IN SEARCH OF …. UNQUESTIONABLY STRONG
WAYNE BYRES
Chairman
Australian Prudential Regulation Authority
RMA Chief Risk Officer Forum
Sydney
15 September 2015
Thank you to the Risk Management Association for again inviting me to address the annual
CRO Forum. These are important events, and APRA is certainly keen to continue to support
them.
My remarks today have been titled ‘In Search Of …. Unquestionably Strong’. Some people
in the room may recall a television series in the late 1970s and early 1980s called ‘In
Search Of …’. The late Leonard Nimoy was the host, and each episode was some form of
investigation or exploration of controversial and mysterious phenomena: 30 minutes each
week devoted to topics such as Bigfoot, the Bermuda Triangle, and the possibility of
visitors from elsewhere in the universe. This sort of thing fascinated me in my youth.
Alas, there is nothing quite as fascinating on the prudential regulator’s watch. But the
Financial System Inquiry has sent us on a new search: to find a standard for
‘unquestionably strong’. As you know, the first recommendation of the FSI was that APRA
should:
“set capital standards such that Australian authorised deposit-taking institution
capital ratios are unquestionably strong.”1
But what ‘unquestionably strong’ meant precisely was largely left for APRA to determine.
We were given some guidance by the FSI, in the suggestion we aim for top quartile
positioning against international peers – and as you know we recently published a study on
how the major banks stack up against that benchmark. But we also made clear that we
don’t think that international comparisons should be the ultimate benchmark against
which ‘unquestionably strong’ is judged. It is undoubtedly a useful sense check, and one
we will continue to make use of, but we are reluctant to tie ourselves mechanically to a
moving target based on an international peer group ranking.
There are two basic reasons for that reluctance.
First and most importantly, because APRA should have the final say on the calibration of
Australian capital standards, and not have it determined by changes in the ratios of
foreign banks. And secondly, because precise comparisons are hard: there is no single,
internationally-harmonised capital ratio that we can readily use to benchmark Australia
against. The Basel framework is a set of minimum standards, and jurisdictions are free, as
APRA has done, to strengthen them where needed for domestic purposes. But these
domestic adjustments mean that, beyond a certain point, precise comparability is
considerably diminished.
I’m going to spend my time today offering a few thoughts on the issue of top quartile
positioning, in the context of the search for ‘unquestionably strong’. In doing so, I want
to:

reinforce the point that top quartile positioning is just one means of looking at the
issue, and certainly not the only one we will use;

highlight that there are many unknowns about the way capital adequacy will be
measured in future, so what I have to say today is not the end of the story; and

