Basel III Capital & Liquidity: Strategic Opportunities & Threats

Basel III Capital and Liquidity Strategic Opportunities and Threats Finance and Risk forum Nov 2012 Presented by David Tattam

Agenda • The Basel Background - I & II • Why Basel III? • Basel III overview • Capital changes • Liquidity changes • Likely impacts on the financial markets • Opportunities and Threats for Mutuals

Two Pillars 1. Minimum capital requirements 2. Supervisory review process Risk weighted assets Definition of capital Credit Risk (1988) Traded Market Risk (1996) Standardised Approach Internal Models Approach Basel I: 1988 - 2008

Three Pillars 1. Minimum capital requirements 3. Market Discipline -disclosure 2. Supervisory review process Risk weighted assets Definition of capital Credit Risk Operational Risk Traded Market Risk Core Capital Supplementary Capital Standardised Approach Internal Ratings-based Approach Standardised Approach Advanced Measurement Approaches Standardised Approach Internal Models Approach Basel II: 2008 – ….. Non-Traded Market Risk

How did Basel II fair in the GFC? • Capital levels required by Basel II were inadequate • Capital requirements were cyclical and reinforced, rather than reduced, business cycle fluctuations; • The assessment of external credit risk is delegated to non-banking institutions, such as rating agencies, subject to possible conflicts of interest • The assumption that banks’ internal models for measuring risk exposures proved wrong; • Basel II provided incentives to intermediaries to put risky exposures off-balance sheet • Basel II did not provide sufficient liquidity levels or drive appropriate matching of asset and liability maturity • No special provisions for “Too Big to Fail” Banks

Basel III Objectives The Basel III reforms are aimed at improving the resilience of the global banking system by: raising the quality, quantity and international consistency of bank capital and liquidity constraining the build-up of leverage and maturity mismatches introducing capital buffers that can be drawn upon in difficult times. improving risk management and governance strengthening banks’ transparency and disclosures. Source: Bank Regulation and the Future of Banking – John Laker, July 2012

Main elements of Basle III Capital Strengthening • New definition of regulatory capital under which common equity is the predominant form of Tier 1 capital; • Stricter approach to regulatory adjustments under which most deductions from capital are to be from Common Equity Tier 1 capital; • an increase in the minimum amounts of capital • Common Equity Tier 1 Capital must be at least 4.5 per • Tier 1 Capital ratio at least 6 per cent • New capital conservation buffer of 2.5 %. Constraints on capital distributions where an ADI’s falls within the buffer range; • New countercyclical buffer of up to 2.5 per cent applied with discretion by APRA when excessive credit growth and other indicators point to a system-wide build up of risk; and • New leverage ratio to help contain the build up of leverage in the banking system

Main elements of Basle III Liquidity Strengthening • Stricter definition of HQLA • 15 Month going concern cash flow forecast • Liquidity Coverage Ratio (LCR) for major banks • Net Stable Funding Requirement (NSFR) for major banks

Main Basel III Changes

Basel 2.5 changes - timetable Source: PwC http://www.pwc.com.au/industry/financial-services-regulation/assets/Landscape-for-Banks-Sept2011.pdf

Basel III changes - timetable Source: PwC http://www.pwc.com.au/industry/financial-services-regulation/assets/Landscape-for-Banks-Sept2011.pdf

Capital Adequacy Ratio Capital > PCR% Risk weighted assets Credit Risk Operational Risk Traded Market Risk (N/A as do not trade)

Capital Adequacy Ratio Capital > PCR% Risk weighted assets

Capital Focus on Common Equity • Retained Earnings • Ordinary Shares

APRA submissions 30 Mar 2012 “Another theme in submissions was that the Basel III reforms presented particular difficulties for ADIs with a mutual corporate structure, which are unable to issue ordinary shares. APRA acknowledges this concern and will consult separately with mutual ADIs on the issues raised.”

Common equity – Ordinary shares • Prohibition against a contractual cap • ASIC - dividends in ‘investor shares issued by a mutual entity must be limited by reference to an external benchmark of not more than a fixed percentage of the company’s annual profit after tax’. • APRA understands that instruments providing for the payment of dividends by reference to an external benchmark or a fixed proportion of after tax profits will not be inconsistent with the Basel III prohibition provided that: • there is no linkage between dividend payments and the price paid at issuance; • the amount is a maximum amount, does not operate as a de facto minimum and the ADI retains full discretion to reduce or waive distributions/ payments where necessary; and • there are no other features that could weaken the ADI as a going concern during periods of market stress.

