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BFCSA: Christopher Joye explains in AFR - worse than the GFC. APRA allowed Major Banks lowering of risk weightings to 15% in 2008

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New data released during the week allows us to objectively lift the lid on the true level of risk in Australia’s banking system. Remarkably the evidence suggests the biggest banks have actually reduced tier-one “equity” capital and increased leverage over the past decade, which contradicts the consensus that our banks are more conservatively capitalised since the global financial crisis.

Information published by the Australian Prudential Regulation Authority (APRA), which should be carefully inspected by David Murray’s financial system inquiry, addresses several myths that investors and financial advisers have swallowed hook, line and sinker.

The $400 billion too-big-to-fail major banks are leveraged about 10 times, right? Wrong.

But they have more loss-absorbing tier-one equity capital and less leverage than competitors? Incorrect.

Well, they have absolutely boosted equity and cut leverage after the lessons learned during the GFC about the ease with which highly geared entities fall over? Wrong again.

Every quarter, APRA reports statistics on the “performance” of all deposit-taking institutions. While the big banks like to criticise comparisons of their capital and leverage with overseas peers – which are hampered by differences in measurement methods – APRA’s data is beyond reproach. It is the final word on Aussie banking risk, given it is calculated and published by the regulator that sets the capital rules banks must abide by.

One of the first charts APRA published this week was the amount of “common equity tier-one capital” held by deposit-takers as a share of “risk-weighted” assets. This is similar to the first-loss equity home owners have invested in their property. If you have a 10 per cent deposit, you are leveraging that equity 10 times with your mortgage when you buy a home.


According to APRA, the major banks had 8.6 per cent common equity tier-one capital at June 30, 2014. That means they borrowed 91.4 per cent of the value of the assets on their balance sheets to fund them. Depositors and bond investors lend this money to banks. The assets are mainly residential home loans (about 65 per cent) and business and personal loans (the rest).

On this basis, the major banks look to be leveraged 11.6 times, which is not absurdly high. Nevertheless, APRA concludes that all “other banks” – including Bendigo & Adelaide, Bank of Queensland, AMP and SunCorp – hold significantly more equity (on average 9.8 per cent) and therefore less leverage (10.2 times) than the majors.

The remaining deposit-takers – building societies, credit unions and foreign subsidiary banks – are even more conservative. Their equity capital ranges, on average, from 15.1 per cent (foreign banks) to 16.6 per cent (building societies). Leverage is, as a result, about half the level adopted by majors at between 6.0 times (building societies) and 6.6 times (foreign banks).

Yet these capital and leverage estimates are misleading. In all other industries, leverage is calculated the same way – it simply equals the dollar value of an asset (say your home) divided by the dollar value of the equity you have in it.

But bankers and regulators heroically assume that a certain portion of residential home-loan assets are completely risk-free through the application of a concept called the “risk weighting”. Before 2008, all Australian home loans had a 50 per cent risk weighting, which meant bankers could suppose that only half the value of these loan assets would ever be at risk of loss.

If you thought a bank was holding a 10 per cent equity buffer against any losses on the home loans on its balance sheet, the real equity level before 2008 was 5 per cent. So true leverage was 20 times – not the 10 times widely believed.



Pretending that half the value of all loans are risk-free is an arbitrary guess that bankers and regulators have historically thought was safe. After 2008 bankers and regulators rather ironically agreed this assumption was too cautious. They had admittedly made their minds up years earlier without the benefit of witnessing the 30 per cent house price falls, soaring loan losses and many bank failures unveiled during the GFC.

In 2008 they reduced the already generous 50 per cent risk weighting to just 35 per cent for all “standard” home loans. So banks could hold less equity and more leverage. The news was even better for “advanced” banks, which in Australia only includes the four majors and Macquarie, which were permitted to determine their own “internal” risk weights.

Today the average risk weight applied by the majors to standard home loans is a stunningly low 15 per cent. This permits them to hold less than half the capital and more than twice the leverage of competitors when lending against Australia’s frothy housing market.

If you thought a major bank had tier-one equity capital of, say, 10 per cent against their home loan assets, a 15 per cent risk-weight means actual tier-one equity is only 1.5 per cent and real leverage is 67 times (rather than 10 times). Put another way, the majors retain less than $1.50 of equity capital for every $100 of home loans. Competitors hold 2.7 times this equity.

And this is where things get really interesting. Using the latest APRA data, we can examine the change in the major banks’ tier-one capital as a share of both risk-weighted assets and the dollar value of assets over time. Our analysis finds that the majors’ tier-one capital relative to the dollar value of loan assets has declined from 7.3 per cent in 2004 to 6.9 per cent in 2014.

Relative to total assets, tier-one capital has gone from 4.8 per cent to 4.7 per cent. Contrary to popular myth, major bank leverage has increased, not decreased, over this period from 20.7 times to 21.1 times.


It was only after 2008 when regulators allowed the majors to slash risk weightings on home loans from 50 per cent to 15 per cent today that we have seen their reported – and purely academic – tier-one capital measured against these newly “risk-weighted” loan assets – which shrunk in value – spike from 6.7 per cent in December 2007 to 10.5 per cent in June 2014. By arbitrarily boosting the risk-free share of major bank home loans from 50 per cent to 85 per cent via the regulatory artifice that is a risk weighting, one gets the fictional jump in their tier-one capital that everyone believes is real.


Naturally the story is very different for all “other banks” that did not benefit from the changes. They have indeed increased true tier-one capital held against gross loans from 7.2 per cent in 2004 to 8.2 per cent today (and thus lowered leverage) with, of course, no massive disconnect between real and risk-weighted capital after 2008.




A leading bank analyst, who requested anonymity, says the 70 per cent reduction in major bank risk weightings after 2008 has been “an immense regulatory arbitrage that is the cornerstone of their comparative advantage”. He confirms this accounts for “the majors’ reported increase in tier-one capital” and believes it is “a critical problem [Treasurer] Joe Hockey must address”.

The policy answer is not allowing governments to bail out banks by unilaterally converting debts into equity in a crisis. The banks need to hold more equity in the first place, which they will furiously resist.




The Australian Financial Review


Christopher Joye

Christopher Joye is a leading economist, fund manager and policy adviser. He previously worked for Goldman Sachs and the RBA, and was a director of the Menzies Research Centre. He is currently a director of YBR Funds Management Pty Ltd.

Follow us in Twitter@cjoye

Stories by Christopher Joye

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Guest Monday, 25 January 2021