On March 31 the Treasury closes the formal consultation process on the final report of the Financial System Inquiry (FSI), which makes 44 recommendations on a wide variety of topics on Australia’s financial regulation.
One of the most controversial aspects of the FSI final report regards Recommendation 1 on bank capital levels. Such a recommendation prescribes “set capital standards such that Australian authorised deposit-taking institution [ADI] capital ratios are unquestionably strong”. According to the Inquiry, the baseline target is to place Australian ADIs in the top quartile of internationally active banks.
The main purpose of this recommendation is to increase the resilience of Australia’s financial system when faced with yet another GFC-type scenario. The argument is that the higher the capital level a bank possesses, the more resilient it becomes to external shocks. Few would dispute this relationship between capital levels and loss-absorbing capacity, and similarly few would dispute the laudable cause of increasing resilience in the financial system.
Yet there are a few concerns with Recommendation 1 that were left unresolved.
The first issue regards how to properly assess capital requirements. Different assets carry different risks. For example, a million dollars in Treasury bonds is safer than a million dollars in subprime commercial bonds. This problem is so acute that experts cannot agree on a universal yardstick to measure risk-adjusted capital ratios. As Figure 4 in the FSI report shows, the adjusted Australian major bank average ratio could range — depending on the calculation source — from 9.2 percent (Basel Committee on Banking Supervision), to 10.0 percent (Australian Prudential Regulation Authority), to 12.7 percent (Australian Bankers’ Association).
If we cannot agree on measurement units, can we successfully verify the international top-quartile baseline target? The answer is: no, we cannot. Even the Inquiry in its final report recognises the impossibility: “no benchmark of international practice exists for calculating capital ratios … it is highly complex to compare even two jurisdictions, let alone to compare all jurisdictions”.
Putting aside these technical nuisances on capital ratio yardsticks, there is another incongruence with the baseline target itself. There is no theoretical or evidence base in the FSI report for why the top quartile was picked, which makes it an unsubstantiated magic number. However, capital requirements should not to be treated like an Olympic medal tally — the international banking system is not a racing podium.
Another major weakness in Recommendation 1 is that it underplays the other side of the coin on capital levels: the cost of raising capital. Make no mistake, it is costly – which is why banks are reluctant to voluntarily increase their capital ratios. Capital requirements costs are dynamic, non-linear and at many points stochastic, which means they are extremely hard to predict and vary in nature and volume according to daily conditions of the market.
Fiddling with bank’s decision on its right balance of capital ratios might affect its profitability, which in turn impacts the ability to raise funds, potentially damaging the financial health of industry. There is much art to the science of capital levels. No one, not a government, is able to fully understand the complexities of the subject. A well-intentioned recommendation can therefore have adverse effects to its original goal. Ultimately, the strength of the financial system lies in the business strength of its members.
An interesting feature of capital ratios is the trade-off between potential benefits combined with increasing costs, which opens room for an optimal point. Like most things in life, we are faced with excluding choices — as one must forgo something in return for gaining another.
The perils of Recommendation 1 can be understood as a situation of ‘speed limits vs car crashes’. We can reduce — or even eliminate — all car crashes in Australia if we limit our travel speed at 25km/h. Yet imagine the economic and social costs of such drastic measure. Even though there are more than a thousand fatal car crashes in Australia every year, killing people and imposing emotional losses to friends and family members, we are reluctant to decrease of speed limits, and often see lobbying to have them increased.
Are we willing to slow the speed limit of Australia’s financial market? The impact on production, economic development and jobs could be devastating.
Ideas to completely overhaul the banking system are not new. Back in 1933 the Chicago Plan advocated for 100 per cent capital ratios. Some libertarians, on the other side, call for completely leaving free markets to decide. The (as yet unknown) optimal point might be in middle.
Instead of top-down, fixed-jacket regulations on the right amount of capital levels, Australia’s financial system would benefit more from a humble, bottom-up approach largely reliant on industry input. Our banking system already proved to have sound resilience through the GFC, deemed to be the largest international crisis since 1929. It deserves more credit—and a far bigger seat at the table—in designing the right recipe for Recommendation 1.
Dr Patrick Carvalho is a Research Fellow at the Centre for Independent Studies.
