Europe resists global Basel bank reforms

Europe is delaying, and threatening to derail, reforms that’d mean our banks having to raise much more capital.

APRA chief Wayne Byres. The regulator has held off a final decision on risk-weightings pending the outcome of the Basel process.

The European resistance to the final tranche of post-crisis banking reforms has delayed, and threatens to derail, proposals that would result in the Australian majors having to raise or generate another very big lump of capital.

Overnight the 45 members of the Group of Central Bank Governors and Heads of Supervision which oversees the Basel Committee on banking supervision — in effect the global banking regulator — deferred a vote on reforms that were supposed to be approved by the end of 2016.

The final leg of the Basel III reforms, dubbed “Basel IV’’ by the industry, include a floor under the risk-weightings banks that use their own internal models to assess the risk and capital requirements of their lending. The push for a standard floor was driven by the wide variations between the risk-weights used by individual international banks.

The unresolved measures also include the introduction of a simple leverage ratio and how the reintroduction of a new accounting treatment for potential loan losses — counter-cyclical or “dynamic’’ provisioning for likely future loan losses — might be incorporated into regulatory capital calculations.

The most controversial measure, however, has been the proposed floor under risk-weightings.

In Australia, when the Australian Prudential Regulation Authority, responding in part to the Financial System Inquiry’s recommendations, introduced a minimum average floor of 25 per cent for the major banks’ mortgage risk-weights, they were forced to raise more than $20 billion of new capital.

APRA has indicated that the floor is likely to be raised further, probably towards 30 per cent, once the final Basel committee reforms are in place. It has held off making a decision on where it will set the final floor pending the outcome of the Basel process, which now looks likely to be at least several months away.

If APRA was to raise the floor it could result in the banks having to raise or create (through retained earnings and balance sheet management that reduces their regulatory capital requirements) another $20 billion of capital, albeit probably over several years.

In anticipation of the additional regulatory capital requirements, the majors have been pre-emptively building their common equity tier one capital bases through the sales of non-core or low-returning assets and the shrinking of their higher-risk and/or lower-returning loan portfolios.

The deferring of a decision on the reforms occurred in the context of resistance from European bank regulators, who see the risk-weight floors as undermining the competitiveness and the ability of their banks, particularly relative to US banks.

Not only are the eurozone banks less well-capitalised than their US counterparts (and Australian banks) but they hold far more of their loans on their balance sheets than the US banks, which tend to securitise and onsell far more of their loans, particularly mortgage-backed loans, than the Europeans. European markets for securitised debt are far less developed than those in the US.

The European Union has been quite explicit in saying that it wouldn’t accept any reforms that entailed a significant increase in the capital requirements for its banks, which the Basel reforms would inevitably result in.

Not only has Europe been far less aggressive than the US, or indeed the UK, in responding to the impact of the financial crisis on its banking sector — as the well-chronicled problems within the German and Italian systems illustrate — but the European Central Bank’s pursuit of unconventional monetary policies and negative interest rates has been draining their profitability and their ability to generate organic capital or raise new equity.

The delay in agreeing the last wave of global banking reforms — and the threat of undermining or even unravelling what had been a global consensus on how prudential regulation should be reformed in response to the experience of the crisis — comes at a delicate moment, perhaps deliberately so.

US President-elect Donald Trump has indicated that he wants to roll back some of the banking reforms enacted in the US after the crisis — the Dodd Frank legislation — as has his nominee as Treasury Secretary, former Goldman Sachs veteran Steven Mnuchin.

Mnuchin has said he wants to strip back elements of the legislation that inhibit banks from lending but hasn’t been specific about what the changes might be. Lowering regulatory capital requirements would, of course, create more balance sheet space for lending.

The Europeans want to see whether the international banking playing field is tilted further towards their US competitors before signing off on any new rules that impact their own banks disproportionately.

Those banks, like many European banks — and virtually all Australian banks — that have big exposures to residential mortgage lending would be the most impacted by the proposed new rules, which would see the floors under the risk-weights rising steadily through to 2025. Residential mortgages carry the lowest risk-weights because of their perceived low inherent riskiness.

Before APRA introduced the 25 per cent floor for mortgages for banks using their own internal models to assess risk — the four majors and Macquarie — their average risk-weights for mortgages were around 18 per cent versus the 39 per cent of the smaller banks using the “standardised’’ approach, even though the underlying assets were fundamentally the same.

The majors do, however, have more sophisticated systems and their calculations under the “advanced’’ approach to their regulatory capital requirements include elements of operational and market risk that complicate direct comparisons with the risk-weightings of the smaller banks using the standard approach.

If the final tranche of Basel reforms is put into place, however, and if, as has been suggested, the floor for banks using internal models ultimately rises to 75 per cent of the standard model for assessing risk, the majors would end up with risk-weighting floors of about 30 per cent.

That appears to be in line with APRA’s own thinking and could be implemented regardless of whether or not the rest of the world signs off on a global standard.

There are competition arguments for APRA going it alone — rebalancing the impact of regulatory capital requirements on the competitiveness of smaller banks versus the majors — as well as prudential reasons, given the concentration risks in the Australian system generated by the banks’ exposures to the housing market.