headline ratios.
To emphasise the issues with headline capital ratios, the CBA pointed to an
international report which erroneously stated that Australian banks were less
capitalised compared to northern European and US banks.
From the ANZ's perspective, APRA's different approach was particularly
perceived to be an issue given the bank's regional expansion strategy:
... some of the rules which are being applied—for example,
the rule around associates—mean that, if we are looking to expand into Asia,
the capital treatment in the approach that we would take in expanding into that
market would be different to competitors who are operating in different
jurisdictions, and we would see that potentially we could be at a competitive
disadvantage ... The issue around giving zero benefit for capital in
associates has a material business impact and therefore does affect both the
strategy and the cost of doing business.
When questioned by the committee about this issue, APRA officials stated
that they have given it consideration but suggested that, empirically, the
markets appear to understand the position of Australian banks. APRA considers
that Australian banks are relatively welcome in international equity and debt
markets; an important observation given that the bond investors who provide
bank funding are sophisticated financiers. Further, the strong credit ratings
held by the major Australian banks also reflect an understanding of APRA's
On the ratings side, I do not think anyone could say that the
major ratings houses are cursory or naive investors, and they perfectly well
understand this. As it happens, we meet with them from time to time and go
through all this in great detail. The substantial banks in this country, their
collective rating, puts them in the top three national banking groups in the
world. So pretty clearly on the credit ratings side they are not suffering
because we hold them to a firmer standard. If you look at the equity side and
compare the market capitalisation of our banks to any set of Western nation
peers, our banks relatively are at historic highs. The equity market seems to
understand what is happening.
There are some commentators in the market who you could
characterise as—I would think 'lazy' is not the right answer but let us say
something else—cursory or distant, who do pull the headline numbers and not
look behind them. But I would suggest that those are not the investors that
make the market. The margin in markets is made by the smarter, more active
investors. They are not the ones that sit back and do not do the work.
The difficulty with comparing capital ratios across jurisdictions was
discussed in a 2010 IMF report relating to the implementation of Basel II,
which supported APRA's overall approach to these matters.
Additionally, APRA pointed out that the banks can be proactive in demonstrating
that their capital ratios are not effectively lower than their international
counterparts, an option acknowledged by ANZ that it exercises:
... there is nothing to stop the banks—and some of them
have been doing it—publishing a comparable number that they have calculated.
So, using the example of eight versus 10, I guess it depends which bank you are
reading from. There is nothing to stop them saying, 'We're an eight on an APRA
basis and a 10 on what we calculate on a Basel basis.' Also, the Basel
committee has recognised this issue, so there is now a template which tries to
take a standardised disclosure approach so that the banks around the world can
use that template and demonstrate where they would sit on a comparable basis.
In September 2012, APRA published a statement that 'acknowledges
industry's continuing concerns about the comparability of capital positions of
banking institutions across other jurisdictions'. Accordingly, APRA advised
that in 2013 it will consult on the Basel Committee's proposals for disclosure
requirements for the composition of capital, which includes the common
reporting template 'that will enable investors and analysts to make cross‑border
comparisons for banking institutions in a straightforward and efficient way'.
Treatment of mutual ADIs
Being an international agreement, Basel III will clearly pose some
challenges for implementation at a domestic level as some unique features of
individual banking markets and jurisdictions will need to be accounted for.
Abacus-Australian Mutuals, the peak industry body representing Australian building
societies, credit unions, mutual banks and friendly societies, noted that:
Basel III is actually a capital framework that is meant for
large internationally active listed institutions. It is written with those
institutions in mind.
Australian mutual ADIs already face different regulation than their
international counterparts, given that APRA has applied Basel II to all ADIs
and has otherwise taken a conservative approach to implementing the Basel
Accords. Abacus commented on the Basel III requirements for mutuals in other
There is a very mixed implementation across Europe and the
United States. The United States does not even apply it to all its banks, let
alone some of its cooperative or mutually owned institutions. Some parts of
Europe are implementing Basel III in part to our sector, but are providing some
concessions that recognise the difference of the governance model that we have.
A particular issue for mutual ADIs under Basel III is that although they
are well-capitalised, they will likely find it difficult to meet the common
equity tier 1 ordinary shares requirements as they are unable to issue ordinary
shares. Abacus also noted issues with the treatment of mutual additional tier 1
and tier 2 capital instruments.
