Protecting taxpayers a key driver

20 October 2014

James Eyres


Financial System Inquiry chairman David Murray is considering all the arguments about whether it is necessary to create a more stable banking sector and if so, how that should be achieved.


The overarching philosphical driver of this year's inquiry has been a global one, how to reduce the chances that taxpayers are forced to pay for a financial institution failure.


In the coming weeks, as he finalises his final report for the Treasurer, Murra will have to paint both his big picture - by describing whether global risks demand more regulatory capital - and the detail.


On the latter, the report should explore what level of captial is necessary to minimise the risks of the government having to step in to prop up a failing bank; and whether any increases to capital should be made via adding more common equity, or alternatively requiring more debt instruments to sit in between that equity and depositors' funds.


Well before Murray and his secretariat began investigations into the banks' ability to absorb losses in a crisis, the banks have been building capital levels.  This has been a function of both demands from the market (nervy post-GFC international bond investors are better protected if the equity buffer is larger) and regulators.


The Australian Prudential Regulatation Authority now requires common equity tier one (CETI) capital of at least 8 per cent of risk weighted assets.  According to JP Morgan analyst Scott Manning CETI ratios (tier 1 capital is common equity plus hybrid debt) across the major banks 8.5 per cent, 150 basis points above the 7 per cent average since 1990, and 300 basis points higher than the low point before the GFC of 5.5 per cent.


So-called "total regulatory capital" (which adds subordinated debt) over risk weighted assets across the major banks is currently 12 per cent, 1 percentage point higher than the 11 per cent average since 1990, according to JP Morgan.


This focus on building up capital has reduced the big banks returns on equity - down from the low 20s ahead of the GFC to around 16 per cent today, which has reduced returns to shareholders.  But balance sheet funding is also more "sticky"" as banks have reduced the proportion of funding from wholesale capital markets in favour of higher levels of domestic deposits.


If Murray is inclined to recommend that total capital levels in the big banks should be even higher - and the market thinks that he will - he may target higher CETI, which chould be achieved in two ways, by stipulating a higher D-SIB capital charge (currently set at 1 per cent by APRA on the big banks to recognise their systemic importance); or by increasing risk weightings assigned to particular types of lending such as mortgages............


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