Nationwide Building Society UK • Core Capital Deferred Shares (CCDS) • No fixed dividend – discretionary payments • Cap of 15%. Will vary each year based on CPI • No redemption or call date • 1 vote per institutional investor regardless of holding • Will be listed

Risk Weighted Assets • Securitisation • Capital Relief • Investments – Securitisation and Re-securitisations • Credit Risk on derivatives • Market Risk

PCR% • Capital Conservation Buffer • Countercyclical Buffer • Higher capital composition thresholds: • Common Equity • Higher Tier 1 • Leverage Ratio The unfettered power of the PCR% !!

Basel III – Capital Strengthening Rules Capital ratio 8.0% Conservation Buffer 2.5% 10.5% Counter-cyclical buffer 0% - 2.5% Effective minimum capital ratio 10.5% - 13%

APRA Implementation

Basel III Capital Changes Source: Morrison/Forester

Capital • Currently major banks common equity = 8% using BIII but 1.1% lower using APRA’s tighter definition (Equity Inv in affiliates and deferred tax assets are deductibles). • Expected dividends no longer need to be deducted • All prudential capital needs to be equity, become equity, or be cancelled in the event of a failure. Because this rule has not applied to the current stock of non-common equity capital, the current Australian stock does not comply with Basel III for the banks. Will need replacing.

Leverage Ratio • Focussed on reducing / controlling leverage in banking system • Numerator = T1 capital • Denominator = all on and off-balance sheet exposures, including derivatives converted to a loan equivalent • Capped at 3%, subject to review in 2017 • Monitoring started 1st January 2011 • Disclosure starts 1st January 2015 • Should be no problem in compliance for Australian ADIs and all apparently currently comply

ICAAP Changes (1 Jan 13)CPG 110 • Incorporates Risk Appetite • Focus on integration of ICAAP, Risk Management, Strategic and Business Plans, Risk Appetite • ICAAP Polices and Procedures • Bottom up and Top down approaches • Determine quantity and quality of capital • Ensure includes stress testing and scenario analysis; • Independent review by skilled persons • implement appropriate processes for reporting to Board (and APRA) on the ICAAP and its outcomes; • prepare an ICAAP summary statement and an ICAAP report to be submitted to APRA annually

Liquidity Problems • Too much reliance on foreign funding • Too much reliance on short term funding • Inadequate funding plans • Inadequate levels of liquid assets

Liquidity MLH ADIs • Qualifying HQLA • Cash flow forecasting Scenario ADIs • Qualifying HQLA • HQLA Requirements • Longer term funding • Cash flow forecasting (stressed)

HQLA • Highest quality bucket (Level 1 HQLA) comprises: • cash; • central bank reserves • marketable securities representing claims on or claims guaranteed by sovereigns, quasi-sovereigns, central banks and multilateral development banks, which have undoubted liquidity, even during stressed market conditions, and which are assigned a zero risk-weight under the Basel II standardised approach to credit risk. • 40 per cent of the LCR portfolio can be held in assets defined areas Level 2 HQLA which comprise “assets with a proven record as a reliable source of liquidity”. • APRA has interpreted HQLA1 as: cash, balances with the RBA, and Commonwealth Government and semi-government securities. They also have indicated that there are “no assets that qualify as HQLA2″

MLH Eligible Assets (a) cash; (b) Commonwealth Government and semi-government securities; (c) debt securities guaranteed by the Commonwealth Government or the government of an Australian State or Territory; (d) bank bills, certificate of deposits (CDs) and debt securities issued by ADIs; (e) debt securities issued by supranationals and other foreign governments; (f) deposits (at call and any other deposits readily convertible into cash within two business days) held with other ADIs net of placements by the other ADIs; and (g) any other securities approved by APRA. • Readily convertible into cash within 2 business days • No more than 20% can be Credit Rating 3 or less • No to include RMBS and ABS Securities

Liquidity Coverage Ratio LCR • LCR – 2015 – not Mutuals. 30 day stress survival period. 4 times more demanding than current stress of 5 days. Banks running at a third of what they need to be. • Reduce cash outflows in 30 days – 31 day call deposit, avoid early termination of TDs • Covered bonds • Increase HQLA – not easy as lack of paper • Committed Liquidity Facility (CLF) • Drying up of liquidity on Gov and Semi Gov bond market • Self securitisation