remind you that capital is just one measure of the strength of an ADI, and ideally we
should think about ‘unquestionably strong’ with a broader perspective.
1
Financial System Inquiry (November 2014), Final Report, p41.
2
With those points in mind, I am going to preface my remarks with much the same
disclaimer that was used by the ‘In Search Of …’ series:
“This [speech] presents information based in part on theory and conjecture. The
[speaker's] purpose is to suggest some possible explanations, but not necessarily
the only ones, to the mysteries we will examine."
The obvious starting point is: how do we see the capital position of the Australian banking
system today?
APRA continues to be of the view that the Australian banking system is soundly
capitalised. That starting assessment is importance because, as much as a relative
comparison is important, absolute levels of capital matter too.
Viewed historically, the banking
system’s risk-based capital ratios
are as high as they have ever been.
The system’s CET1 capital ratio
was 9.6 per cent at end June 2015:
more
than
twice
minimum
requirements, and appreciably
above the top of the regulatory
buffer requirements. And there
have been additional capital
raisings since that time which will
in all likelihood further increase
the system capital ratio when it is
next reported at the end of
September. That we have a
soundly-capitalised banking system
has been critical to the relatively
smooth adjustment that has been made to the stronger requirements of Basel III (and for
the largest banks, the D-SIB regime). Like many Asian jurisdictions with strong capital
adequacy frameworks, the implementation of the post-crisis reforms – and the transition
to a new world of permanently higher capital requirements – has been quite orderly.
But as the FSI noted, even if well-capitalised by domestic measures, Australia needs to be
mindful of international comparisons (notwithstanding their shortcomings). We have a
banking system with a material reliance on foreign funding, so ensuring foreign investors
(both in debt and equity) have an understanding of that strength is important to the
functioning of Australia’s financial system.
Our recent study that attempted to do an international capital comparison suggested the
capital ratios of the major banks might, if measured on a basis more consistent with their
peers, be on average around 300 basis points higher.2 There are plenty of caveats to this,3
but it provides a useful rule of thumb. At the time we did our study, the average reported
2
See APRA (July 2015), ‘Information Paper: International Capital Comparison Study’. Available at
www.apra.gov.au
3
As the study noted, APRA did not have access to the data for individual banks in the peer group. As a
result, it was not possible to adjust for some country-specific differences in the application of the Basel
framework. APRA was also unable, due to insufficient data, to adjust reported ratios for the impact of the
capital floor (ie the floor that limits the extent of capital benefit that banks can receive from moving from
standardised risk weights to risk weights derived from internal models). This floor is applied in almost all
jurisdictions other than Australia, although not always in a consistent manner. It is possible that the floor
could have a material impact on the relative positioning of Australian banks vis-à-vis their international peers.
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CET1 ratio across the major banks was 8.6 per cent: we adjusted that up to 11.7 per cent
for a more ‘apples for apples’ comparison. We took as our sample of peers the 100 or so
so-called Group 1 banks in the Basel Committee’s Quantitative Impact Study (QIS): within
this sample, the 75th percentile was 12.4 per cent. On that basis, we concluded that, in
broad terms, positioning CET1 capital ratios at the bottom of the fourth quartile would
require those ratios to be increased by around 70 basis points.
When we published the study, we were conscious that (amongst other things) the data we
were using was already a year old – it was as at June 2014. Beyond the technical
complexity in making these sorts of comparisons, that’s another reason why they are
difficult: by the time you have the data to complete them, there is a risk that the
conclusions are out-of-date. Nevertheless, as broad indicators of relative positioning, and
given we don’t intend to tie ourselves to a precise percentile, we think they at least give
us something reasonable to work with.
I don’t need to make this audience aware that we also recently announced a change to
risk weights for the residential mortgage exposures of banks using the internal-ratings
based (IRB) approach for capital adequacy. By adjusting a parameter within the IRB
formula for mortgage exposures, the average risk weight on Australian residential
mortgage exposures will increase from approximately 16 per cent to at least 25 per cent.
Broadly speaking, this is the equivalent of increasing minimum capital requirements for
the major banks by approximately 80 basis points. Obviously, the impact will vary
somewhat from bank to bank, depending on the size and nature of their lending portfolio.
All other things being equal, this change will lower the banks’ reported capital ratios, but
– because we’ll adjust for it when we next update our study – leave their relative position
internationally unchanged. However, to the extent that the banks respond to the
increased risk weights by increasing their actual capital levels by a corresponding amount –
which is by and large what is occurring – their current reported capital ratios will be
maintained when the higher risk weights come into effect, and their position relative to
international peers will be improved.
It is coincidental that the 80 basis point increase in capital required to maintain capital
ratios in response to the change in mortgage risk weights is just slightly more than the
estimated 70 basis point gap to the 75th percentile that we found in the international
capital comparison study. But it is also quite fortuitous. By moving quickly on this FSI
recommendation, it means that, once the current round of capital raisings are completed,
the CET1 gap that was identified
in June 2014 is likely to have been
substantially closed. That is
important, because it provides
APRA with more time to assess
what further steps we might want
to take, and when, to settle on a
final standard for ‘unquestionably
strong’. In particular, we have
now created the capacity for APRA
to observe and respond to
international developments – of
which I’ll speak more about
shortly – over the next year or so
without a pressing need to move
sooner on domestic measures. And
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assuming, in the meantime, ADIs continue to take sensible opportunities to accumulate
capital they should be well-placed to accommodate future events.
That doesn’t, however, mean we can sit back and relax, or regard the job as complete –
far from it. Beyond the current (actually, 12 months old) gap of 70 basis points, our study
endeavoured to judge where capital ratios might need to settle in the longer term if they
were to be comfortably positioned in the top quartile. Our conclusion was that Australian
major banks are likely to need to increase their capital ratios by at least 200 basis points,
relative to their position in June 2014, over the medium- to long-term.
The first thing I’d like to stress is that figure is very much an estimate. Certainly, it is our
best estimate, and designed to give a sense of our current understanding of what might be
needed. We included the words ‘at least’ because there are reasons to think it might be
more, rather than less. And we referred to ‘capital ratios’ to reflect this was not just a
CET1 measure. But it’s difficult to be more precise based on the information we have
today: there are still too many unknowns and moving parts. Let me quickly list a few.

First, we know that banks around
the world are continuing to build
up capital. In each QIS published
by the Basel Committee, the 75th
percentile has increased – on
average by about 20 basis points
each six months. We expect that
the next QIS study – which will be
published in the next day or so –
will see the top quartile capital
ratios drift marginally higher
again. At some point over the
next couple of years this trend
will likely cease as the global
banking system completes its
recapitalisation but for the time
being there is good reason to think that there will be further increases in the capital
ratios necessary to attain top quartile positioning.