Home > Commentary > Opinion > Car crashes and banking capital levels
Car crashes and banking capital levels
One of the most controversial aspects of the FSI final report regards Recommendation 1 on bank capital levels. Such a recommendation prescribes “set capital standards such that Australian authorised deposit-taking institution [ADI] capital ratios are unquestionably strong”. According to the Inquiry, the baseline target is to place Australian ADIs in the top quartile of internationally active banks.
The main purpose of this recommendation is to increase the resilience of Australia’s financial system when faced with yet another GFC-type scenario. The argument is that the higher the capital level a bank possesses, the more resilient it becomes to external shocks. Few would dispute this relationship between capital levels and loss-absorbing capacity, and similarly few would dispute the laudable cause of increasing resilience in the financial system.
Yet there are a few concerns with Recommendation 1 that were left unresolved.
The first issue regards how to properly assess capital requirements. Different assets carry different risks. For example, a million dollars in Treasury bonds is safer than a million dollars in subprime commercial bonds. This problem is so acute that experts cannot agree on a universal yardstick to measure risk-adjusted capital ratios. As Figure 4 in the FSI report shows, the adjusted Australian major bank average ratio could range — depending on the calculation source — from 9.2 percent (Basel Committee on Banking Supervision), to 10.0 percent (Australian Prudential Regulation Authority), to 12.7 percent (Australian Bankers’ Association).
If we cannot agree on measurement units, can we successfully verify the international top-quartile baseline target? The answer is: no, we cannot. Even the Inquiry in its final report recognises the impossibility: “no benchmark of international practice exists for calculating capital ratios … it is highly complex to compare even two jurisdictions, let alone to compare all jurisdictions”.
Putting aside these technical nuisances on capital ratio yardsticks, there is another incongruence with the baseline target itself. There is no theoretical or evidence base in the FSI report for why the top quartile was picked, which makes it an unsubstantiated magic number. However, capital requirements should not to be treated like an Olympic medal tally — the international banking system is not a racing podium.
Another major weakness in Recommendation 1 is that it underplays the other side of the coin on capital levels: the cost of raising capital. Make no mistake, it is costly – which is why banks are reluctant to voluntarily increase their capital ratios. Capital requirements costs are dynamic, non-linear and at many points stochastic, which means they are extremely hard to predict and vary in nature and volume according to daily conditions of the market.
Fiddling with bank’s decision on its right balance of capital ratios might affect its profitability, which in turn impacts the ability to raise funds, potentially damaging the financial health of industry. There is much art to the science of capital levels. No one, not a government, is able to fully understand the complexities of the subject. A well-intentioned recommendation can therefore have adverse effects to its original goal. Ultimately, the strength of the financial system lies in the business strength of its members.
An interesting feature of capital ratios is the trade-off between potential benefits combined with increasing costs, which opens room for an optimal point. Like most things in life, we are faced with excluding choices — as one must forgo something in return for gaining another.
The perils of Recommendation 1 can be understood as a situation of ‘speed limits vs car crashes’. We can reduce — or even eliminate — all car crashes in Australia if we limit our travel speed at 25km/h. Yet imagine the economic and social costs of such drastic measure. Even though there are more than a thousand fatal car crashes in Australia every year, killing people and imposing emotional losses to friends and family members, we are reluctant to decrease of speed limits, and often see lobbying to have them increased.
Are we willing to slow the speed limit of Australia’s financial market? The impact on production, economic development and jobs could be devastating.
Ideas to completely overhaul the banking system are not new. Back in 1933 the Chicago Plan advocated for 100 per cent capital ratios. Some libertarians, on the other side, call for completely leaving free markets to decide. The (as yet unknown) optimal point might be in middle.
Instead of top-down, fixed-jacket regulations on the right amount of capital levels, Australia’s financial system would benefit more from a humble, bottom-up approach largely reliant on industry input. Our banking system already proved to have sound resilience through the GFC, deemed to be the largest international crisis since 1929. It deserves more credit—and a far bigger seat at the table—in designing the right recipe for Recommendation 1.
Dr Patrick Carvalho is a Research Fellow at the Centre for Independent Studies.
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