Late last week the ANZ Bank released it’s “Basel II Pillar 3, APS 330: Capital Adequacy & Risk Management in ANZ” document. Even the title makes you think that this is something for the in-crowd. That, with any luck even though it must be released to the market, no-one will understand it.
And for the record, we don’t claim to have any better idea than anyone else what it all means. So, rather than spout off, we’ll just deliver you a few of the headlines from it:
- ANZ’s total credit exposure is $537 billion. Of which $239bn is corporate and $187bn is residential.
- It has a “General reserve for credit losses” of $2.8bn. That means, loans that it doesn’t expect to be repaid. With $367 million of personal lending that it has, or is expecting to write-off this year.
To put that in perspective, APRA also tells us that as of the end of October, ANZ held approximately $51 billion of household deposits. Plus about another $78bn of commercial deposits.
In the last two years all the major banks have increased both their deposits and their lending. ANZ’s lending against owner-occupied housing has increased from $66bn in 2006 to $86bn to the end of October this year.
So, what does this tell us about the stability of the Australian banking system? We are told by the banks, government and regulators that Australian banks are strong. Even so, it was deemed necessary to introduce a government back deposit insurance.
Chances are that Australian banks will be able to weather the current storm. But we do question their ability to continue to grow revenues.
Quite simply, the last thirty years has seen a huge expansion in credit. It has helped to push up and support increased asset prices, not because a house has any actual increased value, but rather because the increase in credit has enabled buyers to borrow more and encouraged sellers to ask for a higher price.
So, if the markets now generally agree that there has lending levels have reached unacceptable levels it must therefore be the case that asset prices should fall. For, if banks are imposing stronger lending criteria then it must mean that fewer dollars will be loaned out to purchase assets.
And what about all those loans that were funded using cash made available by securitizing loans? How is that going to be replaced?
Therefore, if the banks are lending out fewer dollars their revenue streams will also be impacted. This should inevitably mean that spreads between the cash rate and mortgage lending rates will widen as the banks strive to maintain profit margins.
But will shareholders be happy with a new world of lower growth? Or, given a bit of breathing space will the banks eventually rediscover their appetite for increased risk?
We would think the latter is more likely the case. Markets very rarely learn their lesson.
The Exciting World of Basel II
Here’s something you don’t see very often. Last week the Australian Prudential Regulation Authority (APRA) sought to strenuously deny that it had tightened its Tier 1 capital ratio.
According to the standards set by Basel II framework, “at least 50% of a bank’s capital base to consist of a core element comprised of equity capital and published reserves from post-tax retained earnings.” This is termed as the Tier 1 capital.
In simple terms this means the shareholders equity, plus retained earnings (ie. What is left over after dividends have been paid), adjusted for inflation.
Tier 2 makes up the other 50% and includes all the fancy investments: “Undisclosed reserves, Asset revaluation reserves, General provisions/general loan-loss reserves, Hybrid (debt/equity) capital instruments, Subordinated debt.”
The combined Tier 1 & 2 must then equate to 8% of “total risk-weighted assets.” In other words, a bank must have at least 8% of its capital in assets that are deemed to be liquid when adjusted for various weightings.
For instance, cash is weighted at 0% as it is presumed to be the most liquid, along with claims on other central banks. Gold may also be included at the discretion of a national government. Whereas residential mortgage loans have a 50% weighting and commercial loans have a 100% weighting. This is because both residential and commercial lending is viewed as being relatively illiquid. Which they are.
Compare the process for liquidating a share portfolio with liquidating a real estate portfolio and you can see the reason for weighting the assets that way.
It also helps to explain how so many of the US banks in particular have got into so much trouble. Bearing in mind that a loan to a first class borrower receives the same weighting as a loan to a “junk” borrower.
Therefore, if those banks have been using up all their cash to pay out depositors, meet margin calls or realize cash losses on liquid assets it can have a big impact on Tier 1 capital.
Cheers.
Kris.
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