Aussie Banks And Basel

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By Greg Peel

The Basel Committee on Banking Supervision is a body established to provide homogenous global banking regulations. The first such set was provided in Basel I, with a follow-up in Basel II. Basel III introduces changes in the wake of the Global Financial Crisis.

Basel III focuses on two particular factors – capital and liquidity. Banking is a naturally leveraged business, such that equity capital, deposits and sources of debt funding are used, for the most part, to lend money to businesses and individuals, with the bank's profitability being based on the difference between that rate at which it borrows and the rate at which it lends.

Banks provide a multiplier effect to money, in that your deposit is lent to fund the purchase of your neighbour's house despite you still having a claim on your deposit. In the case of debt sourced by banks, it's all a matter of net interest margins. The risk a bank runs is if suddenly everyone on the deposit side wants their money back, or a lender calls in a loan to the bank, that money is not readily available. On that basis, banks must be able to keep a reasonable buffer against loans being called in and must be able to quickly liquidate assets if need be. But the whole banking business runs on probabilities.

Under Basel II, banks were only required to hold 4% of “tier one” capital, which in simple terms means equity and retained earnings. This effectively meant a bank could leverage 25 times. The GFC nevertheless showed up this level as being inadequate. But what the GFC really showed up is the risk of a bank not being able to lay its hands on money quickly – liquidity.

A mortgage, for example, is not a liquid asset. It takes a long time to foreclose a mortgage and sell a house. The GFC also showed mortgage CDOs were far from being liquid instruments. Government bonds, on the other hand, is an example of a very liquid asset, as they can be sold very readily on the official market.

Prior to the GFC, Australian bank tier one ratios were no lower than about 6%. The GFC forced the banks to make large provisions against potential bad debts, make large provisions against general uncertainty of global financial markets, and to raise capital in order to do so. Banks also reined in their dividend payouts to equity holders. Now Australian bank tier one ratios are anywhere between 8.6% and 11.1%, as Deutsche Bank notes. As has been the case across the globe in 2010, banks are sitting on large amounts of cash that could otherwise go towards acquiring more assets (making loans) but for the uncertainty surrounding just what new capital and liquidity regulations might come out of Basel III on the one hand, and locally on the other. In Australia's case, the Australian Prudential Regulation Authority (APRA) is yet to provide its regulatory overhaul. In the US, the new “FinReg” laws have already been established.

On the release of the Basel III requirements, Australian banks were able to breathe a sigh of relief.

Basel III requires banks to hold a minimum of 4.5% common equity (up from 2.0%), a minimum of tier one capital of 6% (up from 4%), and a minimum total capital of 8.0%. These levels must be attained on a phase-in basis between 2013 and 2015. Between 2016 and 2019, banks must also add a further 2.5% “capital conservation buffer”.

The number that matters, therefore, is the total 8.5% tier one capital requirement by 2019. Here we are in 2010, and as noted above Australian banks already satisfy this requirement. The banking sector was not only relieved to find the new capital ratio requirements were not hugely onerous, they were also surprised to learn just how long they had to comply.

In theory, Australian banks could go berserk on the excess capital they have today for short term gain before beginning to reel things in again later in the decade. But that is unlikely.

What is more likely is that Australian banks will be able to start bringing their “provisions for general uncertainty” back into earnings at the same time bad debt provisions are being wound down, to more aggressively pursue acquisitions, and to free up the tight lending standards they had imposed during the Great Uncertainty. This they can do without risking too much of their capital buffer.

The simple capacity to be able to feel happier about lending again is good for the Australian economy, and may help to finally turn around declining business credit demand.

There is nevertheless more to consider. For starters, some of those “provisions for uncertainty” will likely remain in place on a “rainy day” basis. If the global economy were to go in double-dip, for example, or were Europe to blow up again, such a capital buffer might come in handy.

Another consideration is a popular source of bank funding – the hybrid debt issue. Because hybrids involve, for example, debt that can be converted into common equity at some point, they have always been a grey area when it comes to what is actually considered “tier one”. When such instruments were still in their infancy, banks were able to put them up as tier one capital. More recently, regulators have been more strict. Under Basel III, hybrid issues that no longer qualify as either tier one or tier two capital will have to be phased out. But again, banks have ten years from 2013 to do this.

Basel III also requires a Liquidity Coverage Ratio to be met, albeit this will not be introduced until 2015. However, Australian banks are at a disadvantage here given a sparsity of government bond issues compared with, for example, the US. Australia may need an extended time frame to meet the LCR, suggests JP Morgan.

A further Basel III regulation is the individual requirement of an additional 2.5% of capital as a “counter-cyclical” measure were a particular bank be deemed to be building up too much “systemic” risk. This is best described as the “too big to fail” buffer. At this point it is considered that Australian banks are not so small that they wouldn't be considered a risk to the system as a whole were they to fail.

So the upshot is that while the big Australian banks are already well inside the new minimum requirements, they are “not in a position to relax,” as JP Morgan puts it. Citi further points out that while Australia's smaller regional banks would not be considered systematically important they may still struggle to maintain sufficient tier one capital ratios given weak organic capital growth. This could lead to capital raisings or more conservative dividend polices.

The next problem is as to how APRA will respond. Stockbrokers suggest that APRA will not likely wish to impose even tougher local rules, but may speed up capital requirements ahead of the Basel III timetable to ensure the local banks don't slip below in the meantime. APRA will also likely address the LCR problem to the local banks' advantage.

The Basel III announcement has not driven any broker to change its ratings or targets on local banks. Both Goldman Sachs and Citi suggest that the excess capital now on Australian balance sheets may still lead to some form of capital management, such as share buybacks, to boost earnings per share growth.

Citi believes ANZ Bank ((ANZ)) is best placed to meet the new Basel requirements. The analysts also believe ANZ is best placed in general to perform in what they describe as the new “utility” phase of the banking cycle.

Once upon a time banks were fairly conservative investments, ticking along nicely providing a reasonable yield against restrained capital growth. They were even considered “defensive”, which is hard to fathom having just been through a bank-led GFC. In this way they were similar to utility companies such as an electricity retailer or a telco.

But the two decades pre-GFC saw a change in the nature of banking, brought about by much increased leverage and all sorts of new lending and investment instruments. Not only did banks become less defensive, they became very cyclical – living and dying on global economic strength or otherwise. Post-GFC, and post Basel III, Citi sees Australian banks as slipping back to become more like their earlier incarnations.

Westpac ((WBC)) and Commonwealth ((CBA)) came screaming out of the GFC by taking on as much as they could of the stimulated mortgage drive. With households now gearing down in the new environment, these two banks will find outperformance difficult from here, suggests Citi.

National ((NAB)) has been the underperformer post-GFC, but Citi sees NAB as being able to re-rate in the next couple of years as bad debts normalise and the bank is able to deliver superior earnings growth.

The release of the Basel III requirements has given all banks, including Australia's, another kick along in what was already a good rally in September on easing global economic fears. Macquarie suggested nevertheless, prior to Basel III, that the Australian banks were already trading around fair value now on current earnings forecasts.

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