Bank Capital Adequacy in Australia
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund
  • | 2 https://isni.org/isni/0000000404811396, International Monetary Fund

Contributor Notes

Author’s E-Mail Address: bjang@imf.org, nsheridan@imf.org

The paper finds that, given Australia's conservative approach in implementing the Basel II framework, Australian banks' headline capital ratios underestimate their capital strengths. Given their high capital quality and the progress in their funding profiles since the global financial crisis, the Australian banks are making good progress toward meeting the Basel III requirements, including the new liquidity standards. Stress tests calibrated on the Irish crisis experience show that the banks could withstand sizable shocks to their exposure to residential mortgages. However, combining residential mortgage shocks with corporate losses expected at the peak of the global financial crisis would put more pressure on Australian banks' capital. Therefore, it would be useful to consider the merits of higher capital requirements for systemically important domestic banks.

Abstract

The paper finds that, given Australia's conservative approach in implementing the Basel II framework, Australian banks' headline capital ratios underestimate their capital strengths. Given their high capital quality and the progress in their funding profiles since the global financial crisis, the Australian banks are making good progress toward meeting the Basel III requirements, including the new liquidity standards. Stress tests calibrated on the Irish crisis experience show that the banks could withstand sizable shocks to their exposure to residential mortgages. However, combining residential mortgage shocks with corporate losses expected at the peak of the global financial crisis would put more pressure on Australian banks' capital. Therefore, it would be useful to consider the merits of higher capital requirements for systemically important domestic banks.

I. Introduction

The Australian banking system was resilient during the global financial crisis, attributed in part to intensive supervision and sound regulation. The banking sector is profitable with capital above regulatory minimums and is dominated by four major banks (all Australian-owned). They are individually and collectively large relative to the size of the banking system and their combined assets are large relative to GDP.

Banks’ main vulnerabilities are their exposure to highly indebted households through residential mortgage lending, together with their sizable short-term offshore borrowing. Household debt is high at about 150 percent of disposable income but is held mainly by higher income households. Moreover, exposure to high-risk mortgages is small. The potential risks associated with household lending are mitigated by a number of factors, including banks’ prudent lending practices and Australian Prudential Regulation Authority (APRA)’s conservative approach in implementing the Basel II framework. Banks also have reduced their use of short-term offshore wholesale funding by increasing deposits and lengthening the tenor of their funding, but short-term external debt remains sizable.

The paper finds that the four major Australian banks have capital well about the regulatory requirements with high quality capital. While their headline capital ratios are below the global average for large banks in a sample of advanced and emerging market economies, Australia’s more conservative approach in implementing the Basel II framework implies that Australian banks’ headline capital ratios underestimate their capital strength. For example, a comparison with Canadian banks highlights the impact of Australia’s more conservative approach. The four major Australian banks are well-positioned to meet the higher capital requirements under Basel III, and with the improvements in their funding profiles since the global financial crisis they are making good progress toward meeting the Basel III liquidity standards.

Stress tests calibrated on the Irish crisis experience show that the banks are largely able to withstand sizable shocks to their exposure to residential mortgages. However, combining residential mortgage shocks with corporate losses expected at the peak of the global financial crisis would bring down the banks’ average total capital ratio below the regulatory minimum. Given high bank concentration and market uncertainty, therefore, the merits of higher capital requirements need to be considered for systemically important domestic banks, taking into account the currently evolving international standards.

II. Features of the Australian Banking System

The Australian banking system is dominated by the four major banks and banking concentration increased in the wake of the global financial crisis. The assets of the four major banks are around 75 percent of total banking sector assets and 80 percent of the residential mortgage market. The increase in concentration was due to the slower growth of smaller banks normally reliant on securitization, constrained by reduced access to funding; reduced lending by foreign-owned banks in the wake of the crisis; and acquisitions of two medium-sized banks by the larger banks in 2008 (St. George by Westpac and BankWest by Commonwealth Bank of Australia, the latter purchase being of a foreign-owned bank).

For international comparison of the dominance of the four major banks, the combined assets of the four largest banks in a sample of advanced and emerging market countries are compared to total banking sector assets and to GDP. Relative to the size of the total banking sector, Australia lies in the middle of the distribution (Figure 1). The combined assets of the four major banks in Australia are about 180 percent of GDP. This is towards the center of the distribution for the sample of countries and in the middle of similar countries (Figure 2).