Abacus indicated that APRA is consulting on the ordinary shares issue.
When questioned by the committee, APRA officials acknowledged the issue and
updated the committee on progress to resolve it, advising that the mutuals have
engaged a consultant to work with APRA to help develop a solution. According to
a senior APRA official, such a solution 'will not necessarily be received
joyfully but will achieve the outcome'.
Limited sovereign debt
As sovereign debt is a high-quality liquid asset, it will play a key role
in allowing international banks to meet their Basel III liquidity requirements.
However, Australia has insufficient sovereign debt to satisfy Australian ADIs'
liquidity requirements. To address this, the RBA and APRA announced in December
2010 that an ADI will be able to establish a committed secured liquidity
facility (CSLF) with the RBA to help meet any shortfall in minimum LCR
Some issues with how ADIs will utilise the CSLF have been anticipated by
the regulators and other observers. To address them, APRA noted that it 'will
require participating ADIs to demonstrate that they have taken all reasonable
steps towards meeting their liquidity requirements through their own balance
sheet management, before relying on the RBA facility'.
However, some submitters question how the CSLF arrangements will change the
role of the RBA. Professor Sathye argued that the CSLF:
... essentially provides a life line even before a
stressed situation so the lender of the last resort role becomes lender
of the continuing resort. The banks would pay a fixed fee of 15 basis
points on both drawn and undrawn amounts. Basically, the banks are purchasing
the LCR compliance.
Continuing this reasoning, Professor Sathye argued that it may lead to 'LCR
games' because banks would seek as much of the committed secured liquidity
facility as they could, and invest other assets which they would have to hold,
such as cash, into assets which would earn interest. The professor suggested
that banks could invest in sovereign debt of other countries and the securities
of international organisations such as the IMF.
Treatment of internet-based
ING Direct questioned the different approach APRA is taking to internet‑based
accounts compared to other national regulators, as APRA's draft liquidity
prudential standard assumes that internet accounts will be more vulnerable if
there was a run on a bank during a crisis. ING Direct objected to this
assumption, observing that 'over the 30-day horizon on which the assumptions
are drawn you can get your money out of any bank any way you like'. ING Direct
also advised that it considers APRA's approach is 'fairly unique' compared to
that taken by other regulators.
Definition of 'basic deposit
Basic deposit products are currently excluded from the product disclosure
statement regime (as long as the product's cost and future payment requirements
are disclosed) and advisers do not need to give a statement of advice to their
client. However, only term deposits that are breakable on 31 days' notice would
achieve recognition of the 31-day term under the Basel III liquidity standards.
In other words:
Under Basel III banks will be required to hold more liquidity
if their funding is not locked in. If a term deposit can be broken without any
notice, as is currently the case, banks will have to hold more liquidity than
they would if that term deposit did have a notice period.
In November 2011, ASIC released a consultation paper after identifying
that regulatory 'relief may be required due to potentially significant
regulatory uncertainty about whether term deposits that are only breakable on
31 days' notice can qualify as basic deposit products under the
Abacus suggests that ASIC's interpretation is 'controversial and at odds with
current market practice'. Abacus notes that many ADIs currently issue basic
deposit product term deposits of two years that are only breakable at the
discretion of the ADI.
Abacus recommends that the 'basic deposit product' definition be amended to:
- remove doubt that term deposits of up to two years, where early
withdrawal is at the discretion of the ADI, are covered; and
- also cover term deposits of up to five years where early
withdrawal is at the discretion of the depositor but is subject to a notice of
withdrawal period of up to 31 days.
In August 2012, ASIC advised the committee that it is 'getting very
close to finalising the advice to industry on how we are going to treat that
relief, the time period for the term deposits in question and what sort of
information deposit taking institutions that issue those term deposits should
provide to their customers'.
