Chapter 3

Basel III

3.1 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 Australia.

Overview of capital regulation and the Basel Accords

3.2 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.[1]

3.3 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 supervision worldwide'.[2] The Basel Committee does not have the authority to impose the standards it develops, instead:

... 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.[3]

3.4 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'.[4]

Basel I

3.5 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).[5] 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.[6] 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 requirements:

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'.[7]
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.

3.6 A bank's total risk-based capital ratio is determined by the following equation:

3.7 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.

Basel II

3.8 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'.[8] 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'.[9]

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.[10]

3.10 Basel II was implemented in Australia at the start of 2008, a similar timeframe to that taken by the EU.[11] The US had not introduced the new regime before the global financial crisis commenced.[12]

The GFC and development of Basel III

3.11 Although the origins of the global financial crisis existed before Basel II was implemented by key countries,[13] 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 view:

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 stability.[14]

3.12 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.[15]

* * *

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.[16]

* * *

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.[17]

3.13 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.[18]

3.14 Some amendments to the Basel Accords were made through Basel 2.5, which was finalised in July 2009 and commenced from 1 January 2012.[19] Basel 2.5 focused on accounting for the inherent risks of securitisations, re-securitisations[20] 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.[21] 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'.[22]

3.15 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 leverage'.[23] 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 [24] and re-emphasised the commitment and the need to implement Basel III at Cannes in November 2011.[25] 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.[26]

Details of Basel III

3.16 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.[27]

3.17 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 monitoring.

Capital requirements under Basel III

3.18 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 summarised in
Table 3.1. The overall capital ratios are outlined in Table 3.2.

Table 3.1: Summary of the Basel III capital measures

*Areas of focus*	*Measure*
Increasing the quality of capital	A 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.
	Deductions from capital must generally be made from common equity tier 1 and available tier 1 capital must be determined after deductions rather than before.
	The 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 redeem';[28] 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	Outside 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.[29]
	Total regulatory capital (tier 1 capital plus tier 2 capital) must be at least 8% of risk‑weighted assets at all times.
	Overall tier 1 capital must be at least 6% of risk-weighted assets at all times.
Countercyclical buffer	A 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.
Reduced leverage	A 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.
Risk coverage	A 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.
Other measures	Higher standards for supervisory reviews (pillar 2) and public disclosures by banks (pillar 3).

Table 3.2: Minimum capital ratio requirements under Basel III

Category		% of RWA
Common equity tier 1 capital	Minimum	4.5
	Minimum plus conservation buffer	2.5
	Total common equity	7.0
	If needed, an additional countercyclical buffer to be met by common equity tier 1 capital	0–2.5
Tier 1 capital	Total tier 1 capital	6.0
Tier 1 capital	Minimum plus conservation buffer	8.5
Total capital	Total capital (tier 1 + tier 2)	8.0
Total capital	Total capital plus conservation buffer	10.5

Liquidity measures under Basel III

3.19 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 introduced:

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 scenario); and
Net stable funding ratio (NSFR)—the NSFR is a longer-term structural ratio intended to encourage banks to use stable funding sources [30] (i.e. reduce their dependency on short-term wholesale funding). The NSFR requirement is:

3.20 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

3.21 APRA commenced consultation on the implementation of Basel III in December 2010 by advising the ADIs of its support of the reforms.[31] 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.

3.22 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 Australia:

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.[32]

* * *

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.[33]

3.23 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 banking sector':

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.[34]

3.24 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.[35]

3.25 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.[36]

3.26 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'.[37] 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.[38] 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.[39]

Impact on the Australian economy

3.27 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 actually have,[40] 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.[41]

3.28 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.[42] Domestically, the RBA considers that the imposition is not going to be 'particularly large'.[43] 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.[44]

3.29 Of course, Basel III will not make the international banking system bulletproof:

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.[45]

3.30 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.[46]

Implementation of Basel III in Australia

3.31 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 jurisdictions;
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.

3.32 These issues will be discussed in the following paragraphs.

The implementation timetable in Australia

3.33 Globally, Basel III is required to be fully implemented by 1 January 2019, with a transition to the arrangements commencing in January 2013.[47] 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 reforms,[48] namely that:

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.[49]

3.34 APRA has indicated that in 2015 it will advise whether a countercyclical buffer will apply from 2016 and whether transitional arrangements are required.[50] 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.[51] 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).[52]

Impact of the accelerated implementation timetable

3.35 Since Basel I, Australian banks have consistently held capital well above the minimum requirements.[53] 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.[54]

Figure 3.1: Actual capital v Basel III minimum capital requirements, selected larger banks (end June 2011)

Figure 3.1: Actual capital v Basel III minimum capital requirements, selected larger banks (end June 2011)

Source: APRA, Submission 55, p. 5.

3.36 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:[55]

... 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.[56]

3.37 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 it?

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.[57]

3.38 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. [58]

3.39 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.[59]

3.40 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.[60]

3.41 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.[61]

3.42 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.[62]

Committee comment

3.43 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

3.44 As acknowledged and supported by Treasury, APRA has continuously taken a conservative approach to implementing the Basel Accords.[63] 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.[64] Accordingly, such items would need to be deducted in full from common equity tier 1 capital.

3.45 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 mortgages; and
to the amount of capital required for interest rate risk within the banking book.[65]

3.46 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.[66]

Treatment of investments in non-consolidated financial institutions

3.47 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.[67]

3.48 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 prudent'.[68] Another APRA official further explained the guiding rationale behind this approach:

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.[69]

3.49 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.[70]

3.50 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.[71] 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.[72]

3.51 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.[73]

3.52 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 approach:

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.[74]

3.53 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.[75] 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:[76]

... 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.[77]

3.54 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'.[78]

Treatment of mutual ADIs

3.55 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.[79]

3.56 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 jurisdictions:

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.[80]

3.57 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.

3.58 Abacus indicated that APRA is consulting on the ordinary shares issue.[81] 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'.[82]

Limited sovereign debt

3.59 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 requirements.

3.60 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'.[83] 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.[84]

3.61 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.[85]

Treatment of internet-based accounts

3.62 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.[86]

Definition of 'basic deposit product'

3.63 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.[87]

3.64 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 Corporations Act'.[88] 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.[89] 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.[90]

3.65 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'.[91]

Application of the countercyclical capital buffer

3.66 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,[92] 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 guide:

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.[93]

Committee view

3.67 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.

3.68 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.

3.69 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,[94] 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.

3.70 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 area.

3.71 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.

Recommendation 3.1

3.72 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 are well-capitalised.

Recommendation 3.2

3.73 That APRA review its approach to how internet-based accounts should be treated under the Basel III liquidity requirements.

Recommendation 3.3

3.74 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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