Second, the 70 basis points gap at June 2014 was an estimate of the minimum amount
necessary to achieve 75th percentile positioning. In practice, being comfortably
positioned in the top quartile would suggest targeting something more than the very
bottom of the quartile, to give a margin of comfort that the positioning will be
maintained over time.

Third, we recognised that there were aspects of the comparison for which we could
not make adjustments - areas where we know that other jurisdictions impose
requirements, like APRA, that are in excess of the Basel minimums, but for which we
had insufficient data to account for. We said in the study that there weren’t likely to
be too many of these items, but they might mean we have slightly overstated the
relative position of the Australian majors.
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
Fourth, while CET1 ratios are
obviously of prime importance,
they are not the full story. We
did our comparisons using four
different capital measures, since
all are relevant for considering
financial strength. We found the
Australian majors rank lower
when, for example, total capital
and leverage ratios are used in
the comparison. While we might
give primacy to the CET1 ratio,
we shouldn’t fixate on it alone.
We know that in the financial
crisis, the leverage ratio –
despite (or perhaps because of?)
its simplicity – was something
investors paid attention to. We need to be mindful that the strengthening of
Australian risk-based capital ratios has not generated an equivalent strengthening of
leverage ratios thus far.

Finally, there are of course a range of initiatives coming down the pipeline from the
Basel Committee that could materially change the capital framework. The entire
framework of risk weights – standardised and model-based – is under review, as are
the trading book and operational risk regimes. The Committee is also updating the
operation of the so-called capital floor – something that APRA did away with some
years ago on the basis that it was not binding. In a revised form, that may not be the
case in future. Of course, these changes will affect all banks around the world in some
way but, in the context of international relativities, some of the changes may well
affect Australian ADIs to a proportionally greater extent than is the case in some other
jurisdictions.
All of this means there are plenty of balls in the air at present and how they will land is
not yet clear. The uncertainty that is created has been described as unhelpful: if it’s any
consolation to you, I agree. Both regulators and banks would benefit from more certainty
about the final shape of the regulatory framework. But while there is much that is
uncertain, one thing that is clear is the direction the world is moving. That is towards
higher capital ratios, reflecting a view that not enough has yet been done to deliver a
resilient financial system taking into account the lessons of the financial crisis. So
continuing to steadily accumulate capital looks to be a sensible strategy for a while yet.
Before I finish, I want to make two other important comments.
The first is that, while capital comparisons across jurisdictions are useful, there is a more
fundamental capital comparison that no one can afford to lose sight of. That is the
comparison of Australian capital ratios against Australian minimum requirements. For all
the effort put in to providing comparable measures of capital, what ultimately counts – to
investors as well as regulators – is how much capital a bank has over and above its
regulatory minima. When I convert my height from inches to centimetres, I produce a
bigger number but I don’t get taller. Similarly, converting an APRA-defined capital ratio
into some other (higher) measure doesn’t make a bank sounder, or create any extra
capital buffer. That’s another reason why we’re a little wary of giving too much
prominence to international comparisons: if investors are interested, as they should be, in
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the likelihood that a regulator might intervene in the affairs of a bank, then the buffer
between the locally-calculated ratio and the locally-calculated minimum is what counts.
And finally, I’ve spent a lot of time today talking about capital levels, but it’s important
we don’t lose sight of the fact that an unquestionably strong bank requires more than just
plenty of capital. In banking, asset quality, liquidity and funding, earnings and
management quality are also highly relevant to financial strength. In fact, if a bank is weak
in these areas, a strong capital position won’t last long. What is ‘unquestionably strong’
therefore needs to be viewed in the context of the other risks to which a bank is exposed,
and the environment in which it operates.
I was careful in my opening remarks to stress that APRA was still thinking about how to
define ‘unquestionably strong’ and the role of top quartile positioning. As of today, I think
there are five key points to make:

we have a soundly capitalised banking system overall in Australia;

with the aid of recent capital raisings, the initial 70 basis point CET1 gap to the top
quartile that we identified is likely to have been substantially closed;

higher capital ratios are likely to be needed if current relative positioning is to be
retained and enhanced, particularly if measures beyond CET1 are examined;

by quickly moving on the FSI recommendation regarding mortgage risk weights, APRA
has created time to consider international developments emerging over the next year
or so; and

given where we are today, APRA and the banking industry have time to manage any
transition to higher capital requirements in an orderly fashion.
The need to accommodate international developments means that there is good reason not
to rush to set a standard for ‘unquestionably strong’. It is also important that, when we
settle on an ‘unquestionably strong’ standard, we capture wider perspectives of a bank’s
strength than just capital.
Unfortunately, talking about that wider perspective would require a second episode of ‘In
Search Of ….’ to cover. However, for those of you who are interested in it, I’ll be giving
another speech on that issue very soon. So stay tuned!
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