Liquidity Liquidity coverage ratio High quality liquid assets • 60% Level 1 assets (min): Cash, central bank reserves, and sovereigns • 40% Level 2 assets (max): Non-financial corporate or covered bonds rated AA- or above. Possibly some RMBS. Expected cash outflow • Run-off rates: the amount of funding maturing in the 30-day window that won't roll over. E.g.: • 5-10% for deposits • 25-75% for Non-financial corporates, sovereigns, central banks, and public sector entities • 100% for financial institutions

Impact of LCR • Major banks (June 2011). HQLA $132bn, Need $429bn, shortfall $297bn • Reduce requirement (30 day cash outflow) or increase HQLA • Insufficient HQLA in Australia • Committed Liquidity Facility – CLF. Must exhaust other avenues. Cost 15bpts + collateralise with repo eligible securities (RMBS, Covered Bonds)

Liquidity • CLF cost is 15 bpts. If banks hold 20% in liquidity, cost is 20% * .15% = 3 bpts. Compare to if hold actual assets. For major banks, cost expected to be between 7 and 10 bpts.

Net Stable Funding Requirement NSFR NSFR – 2018 – not Mutuals. Banks around 80%. LCR will get to around 85%. Deposits must grow greater than illiquid assets

Net stable funding ratio • Is a ratio of available amount of stable funding to a required amount of stable funding. This ratio must be greater than 100%. • “Stable funding” is defined as those types and amounts of equity and liability financing expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress. The amount of such funding required of a specific institution is a function of the liquidity characteristics of various types of assets held, OBS contingent exposures incurred, and/or the activities pursued by the institution.

Summary • Liquidity Cover Ratio • Maintain enough liquid assets for 30 days to cover cash outflow in a stress scenario • Net Stable Funding Ratio • Maintain enough stable sources of funding for 1 year to cover illiquid assets and contingent calls

Impact? “In general, more capital in banking institutions in any jurisdiction means slightly higher lending interest rates, less borrowing, and slower economic growth in good times. But on the other hand, more capital means safer banking institutions and a safer financial system, reducing the risk of bank failures and financial crises. The challenge for APRA and global regulators is to balance the benefits of safer banking systems, with any output, efficiency or competition costs associated with higher capital requirements.” APRA Insight Issue 2/2012

Impacts “… Australian banks, and Australian ADIs more generally, are well placed to meet the new standards. As best we can tell, we aren’t too far from our destination, so the cost of the journey there shouldn’t be too great. We are unlikely to face the potentially large transition costs that are of more concern in some other jurisdictions …” - Wayne Byres, Executive General Manager, Diversified Institutions Division, APRA (“Basel III: The Journey and the Destination” presented to the LaTrobe Finance and Corporate Governance Conference on 29 April 2011)

Impacts “the importance of distinguishing between the costs to banking institutions of holding higher levels of capital and liquidity, which are largely private costs, and the economic benefits of a safer global banking system that would be less prone to financial crisis. These benefits will accrue as private benefits to the shareholders of banking institutions; they will also accrue as public benefits to the real economy and taxpayers. John Laker - APRA’S BASEL III IMPLEMENTATION - INTRODUCTORY REMARKS – Finsia – Nov 11

Costs The ‘cost’ element in the chain of economic effects of such higher regulatory capital is: 1. higher bank equity ratios; 2. higher weighted funding costs (including debt and equity funding) and lower return on equity; 3. banking institutions increase lending rates to restore some of their lost return on equity; 4. borrowers increase their aggregate borrowings more slowly than would otherwise have been the case; and 5. GDP grows more slowly than would have otherwise been the case, for most of the business cycle.

Benefits The ‘benefit’ chain is: 1. higher bank equity ratios; 2. safer banks, which can therefore borrow funds and raise capital more cheaply; 3. reduced bank failure and impairment rates; and 4. reduced risk and potential depths of financial crises.

Impact on Mutual ADIs Basel III Banks Mutual ADIs

G-20 SIFIs • Bank of America • Bank of China • Bank of New York Mellon • Banque Populaire CdE • Barclays • BNP Paribas • Citigroup • Commerzbank • Credit Suisse • Deutsche Bank • Dexia • Goldman Sachs Group • Crédit Agricole • HSBC • ING Bank • JP Morgan Chase • Lloyds Banking Group Mitsubishi UFJ FG • Mizuho FG • Morgan Stanley • Nordea • Royal Bank of Scotland • Santander • Société Générale • State Street • Sumitomo • Mitsui FG • UBS • Unicredit Group • Wells Fargo

Basel III Capital & Liquidity: Strategic Opportunities & Threats