Talking Point Who will bear the brunt of bank bailouts?

June 2013
For professional investors only
Talking Point
Who will bear the brunt of bank
by Peter Fullerton, Senior Credit Analyst - Fixed Income
Banks used to be considered as relatively low risk investments, braced by a complex array of regulatory
requirements and oversight, rating agency scrutiny, stress testing and the apparent willingness of Governments
to bail out major banks if they ever got into trouble. In hindsight, the significant trauma experienced by the US
and European banking system during the GFC and more recently with the banking crisis in Cyprus, it is clear
that certain banks were more risky and complex investments than was originally thought. In this article, we
provide some colour around why banks fail, what the implications are for investors when banks fail and how the
Australian banks appear to be placed in the current environment.
Why do banks fail?
Looking at a bank from a simplistic point of view, they “borrow” money in the form of deposits or they issue
bonds into institutional debt markets (both domestic and offshore), and then lend that money out in various
forms of loans. The bank makes a profit by charging the borrower a higher rate of interest than they are paying
deposit or bond holders. Any form of lending entails the expectation that a certain portion of the borrowers
won’t be able to repay their loans and banks maintain provisions in an attempt to absorb expected levels of
Figure 1 – Capital/Liabilities vs Loan Assets for the Commonwealth Bank of Australia
CBA Capital v Loans ‐ 31 Dec 2012
Loan Loss Provisions
$AUD bn
Loans (Other)
Covered Bonds
Loans (Mortgages)
Equity T1
Sub Debt T2
Hybrid T1
Equity, Bonds, Deposits (Liabilities and Owners Equity)
Loans (Assets)
Source: CBA Annual Report 2012
Figure 1 provides a stylised representation of CBA’s balance sheet, showing sources of funds in the left hand
column and uses of funds on the right hand side. At 31 December 2012, CBA maintained provisions for loan
losses equal to 0.87% of total loans and the cost of this expected level of non-performing loans are essentially
incorporated into the cost of lending, like an operating expense. If the actual loan losses are above these
provision levels then someone needs to bear those losses – the key question then becomes who bears these
What are the implications for investors and deposit holders when a bank fails?
Before the GFC, markets expected that because major banks where so intrinsically important to an economy
Governments would step in and support any bank in distress. This would ensure all depositors and investors
Issued by Schroder Investment Management Australia Limited
123 Pitt Street Sydney NSW 2000
ABN 22 000 443 274 Australian Financial Services Licence 226473
June 2013
Forr professional advisers onlyy
would be “ba
ailed-out” an
nd not lose an
ny of their invvested capita
al, regardless of where thhey had inve
ested in the
capital struccture. As a re
esult, investo
ors were williing to take on only a sma
all incrementtal return for investing
down the ca
apital structurre in hybrid and
a tier secu
The econom
mic and socia
al cost of bailling out bankks has proven to be significant, particcularly in Euro
ope and the
US, as highe
er taxes and lower Government expe
enditure are ultimately
assed on to ssociety. Now in the post
GFC world, it is clear invvestors should expect tha
at the provide
ers of capital to banks wiill be the prim
absorbers o
of losses in a stressed situ
uation, not th
he public purrse.
Changes in legislation and bank regu
ulations are now all gearred towards prescribing
“hhow” and mo
importantly ““who” will be
ear the losses
s associated
d with bank fa
ailure (comm
monly known as the Basel III
requirementts). In a nutsshell, regulators will start at the bottom
m of the capital structuree (the left han
nd side of
figure 1) and
d move upwa
ards, writing off security vvalues in an orderly and sequential m
manner until they
have at
least written
n off a comme
ensurate am
mount of equitty, tiered sec
curities, bond
ds etc. to maatch the levell of loan or
trading losse
The key imp
plication of th
his change is
s investors sh
hould be fully
y aware of th
heir position in the capita
al structure
and ask them
mselves if th
hey are being
g appropriate
ely remunera
ated for that particular
levvel of risk. Deposit
holders can be more com
mfortable tha
an those inve
estors ranked
d below them
m who will moost likely be forced to bear
losses. How
wever, equityy and tiered security
estors need to
o be very cog
gnisant of th e fact they are
a now first in
line to bear losses, otherwise known as the “bail--in”.