Figure 1.
Figure 1.

Assets of Four Major Banks for Selected Countries, 2010

(In percent of these banks’ home country banking sector assets)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

Sources: Bankscope; Banks’ Annual Reports; and IMF staff calculations.
Figure 2.
Figure 2.

Banking Sector Assets for Selected Countries 1/

(Four largest banks as a percentage of these banks’ home-country GDP, end 2010)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

1/ AUS represents the four large Australian banks (Australia and New Zealand Bank, Commonwealth Bank, National Australia Bank, and Westpac).Sources: Bankscope; Banks’ Annual Reports; and IMF staff calculations.

The large size of the four banks relative to GDP and the banking system behooves careful attention to their vulnerabilities and resilience to shocks.2 Any distress among these banks could have a sizable impact on the financial sector and the real economy in Australia and New Zealand.3 Moreover, they may be perceived by the markets as too big to fail, which implies they could pose a potential fiscal liability. Against this backdrop and in the context of the ongoing discussion for systemically important global banks, the merits of higher capital requirements, complemented by intensive supervision, need to be considered for systematically important domestic banks.4

The four major banks’ key financial soundness indicators are summarized in Table 1, which highlights some of their strengths. All the four banks are profitable with capital above regulatory minimums. Capital adequacy has improved, driven both by increases in capital and declines in risk-weighted assets, and the quality of bank capital is high, as it is mainly common equity.

Table 1.

Australia’s Four Major Banks: Selected Financial Soundness Indicators

(In percent)

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Sources: Banks’ disclosure statements, and Fund staff calculations.

Includes St. George.

TCE = tangible common equity = total equity minus intangible assets (including goodwill).

Tangible assets = total assets minus intangible assets (including goodwill).

Australian banks’ conservative lending practices, together with robust supervision by APRA and the Australian economy’s strong performance since the global crisis, have contributed to a low nonperforming loan ratio compared to other advanced countries (Figures 3 and 4).5 Despite banks’ high exposure to residential mortgages (56 percent of total loans at end-2010), exposure to high-risk mortgages is small, as less than 10 percent of owner-occupiers had mortgages with loan-to-value ratios higher than 80 percent and debt service ratios greater than 30 percent.6 Moreover, debt is mainly held by higher income households, with households in the top two income quintiles holding almost three quarters of household debt (Figure 5). The full recourse nature of mortgage lending also helps limit strategic loan defaults.

Figure 3.
Figure 3.

Bank Nonperforming Loans to Total Loans

(In percent)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

Source: GFSR.
Figure 4.
Figure 4.

Bank Nonperforming Loans to Total Loans

(In percent)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

Source: GFSR.
Figure 5.
Figure 5.

Indebted Households, 2009

(Share of household debt held by income quintiles)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

* Income quintiles include all households.Sources: RBA; and Hilda Release 9.0.

Australian banks’ use of short-term offshore funding creates an additional vulnerability as the banks are exposed to potential disruptions in global capital markets. Short-term debt (mostly held by banks) has declined from its pre-crisis peak but remains sizable at 45 percent of GDP at end-September 2011 (Figure 6). In a favorable development, the maturity profile of short-term debt has also been extended, with a greater share maturing in the six-month to one year window.

Figure 6.
Figure 6.

Total Short-Term External Debt 1/

(In percent of GDP)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

1/Short-term debt is on a residual maturity basis for Australia and New Zealand and on an original maturity basis for other countries.Source: WB-IMF-RES-OECD; Joint External Debt Hub; and IMF staff calculations

III. Basel II Implementation and Capital Ratios

A conservative approach to bank regulation and supervision helped maintain financial sector stability in Australia. In implementing the Basel II framework, APRA required banks to adopt a more conservative approach in several cases than required by the Basel II framework, as noted in the IMF’s Basel II Implementation Assessment in 2009. Most importantly, a 20 percent loss given default (LGD) floor was adopted for residential mortgages, above the Basel II floor of 10 percent. As a result, Australian banks’ loss-given-default rates are higher than those of many other countries’ banks (Figure 7). In addition, higher risk weights were required for certain residential mortgages under the standardized approach. Moreover, reduced risk weights, which are permissible in the Basel II framework’s standardized approach, were not introduced for retail lending. Until June 2011 banks’ capital requirements under the advanced approaches remained subject to the 90 percent floor of the Basel I capital requirement, instead of the 80 percent floor applicable in the second year. APRA has also exercised caution in other choices regarding the framework, such as requiring banks using the advanced approaches to hold capital against interest rate risk in the banking book.

