What does the Government's response to the FSI mean for banks?

By Michael Mathieson
Banking Financial Services Financial Services Royal Commission Funds Insurance Superannuation

In brief

Written by Senior Regulatory Counsel Michael Mathieson

The short answer is: it depends on which kind of bank you are. The Financial System Inquiry's final report and the Government's response mean a lot for ANZ, CBA, NAB and Westpac, particularly given their significant residential mortgage portfolios. They also mean a lot for Macquarie. As for the rest of the banks, they are likely to see the ramifications for the major banks as their own gain.

The first chapter of the FSI's final report, and the first component of the Government's response, concerned 'resilience'. In one sense, this is appropriate as resilience in the financial services sector is largely about banks – and the banks not passing on interest rate cuts was the original catalyst for the FSI. It is a little ironic, then, that the final report had nothing of any importance to say about the way in which banks set their interest rates. But the major banks have taken some serious hits when it comes to capital requirements.

Throughout the FSI process, the major banks were adamant that the existing capital requirements were adequate. The FSI disagreed. So did APRA. And an international capital comparison study released by APRA in July 2015 seemed to bear out the FSI/APRA view.

ADI capital ratios must be 'unquestionably strong'

The FSI recommended that capital standards be set such that Australian ADI capital ratios are 'unquestionably strong'. In its response, the Government said it 'agrees that the capital ratios of Australian banks should be unquestionably strong'. It would be difficult to imagine the Government saying anything else. In a formulation used repeatedly by the Government in relation to the FSI's resilience recommendations, it also said: 'We support and endorse APRA as Australia's prudential regulator to implement this recommendation'.

Which raises an interesting point. Capital requirements for banks are, in substance, set by the Basel boffins. In practice, APRA has little room to depart from the Basel line. In order to implement, and adjust, the Basel line, APRA already has all the powers it needs. No change in the law is required. In one sense, the Government's view on these matters is essentially irrelevant. Which then makes one wonder why we needed an FSI to make recommendations to the Government on these matters. But I digress.

In its international capital comparison study, APRA said it regards 'top quartile positioning' as a useful indicator of the strength of the Australian framework. It also said that the major banks would need to increase their capital adequacy ratios by at least 200 basis points, relative to their position in June 2014, to be comfortably positioned in the top quartile of their international peers over the medium to long term. However, APRA has yet to move to implementation. Before it does, it wants to see the outcome of the Basel Committee's deliberations, which are not expected to be known before the end of the year.

Mortgage risk weight differences must be narrowed

The other key resilience recommendation concerned the differences in the average mortgage risk weights for the five major banks (one the one hand) and for the rest of the banking industry. The FSI recommended they be narrowed. Again, the Government agreed.

Risk weights for different kinds of assets play a large role in determining how much capital a bank must hold. The higher the risk weight, the greater the capital required. Given the size of the residential mortgage portfolios of ANZ, CBA, NAB and Westpac, the mortgage risk weights for those mortgages are critical to their capital requirements. Those banks, and Macquarie, use a different method for determining risk weights, relative to the remaining banks.

The FSI found that the average mortgage risk weight for the major banks was 18 per cent while for the rest it was 39 per cent. The FSI suggested that the average risk weight for the major banks should be lifted to 25-30 per cent. In July this year, APRA set a new target average risk weight of 25 per cent, to apply from 1 July 2016.

APRA described this as an 'interim measure'. Again, it will await international developments before settling on a final position.

Interestingly, APRA suggested that the existing average risk weight for the major banks was more like 16 per cent, not 18 per cent. APRA also said that the additional capital required to be held, as part of moving from 16 per cent to 25 per cent, would be commensurate with an increase in capital ratios of roughly 80 basis points (out of the 200 basis points mentioned earlier as being required 'to be comfortably positioned in the top quartile'). In other words, the banks in question will, in complying with this measure, already take about 40 per cent of the journey towards the 'unquestionably strong' benchmark.

Concluding observations

As the opening sentence of Prudential Standard APS 110 Capital Adequacy says: 'Capital is the cornerstone of an ADI's financial strength'. However, it seems to me that capital requirements are going to be dictated to a very significant extent by international considerations and perhaps less so by domestic considerations.