How are th
he Australian banks placed
in th
his new environment?
The bulk of academic re
esearch conv
verges on two
o key factors
s considered key indicatoors of a bank’s financial
health. Firsttly, banks sh
hould have an ingrained a
and discipline
ed approach
h to whom theey lend money (rigorous
origination sstandards and risk manag
gement fram
meworks) and
d secondly, th
he presence of an active and intrusive
regulator wh
ho ensures banks
y with prescrribed regulatiions and stan
ndards. Bassically, if a ba
ank is lending
on a disciplined and resp
ponsible bas
sis it should b
be a more sta
able entity. This
is a far more important driver of
bank health as opposed to the level and compossition of proviisions and re
egulatory or l oss absorbin
ng capital.
On this frontt, the Australian banks ap
ppear to be rreasonably well
w positione
ed. The dom
mestic regulator continuess
to play an im
mportant role
e in ensuring compliance with standarrds and mostt importantlyy, driving earlly compliance
with the new
w banking sta
andards whe
en many of th
heir offshore counterparts
s are lookingg at longer im
periods. The Australian banks appear to have be
een constantly improving
g their loan oorigination sta
andards and
h compared to global pee
g, regulatory capital levels
s remain high
However, investors shou
uldn’t become complacen
nt. In 1992, Westpac sufffered significcant financia
al stress drive
by poorly pe
erforming com
mmercial pro
operty loan lo
osses and there is no gua
arantee stresss in a partic
cular part of
the economyy cannot occcur again.
Credit Grow
wth in the Au
ustralian Eco
Figure 2 – C
Source: RBA, A
ABS, Schroderss
Schroder Invesstment Manage
ement Australia Limited
June 2013
For professional advisers only
Figure 2 highlights that leverage within the Australian economy, particularly households, now sits at materially
higher levels than seen over the last 23 years, largely supported by increasing asset prices (particularly
residential property). Pressure would increase on the Australian banks if the economic environment was to
turn, particularly if there was a sustained decline in residential house prices and forced de-leveraging of
We have already seen one major offshore bank failure in 2013. In January 2013, one of the four major banks
in the Netherlands, SNS Reaal, was nationalised on concerns over high levels of loan losses and decline in the
value of its property portfolio. In this scenario all equity holdings were written off and most tier capital securities
were also written off as well.
Conclusion – what does it all mean?
One key lesson we can learn from the GFC is that investing in banks can involve much higher investment risk
than was previously anticipated. The fact that credit markets are now offering the most attractive funding costs
to more transparent and simple corporations like Microsoft, Johnson and Johnson and Nike and charge higher
rates to banks in general reflects this change in risk assessment. Almost all of the changes in banking
regulation are geared at making it clear governments and central banks won’t bear the brunt of future bank
failures. The shareholders and providers of capital to the banks are now clearly designated as the bearers of
bank failure in future years.
Numerous entities, including rating agencies, investment banks and regulators have performed various
proprietary stress tests on the Australian banks and in many cases, the Australian banks have been considered
to be well capitalised, relative to estimated losses in a stressed environment. However, investors providing
equity or regulatory tier capital need to be fully aware that the banks are considered to be in a sound position
because they are providing the loss absorbing capital. Essentially they are the shock absorbers required to
ensure that banks as economic engines continue to motor along. The banks’ ability to absorb a stressed
situation and to continue to lend and meet deposit holders withdrawal demands is essentially predicated on
these providers of capital bearing the losses! Investors need to be aware of exactly what part of the capital
structure they are investing in and ask themselves are they being appropriately compensated for the risk they
are bearing.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article.
They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274,
AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In
preparing this document, we have relied upon and assumed, without independent verification, the accuracy and
completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not
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