Australian banks are strong; should we pay for them to be stronger?

The Australian Prudential Regulation Authority (APRA) has produced some new estimates of the capital positions of Australia’s major banks. It has done this in response to two suggestions of the Financial System Inquiry: first that it publish capital estimates for the banks which are consistent with international standards, and second that Australian banks should have capital levels which make them unquestionably strong (where “unquestionably strong” is taken to mean that banks should be in the top 25% of banks globally).

The shift to a measurement procedure based on international practice revealed the major banks are holding about 3 percentage points of capital more than the levels APRA had previously published. That is, the banks were much stronger than they appeared to be.

The shift to a comparable basis however also allowed a direct comparison of the Australian banks with banks offshore. The key finding is that for Australian banks to be positioned at the bottom of the top quartile (or top 25%) of their global peers for capital, they will need to increase their capital ratios by around 70 basis points (0.70%).

The report seems very fair. It considers each of the problems which have been pointed out with its previous measurement of capital, it considers a range of alternative measures, and it considers different ways of defining the peer group with which the Australian majors should be compared.

The report is also careful to point out that the data are difficult to interpret and subject to a lot of uncertainties. APRA is also very careful to say that its findings would not be translated directly into policy and should not be interpreted as so being.

The bottom line conclusion however, is stronger:

“Based on the best information currently available, APRA’s view is that the Australian major banks are likely to need to increase their capital ratios by at least 200 basis points [2%], relative to their position in June 2014, to be comfortably positioned in the fourth quartile over the medium- to long-term.”

Shifting goal posts

There are a number of reasons for the higher level. Two are quite straightforward: the global benchmark is drifting higher as more countries are lifting the expectations for their banks, and more regulatory changes are in process which is likely to lift the target levels.

The other important observation is that the 2 percentage point lift would move the Australian banks “comfortably” into the top quartile rather than to the bottom of the top quartile. Obviously it is not “comfortably” for the banks, the shareholders or their borrowers, but perhaps “comfortably” for the regulators.

There are big issues being skated over here. Do we need our banks to be in the safest 25% of global banks, which might require them to hold 0.75% or 1.0% of extra capital; or do we need them to be comfortably in the top quartile which might require them to hold 2.0% of extra capital?

It is easy for the regulator to float the idea of requiring banks to hold an extra two percentage points of capital, but there is a cost involved. It is a proposition which requires some form of cost analysis, and hopefully we will get one when APRA produces its regulatory impact statement.

Rodney Maddock does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.