Figure 7.
Figure 7.

Loss Given Default on Residential Mortgages

(In percent)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

1/ Four largest banks.2/ Four largest banks.3/ Two largest banks. Reporting dates Q4 2008 and Q4 2009.4/ Three banks. Reporting dates Q4 2008 and Q4 2009.5/ Four largest banks.Sources: Banks’ disclosure statements and IMF staff estimates.

The headline regulatory ratios for the four major Australian banks are lower than for other countries (Figures 8 and 9). However, differences in regulatory rules relating to the calculation of required capital suggest that different jurisdictions’ capital ratios should be interpreted with caution. In particular, the risk weighted assets numbers are not directly comparable across countries. APRA’s requirements for computing risk-weighted assets likely imply that risk-weighted assets in Australia are higher than for comparable banks in other countries, resulting in lower headline capital ratios for the same amount of capital. Moreover, due to APRA’s conservative capital eligibility and deduction rules Australian banks tend to hold higher quality capital and this is reflected in their higher rankings in tangible common equity ratios compared with their rankings in total and Tier 1 capital ratios (Figures 10 and 11).

Figure 8.
Figure 8.

Total Regulatory Capital Ratio, 2010

(Four largest banks, in selected countries)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

Sources: Bankscope; and IMF staff calculations.
Figure 9.
Figure 9.

Tier 1 Regulatory Capital Ratio, 2010

(Four largest banks, in selected countries)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

Sources: Bankscope; and IMF staff calculations.
Figure 10.
Figure 10.

Tangible Common Equity to Risk Weighted Assets, 2010

(Four largest banks, in selected countries)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

Sources: Bankscope; and IMF staff calculations.
Figure 11.
Figure 11.

Tangible Common Equity to Tangible Assets, 2010

(Four largest banks, in selected countries)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

Sources: Bankscope; and IMF staff calculations.

Although regulatory differences relating to the calculation of required capital ratios imply that comparisons of banks across jurisdictions should be interpreted with caution, the Pillar 3 disclosure statements facilitate comparisons of banks, both within and across jurisdictions. This paper uses information from these statements to compare the capital ratios of the four major banks in Australia with those in Canada, providing a detailed analysis of the impact of APRA’s conservative approach in implementing the Basel II framework relating to residential mortgages. Canada was chosen as a comparator country because nonperforming housing loan ratios in Australia and Canada have been broadly similar in recent years (Figure 12).7 All the eight banks in the two countries studied in this paper are rated by Fitch AA or AA- and adopted the advanced internal ratings based approach under Basel II.

Figure 12.
Figure 12.

Nonperforming Housing Loans

(In percent of loans *)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

* Percent of loans by value. Includes ‘impaired’ loans unless otherwise stated. For Australia, only includes loans 90+ days in arrears prior to September 2003.** Banks only.+ Percent of loans by number that are 90+ days in arrears.Sources: APRA; Bank of Spain; Canadian Bankers’ Association; Council of Mortage Lenders; FDIC; and RBA.

Australian banks’ high LGD rates required by APRA result in higher Pillar 1 risk weighted assets for the same amount of residential mortgages, compared with most other countries’ banks (Figure 13).8 This in turn leads to lower capital ratios for the same amount of capital. For example, if Australian banks’ LGD rates are reduced to the Basel II 10 percent floor, which is the rate for one of the four Canadian banks,9 the four major Australian banks’ weighted average Tier 1 and total capital ratios are estimated to increase by almost 100 basis points, respectively (Table 2). Even if Australian banks’ LGD rates are lowered to Canada’s four large banks’ average of 13.9 percent, the four major Australian banks’ Tier 1 and total capital ratios are estimated to increase by about 60 basis points, respectively.

Figure 13.
Figure 13.

Loss Given Default on Residential Mortgages

(In percent)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

1/ Includes ANZ, CBA, NAB, and Westpac.2/ Includes BMO, CIBC, Scotiabank, and TD Bank.Sources: Banks’ disclosure statements; and IMF staff calculations.
Table 2.

