Australians are compelled to believe banks that produce super profits are some of the safest banks in the world. But is super profits really a sign of safety or an indication of dangerously high leverage and risk taking?
As we wait for the release of the David Murray Financial System Inquiry final report, strong indications are emerging our big four banks will need to hold more capital after flouting their privilege in calculating their own risk ratings.
Prior to 2004, and in tune with the Basel I accord, banks were allowed to apply a 50 percent risk rating to standard home loans. While every dollar of a business loan, for example, was deemed to be at risk, only 50 percent of a residential mortgage was thought to be at risk. With half the loan risk-free, the bank only had to keep half the Tier 1 capital required.
With the introduction of the Basel II accord published in June 2004, the Basel Committee on Banking Supervision thought it should cut standard home loan risk ratings to 35 percent for loans with a LVR under 80 percent. It also gave ‘Advanced Banks’ the privilege to rate their own assets, after all they were considered to have well developed risk management principals and would never put profit ahead of risk.
In Australia, the ‘Advanced Banks’ are our big four – ANZ, CBA, NAB, WBC and investment bank, Macquarie.
From Pillar 3 disclosures, the Australian Financial Review has calculated current risk-weights for our bank’s home loan portfolios. As required, our smaller non ‘advanced’ banks have risk weightings exceeding the minimum 35 percent. Bendigo is believed to be 39 percent, Suncorp – 40 percent and the Bank of Queensland – 44 percent.
But, according to the Australian Financial Review, Westpac believes only 15 percent of its standard mortgages are at risk (Perfect time for Gail Kelly to retire), ANZ – 18 percent, CBA – 19 percent and NAB – 23 percent. Macquarie is marginally better at 24.4 percent.
The Australian Banking Regulator, APRA, has just conducted its latest stress test on the Australian Banking System. The tests included 13 of our largest banks, accounting for 90 per cent of total industry assets. While previous stress tests included a slowdown in China and fiscal problems in Europe, this year the banking regulator focused on a collapse of Australia’s bubbling housing market.
Two stress scenarios were developed in conjunction with the Reserve Bank of New Zealand:
Scenario A consisted of a housing market double-dip triggered by a sharp slowdown in China. House prices fall by 40 percent and unemployment increases to 13 percent.
Scenario B focused on rising interest rates along with a plunge in commodity prices. Higher unemployment and higher borrowing costs caused a significant drop in Australia’s overvalued housing values.
A footnote in an APRA report noted “regulatory capital for housing held by Standardised banks was (just) sufficient to cover the losses incurred during the stress period.” But this “was not the case” for our Advanced banks.
According to the Australian Financial Review, this finding has been confirmed on Friday by APRA. The Australian Financial Review reports “The text was unclear as to whether the major banks had sufficient or insufficient capital held against their mortgage books to withstand the losses. But an APRA source confirmed to AFR Weekend that it was the latter, and that all residential mortgage capital was wiped out in the stress test.”
» Bank capital at risk from house bust – The Australian Financial Review, 15th November 2014.
» Seeking strength in adversity: Lessons from APRA’s 2014 stress test on Australia’s largest banks – APRA, 7th November 2014.
» Bank debt ratios expose Basel’s faulty risk weightings – The ABC, 8th October 2014.
» Major bank profits on home loans could halve – The Australian Financial Review, 25th July 2014.