Application of the countercyclical
The RBA and APRA have indicated that they will use a different method to
other national regulators when considering whether to trigger the
countercyclical capital buffer—an additional capital requirement of up to 2.5
per cent of total risk weighted assets available to regulators to help deal
with credit boom and bust cycles. Under Basel III, the buffer is to be imposed when
credit growth is occurring at a rate at which, historically, financial system
stability has been undermined. The Basel Committee has put forward a common
reference guide based on an aggregate private sector credit-to-GDP gap,
however, the two Australian authorities indicated that they will not adopt the
Basel approach as they disagree with the reasoning behind the Basel Committee's
While credit booms typically precede periods of financial
instability, the ratio of credit to GDP can change trend for other reasons,
including that the onset of financial deregulation or rapid economic
development can spark financial deepening at a faster pace than previously. In
these situations, the suggested detrending method will incorrectly detect a
credit boom that might not necessarily be problematic. It is also not clear
that the detrending procedure or the specific parameterisation presented in the
BCBS documents is the appropriate technique for detecting a genuine credit boom
that might require a policy response.
The procedure is designed to detect cycles of a particular
frequency, which must be pre-specified and therefore might not be appropriate
for the actual data. In addition, it has been shown in the literature to
sometimes detect cycles that are not there. The results of the procedure are
also very sensitive to small changes in its parameterisation.
For these and other technical reasons, the Australian
authorities do not propose to restrict their analysis to a single indicator or
small number of pre-specified indicators. The full array of available data and
analysis will be marshalled to support the detection of a harmful credit boom,
and the full suite of prudential tools—including but not limited to this buffer—remain
available for use in response.
APRA's regulatory and supervisory activities in recent years have been
widely praised. APRA's approach, including its conservative attitude when
applying domestically the details of past Basel Accords, has served Australia
well. Following the global financial crisis it is clear that Australia has some
of the strongest and safest banks in the world; yet, as demonstrated by post-crisis
outcomes, the regulatory environment that helps ensure this stability is not so
burdensome that the banks cannot earn large returns for their shareholders or
expand into other markets.
The committee supports APRA's overall approach to Basel III at this stage.
Assuming the reforms are widely implemented internationally, they will improve
the stability of the international banking sector and will address some of the
issues evident from the global financial crisis. It is not a big step for the
major Australian banks to comply with the new minimum capital requirements by
the deadline set by APRA, and smaller ADIs already hold capital in excess of
the necessary ratios. The stable funding requirements may be more challenging
for the banks to comply with; however, Australian banks will have to work towards
this. Any significant changes to Basel III, including if there are questions
about the timing of the liquidity reforms, will occur at an international level
and the implications for Australia will have to be considered at that time.
Some of the other recommendations of this inquiry, however, may assist the
sector in meeting the stable funding requirement at a lower cost.
The committee does consider that APRA could be more proactive in some
areas. A particular issue is that Australian banks may appear less capitalised
than their peers as a result of the different regulatory capital calculations
that APRA requires. While the banks have a role in explaining this difference
to international investors themselves, and the standardised reporting template
developed by the Basel Committee may also assist,
in the meantime APRA should facilitate the publication of headline capital
ratios that are calculated according to the Basel Committee's standard requirements.
The committee also encourages APRA to look at other ways that it could improve
the understanding of the Australian banking sector's underlying strength internationally,
to ensure that Australians receive the full benefits of this.
Given the increasing prevalence of internet-based accounts and the
apparent differences between how APRA proposes to treat these accounts for
liquidity purposes compared to the treatment applied by regulators in other
jurisdictions, the committee suggests that APRA reviews its approach in this
Finally, the committee recommends that APRA addresses the unique issues
that Basel III may pose for mutual ADIs as a result of their corporate
structure without further delay, and that it publishes a document which sets
out how these problems have been addressed.
In light of the evidence that international observers are
misinterpreting the level of capital held by Australian banks due to the
Australian Prudential Regulation Authority's (APRA) requirements, the committee
recommends that APRA:
- ensures it initiates consultation on the common disclosure
template developed by the Basel Committee in early 2013;
- in the interim before the common disclosure template is adopted,
facilitates the publication of headline capital ratios for Australian ADIs that
are calculated according to the Basel Committee's standard methodology and are
therefore easier to compare internationally; and
- be more active in promoting internationally that Australian banks
That APRA review its approach to how internet-based accounts should be
treated under the Basel III liquidity requirements.
That APRA addresses, without further delay, the unique issues Basel III
may pose for mutual ADIs as a result of their corporate structure and that it
publishes a document which sets out how these problems have been addressed.
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