Australia’s Four Largest Banks: LGD for Residential Mortgages and Impact on Capital Adequacy Ratios

(In percent)

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Weighted averages

Sources: Banks’ disclosure statements; and IMF staff estimates.

The weighted average of the probabilities of default (PD) on residential mortgages for the Australian four major banks is 2½ times that of Canada’s three large banks, although nonperforming housing loan ratios in Australia and Canada have been broadly similar in recent years (Figure 14).10 In Canada, mortgages insured by government-owned Canada Mortgage and Housing Corporation (CMHC) are assigned a zero risk weight for regulatory capital requirement purposes.11 Thus, almost 70 percent of the four large Canadian banks’ residential mortgages belong to the lowest risk bucket, compared with just 40 percent of the four major Australian banks (Figures 15).

Figure 14.
Figure 14.

Probability of Default on Residential Mortgages

(In percent)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

1/ Includes ANZ, CBA, NAB, and Westpac.2/ Includes BMO, CIBC, Scotiabank, and TD Bank.Sources: Banks’ disclosure statements; and IMF staff estimates.
Figure 15.
Figure 15.

PD Range and Composition of Residential Mortgages

(In percent of total)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

1/ Includes ANZ, CBA, NAB, and Westpac. For CBA, data for December 2010.2/ Includes BMO, CIBC, Scotiabank, and TD Bank.Sources: Banks’ disclosure statements; and IMF staff estimates.

Reflecting the differences in PD and LGD, the Australian banks’ average risk weight is almost 2½ times the average of the Canadian banks (Figure 18). If the Canadian banks’ risk weight is applied to the Australian banks, their total capital ratio is estimated to rise by more than 120 basis points and the Tier 1 capital ratio by about 100 basis points (Figure 19).

Figure 16.
Figure 16.

Canada: PD Range and Composition of Residential Mortgages, October 2010

(In percent of total)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

Sources: Banks’ disclosure statements; and IMF staff estimates.
Figure 17.
Figure 17.

Australia: PD Range and Composition of Residential Mortgages, September 2010 1/

(In percent of total)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

Sources: Banks’ disclosure statements; and IMF staff estimates.1/ For CBA, data for December 2010.
Figure 18.
Figure 18.

Average Risk Weights for Residential Mortgages

(In percent)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

1/ Includes ANZ, CBA, NAB, and Westpac.2/ Includes BMO, CIBC, Scotiabank, and TD Bank.Sources: Banks’ disclosure statements; and IMF staff calculations.
Figure 19.
Figure 19.

Capital Ratios: Comparison with Canada

(In percent)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

1/ Four large Canadian banks (BMO, CIBC, Scotia and TD).2/ Four large Australian banks (ANZ, Commonwealth, NAB, and Westpac).Sources: Banks’disclosure statements; and IMF staffcalculations.

Different jurisdictions apply different approaches to the definitions of eligible capital, Pillar 1 risk-weighted assets, and capital limits, and regulators’ supervisory review process of banks’ own internal capital adequacy assessment could also play an important role in defining the level of capital held.12 Given Australian banks’ high exposure to residential mortgages, the above analysis focuses on factors affecting the calculation of risk weighted assets for mortgages and their impacts on capital ratios for the banks taking advanced internal rating-based approach under Basel II.

The above analysis does not take into account the differences in the definitions of eligible capital. A fuller analysis of all the variances would facilitate international comparisons of headline capital ratios in different countries. For example, analysis by Australia and New Zealand Bank indicates that its Tier 1 capital ratio would rise from 10.1 percent in September 2010 under Australian rules to 13.5 percent under UK rules.13 Westpac’s analysis also shows that its common equity ratio of 8 percent in March 2011 would increase sharply to 13 percent under Canadian rules. These increases partly relate to less conservative LGD assumptions in other jurisdictions, but also relate to differences in the definitions of eligible capital.

IV. Basel III and Australian Banks

Basel III will require banks to hold more and higher-quality capital. Given the high quality of bank capital in Australia, as it is mainly common equity, the Australian banks are in a good position to meet these new requirements.14 Under Basel II, moreover, APRA adopted several rules on the definition of capital and the calculation of RWA which are more conservative than the Basel III rules. Westpac’s analysis, for example, indicates that its common equity ratio of 8 percent in March 2011 would rise to 9.6 percent if APRA’s rules are fully harmonized to Basel III. APRA proposed in a recent discussion paper that Australian banks will be required to hold a minimum 4.5 percent Common Equity Tier 1 ratio and a 6 percent Tier 1 capital ratio from January 2013, ahead of the Basel III timetable. APRA also proposed introducing a capital conservation buffer of 2.5 percent from January 2016.

Basel III also introduces global liquidity standards—a Liquidity Coverage Ratio (LCR) and a Net Stable Funding Ratio (NSFR). The objective of the LCR is to ensure that banks have adequate high-quality liquid assets to survive an acute stress scenario that lasts for one month. In many jurisdictions, banks will meet this requirement largely through holdings of government securities. In the case of Australia, the supply of government securities is somewhat limited due to the fiscal restraint of recent governments so that an alternative approach will be necessary, as allowed for under the Basel III reforms. APRA and the Reserve Bank of Australia (RBA) have designed an approach to meet the new liquidity standard. Banks will be able to establish a committed secured liquidity facility with the RBA. This will be designed to cover any shortfall between a bank’s holdings of high-quality liquid assets and the LCR requirement. The collateral for this facility includes all assets normally eligible for repurchase transactions with the RBA and banks will be charged an ongoing fee for access to this facility.15

The NSFR requirement under Basel III, which remains under development within the BCBS, requires that banks have sufficient stable sources of funding.16 Since the global financial crisis the funding structure of Australian banks has improved, with an increase in retail deposits and long-term wholesale funding and a reduced reliance in short-term offshore funding (on an original maturity basis) (Figure 20).17 Our estimates suggest that the NSFR has improved for three of the four major Australian banks over the past three years (Figure 21). For international comparison, Figure 22 shows estimated NSFRs for the Australian banks against the same sample of banks used for the capital ratio comparison above. These ratios are not published by banks so they need to be interpreted cautiously. However, as can be seen, most banks, including the Australian banks, lie below the 100 percent benchmark, with the Australian banks at or just below the average level. Revised laws now permit Australian banks to issue covered bonds, which may help increase the share of long-term funding further.18

Figure 20.
Figure 20.

Funding Composition of Banks in Australia 1/

(In percent of funding)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

1/ Adjusted for movements in foreign exchange rates.2/ Includes deposits and intragroup funding from non-residents.Sources: APRA; RBA.
Figure 21.
Figure 21.

Where the Four Major Australian Banks Stand vis-à-vis the NSFR

(In percent)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

Sources: Bankscope; Banks’ Annual Reports; and IMF staff estimates.
Figure 22.
Figure 22.

Net Stable Funding Ratio, 2010

(Four largest banks, in selected countries)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

Sources: Bankscope; and IMF staff calculations.

V. How Vulnerable are Australian Banks to Shocks to Residential Mortgages?

To assess the risks of residential mortgage lending, which comprises more than half of the four major banks’ loans, this paper uses the September 2011 data published by the banks on their risk exposure. Following the adoption of the Basel II internal ratings-based approach, the four major banks publish a breakdown of residential mortgage, corporate, and other retail lending exposure disaggregated into seven risk categories in the Pillar 3 statements. For each risk category, the probability of default, loss given default, and risk weights are reported (see for example, data from Westpac in table 3 below).

Table 3.

Westpac: Credit Risk Exposure

(As of September 30, 2011; in millions of Australian dollars)

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Source: Westpac’s disclosure statement.

The four major banks are exposed to residential mortgages, but the data in the Pillar 3 disclosure statements show that residential mortgage lending is considered by the banks to be less risky than corporate and other retail lending. The average risk weight for corporate lending at Westpac, for example, is four times that for residential mortgages (Table 3). Thus, although the amount of corporate lending is just a quarter of residential mortgages in the case of Westpac, the required capital for corporate lending is the same as for residential mortgages, reflecting the assessment that corporate lending is riskier.

The scenarios considered in the paper apply Irish banks’ residential mortgage developments during the global financial crisis to Australian banks’ balance sheet. The Irish banks’ residential mortgage quality has deteriorated sharply, due to the large increases in unemployment to 13.6 percent in 2010 from 4.6 percent in 2007 and a 46 percent decline in housing prices from the peak in 2007 through November 2011, together with high loan-to-value ratios at origination (Figure 23). With Australian banks’ prudent lending practices, including low loan-to-value ratios, Australia would be unlikely to see such a sharp deterioration in asset quality. Nevertheless, this experience is used to calibrate tail-risk scenarios for the Australian banks in order to see whether they are resilient to such severe stress scenarios.

Figure 23.
Figure 23.

Ireland: Loan-to-Value Ratios at Origination

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

Source: Department of Environment, Heritage, and Local Government.

To apply the Irish experience to the Australian banks, the paper assumes that the shares of the three riskiest categories for residential mortgages at the four Australian banks would rise to those of the Irish banks in 2010 and the share of the next low risk category would decline accordingly (Table 4).19

Table 4.

Ireland: Four Large Banks’ Residential Mortgages 1/

(In percent of total)

article image
Source: Banks’ disclosure statements and IMF staff estimates.

Includes Anglo Irish Bank, Irish Life and Permanent plc, Bank of Ireland, and Allied Irish Banks. Includes estimates of assets transferred to National Asset Management agency (NAMA).

Under this scenario (Scenario 1), the four Australian banks’ probability of default is estimated to increase sharply to 11 percent from 2 percent and the estimated losses would be larger than the banks’ total provisions, resulting in a reduction in the banks’ capital. The banks’ Tier 1 capital ratio is estimated to decline by 1½ percentage points (Figure 24 and Table 5). But all the four banks’ Tier 1 capital ratio would remain well above the regulatory minimum ratio of 4 percent. Under a second scenario that is scenario 1 plus an increase of the LGD and risk weights by 1½ times (Scenario 2), one bank’s total capital ratio is projected to decline to below 6 percent, but the other banks’ total capital ratios to remain above 8 percent. Such a large increase in the LGD is unlikely to happen, given Australia’s low loan-to-value ratios and modest house price overvaluation estimated at 10–15 percent. The primary driver for the reductions in capital ratios under both scenarios is downward internal ratings migration, which pushes up the measure of risk-weighted assets and, hence, capital requirements.

Figure 24.
Figure 24.

Capital Ratio Change

(In percent)

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

* Assuming the shares of the 3 highest risk categories for residential mortgage exposures at the levels of Irish banks.** Scenario 1 plus increases of LGD and RW by 1.5 times.Sources: Banks’ disclosure statements; and IMF staff calculations.
Table 5.

Australian Four Large Banks: Impact on Capital

(In millions of Australian dollars, unless otherwise indicated)

article image
Sources: Banks’ disclosure statements and IMF staff estimates.

Includes Australia and New Zealand Bank, Commonwealth Bank, National Australian Bank, and Westpac.

Mortgages subject to an internal ratings-based approach only.

Weighted averages.

The above exercise suggests that the major Australian banks could withstand sizable shocks to residential mortgages. However, this exercise does not consider shocks to corporate and other lending, which should be considered when banks conduct stress testing. For example, Irish banks incurred heavy losses from commercial property lending, which amounted to 31 percent of total loans in 2006. The average haircut applied when commercial property loans were transferred to Ireland’s national asset management agency was about 58 percent.

The four major Australian banks’ corporate exposures, including commercial property lending, are about one-quarter of total bank exposures, which is sizeable. Their commercial property exposures are around 10 percent of total loans, which are well below Irish banks’ exposure of 31 percent. Robust supervision by APRA implies that, even in a tail risk scenario, the Irish experience with the corporate sector and commercial real estate in particular is unlikely to be replicated in Australia. Takats and Tumbarello (2009) estimated the Australian banks’ expected losses from corporate sector distress one year ahead at about 6 percent of their loans to the corporate sector during the peak of the global financial crisis.20 If these losses are applied as a tail-risk shock to the banks’ corporate exposures, the four banks’ average total capital ratio will decline by more than 2 percentage points to about 7 percent under the above Scenario 1 and 5¼ percent under Scenario 2, which are below the regulatory minimum. Potential losses from other credit exposures such as retail lending and personal loans are not taken into account in this calculation.

APRA may want to consider a more severe downside scenario together with funding risk and a longer risk horizon when conducting stress testing next time. In 2010, APRA conducted stress testing together with the New Zealand authorities (see Laker, 2010). The joint stress test results suggest banks’ resilience to sizable but plausible shocks. However, a more severe downside scenario of a sharp fall in commodity and house prices and a jump in global longer-term interest rates could hurt growth and raise unemployment for a substantially longer period than in the recent stress tests. Given Australian banks’ high exposure to residential mortgages, a longer time horizon could be considered to take into account the impact of sustained high unemployment. The risk horizons of the recent FSAP stress tests for United Kingdom, Germany, and Netherlands are five years (Table 6). The recent Irish experience also shows severe shocks for a longer period than the stress test assumptions of 2006 (Figure 25). Moreover, funding risk also needs to be explicitly included in future scenarios, encompassing a disruption to bank funding and a large increase in longer-term real interest rates. The latter could come from a rise in global rates and an increase in Australian banks’ risk premium.

Table 6.

Banking System Stress Tests’ Assumptions

(In percent)

article image
Sources: Various stress test reports and IMF staff calculations.

The lowest growth rate assumed.

Based on the data from 1981-2005.

The highest umemployment rate assumed.

Cumulative.

House prices in Germany have been flat for more than a decade.

Owing due to double digit unemployment rates from 1982-1997. The average umployment rate for 2000-05 was 4.3 percent.

Figure 25.
Figure 25.

Ireland: Stress-Test Assumptions vs. Recent Developments

Citation: IMF Working Papers 2012, 025; 10.5089/9781463932527.001.A001

Source: Irish FSAA Update (2006); and WEO.

While continued strong bank supervision plays a significant role in maintaining financial stability, the merits of higher capital requirements need to be considered for systemically important domestic banks, taking into account the currently evolving international standards. The large market share of the four banks in the domestic market implies that they could be perceived as too big to fail and pose a potential fiscal risk. Analysis of the appropriate capital requirements could be undertaken over the next year (including using stress tests) in the context of the 2012 update of the Financial Sector Stability Assessment with the IMF. More robust capital levels for systemically important banks would be beneficial, particularly in times of market uncertainty.

Bank Capital Adequacy in Australia
Author: Niamh Sheridan and Mr. B. Jang
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    Assets of Four Major Banks for Selected Countries, 2010

    (In percent of these banks’ home country banking sector assets)

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    Banking Sector Assets for Selected Countries 1/

    (Four largest banks as a percentage of these banks’ home-country GDP, end 2010)

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    Bank Nonperforming Loans to Total Loans

    (In percent)

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    Bank Nonperforming Loans to Total Loans

    (In percent)

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    Indebted Households, 2009

    (Share of household debt held by income quintiles)

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    Total Short-Term External Debt 1/

    (In percent of GDP)

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    Loss Given Default on Residential Mortgages

    (In percent)

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    Total Regulatory Capital Ratio, 2010

    (Four largest banks, in selected countries)

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    Tier 1 Regulatory Capital Ratio, 2010

    (Four largest banks, in selected countries)

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    Tangible Common Equity to Risk Weighted Assets, 2010

    (Four largest banks, in selected countries)

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    Tangible Common Equity to Tangible Assets, 2010

    (Four largest banks, in selected countries)

  • View in gallery

    Nonperforming Housing Loans

    (In percent of loans *)

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    Loss Given Default on Residential Mortgages

    (In percent)

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    Probability of Default on Residential Mortgages

    (In percent)

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    PD Range and Composition of Residential Mortgages

    (In percent of total)

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    Canada: PD Range and Composition of Residential Mortgages, October 2010

    (In percent of total)

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    Australia: PD Range and Composition of Residential Mortgages, September 2010 1/

    (In percent of total)

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    Average Risk Weights for Residential Mortgages

    (In percent)

  • View in gallery

    Capital Ratios: Comparison with Canada

    (In percent)

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    Funding Composition of Banks in Australia 1/

    (In percent of funding)

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    Where the Four Major Australian Banks Stand vis-à-vis the NSFR

    (In percent)

  • View in gallery

    Net Stable Funding Ratio, 2010

    (Four largest banks, in selected countries)

  • View in gallery

    Ireland: Loan-to-Value Ratios at Origination

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    Capital Ratio Change

    (In percent)

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    Ireland: Stress-Test Assumptions vs. Recent Developments