Dear Mike and Lindsay, Please Refrain

Dear Mike and Lindsay, I have noticed that each of you recently has recently defended Australia’s financial system, arguing that the banks are well capitalised.  Mike, you suggest that Australia’s banks are holding twice as much capital as they did prior to the financial crisis.

Although Australia’s banks have doubled their equity capital since prior to the crisis to over 140 billion dollars, you do not draw attention to the fact that banks have doubled the loans they have written over this period.  So the ratio of tier 1 equity capital to total assets has broadly remained steady at sub-5% since 2006.

Of course, you both would retort that the denominator used in conventional capital ratios is not total assets but risk weighted assets.  Indeed, banks have lifted their aggregate ratio of tier 1 equity capital to risk weighted assets by over 300 basis points since prior to the crisis to currently stand at over 10%. 

By conferring different risk weights on different assets, risk weighted assets are designed to penalise banks more for writing risky business loans than residential mortgages that are considered to be safer.  But the pitfalls and arbitrariness of using risk weighted assets is reflected in the fact that Basel for instance conferred zero risk weights to European sovereign bonds, including Greece. 

The chart below shows the large and growing divergence between the banking system’s total assets and risk weighted assets since the crisis, thanks largely to the rapid growth in mortgage lending during this time which attract lower risk weights, while business lending has been stagnant. In order to economise on the need to build capital, I wonder whether the banks you represent (and the other majors) have effectively gamed the Basel risk weightings and deliberately pursued a strategy of mortgage led growth?

Thus, the significant lift in the banks’ capital ratios is an illusion when the more robust measure of total assets is used instead of risk weighted assets as the denominator.

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Demystifying bank capital

I’m also concerned at the language you (and other bankers) continue to use when discussing capital regulation.  Why do you continue to propagate the myth that banks in some sense ‘hold’ capital.  The implication of course is that capital requirements compel banks to set aside capital in their vaults that acts like a drag on your balance sheets that could otherwise be used to supply credit to growing businesses and households.

Now Mike, you know quite well that this is a fictitious tale that bankers spin.  In fact, bank capital has nothing to do with a bank’s assets.  Rather, capital lies on the right hand side of a bank’s balance sheet, among liabilities.  Banks fund loans from three sources: they borrow from customers in the form of deposits, they borrow from creditors in the form of long and short term wholesale debt, and they raise equity from shareholders or retained profits.  Equity or bank capital is effectively loss absorbing capital and so represents un-borrowed funds because shareholders are only residual claimants to a bank’s cash flows.

Capital regulation simply requires banks to use a minimum amount of loss absorbing capital to fund its loan book.  Contrary to what you both say Mike and Lindsay, a financial system whose balance sheet is funded with more loss absorbing capital is a safer financial system.

You both (and other bankers) have pointed out that higher capital requirements hinder the ability of banks to lend and would lead to higher lending rates.  But if there are profitable opportunities to lend, there is nothing to stop you from raising more equity or reinvesting more profits and putting the additional funds to work by writing more loans.

I’ve heard the refrain from bankers before that equity is too expensive, right?  Finance academics, Anat Admati and Martin Hellwig, do a splendid job of exploding this myth, by drawing on the Miller-Modigliani theorem developed over half a century ago, which shows that more gearing does not offer companies a free lunch.  That is, loading up on leverage does not indefinitely reduce a company’s cost of capital.  Indeed, more leverage raises a company’s default risk.  Conversely, a bank that raises more equity or loss absorbing capital is associated with lower risk and expected return because it can better withstand a decline in asset values.

If equity is so expensive, why doesn’t the typical non-financial listed company in Australia – which has a capital ratio of around 50% - exploit the free lunch too?  Clearly, there is no arbitrage available because non-banks do not benefit from a government guarantee.

The argument that subjecting banks to more stringent capital requirements would lead to higher lending rates confuses private and public costs.  Banks get away with using less than $10 of equity capital to fund every $100 of assets thanks the taxpayer funded guarantee, which allows banks to borrow at cheaper rates.  If the requirement for a bank to have more loss absorbing capital led to a lift in lending rates, it would reflect a higher private cost incurred by the bank and its shareholders.  But the cost borne by the taxpayer and society more broadly would be lower thanks to the benefits of a safer financial system that is less vulnerable to crises of confidence.

Race to the bottom

Lindsay, you believe that Australia’s bank capital ratios are already in the top quartile compared to other banks around the world.  On the same theme Mike, you have expressed concern that more increases in bank capital suggested by the Murray Financial System Inquiry is unnecessary and would further tilt the playing field against Australia’s banks and lead them to being globally uncompetitive.

This might sounds like a seductive argument to some, but a race to the bottom in capital ratios across different jurisdictions has undermined the resilience of the global financial system and led to its near collapse less than seven years ago.

Based on a robust capital ratio metric of common equity to total assets, the Australian majors lie well below the global median (see chart).  Based on the current value of their assets, Australia’s banks would need to raise an additional $60 billion to reach the global median of 8%, which is the equivalent of over three years of the sector’s dividends.

Given the importance of the banking system to Australia’s stock market and the economy, and the sector’s high concentration, it is reasonable to expect Australia’s banks to have capital ratios that are above the global median, to safeguard the system and protect taxpayers.  Moreover, the analysis contained in Anat Admati and Martin Hellwig’s excellent book, The bankers’ new clothes, implies that the global median capital ratio remains woefully inadequate.

The financial crisis: An ongoing burden for the taxpayer

Mike and Lindsay, you both agree that Australia’s banks successfully navigated the financial crisis, which you argue represents a big tick for the safety of the financial system.  But surely this belies the taxpayer funded support that ultimately safeguarded the financial system, specifically the first time introduction of explicit depositor protection in Australia, in the form of the Financial Claims Scheme.

Lindsay, you express a desire for a strong financial system and warn against a narrow focus on bank capital by the Murray financial system inquiry.  Well, the most effective way to build a secure financial system is for the banks to fund a larger share of their total assets (and not the nonsense of risk weighted assets) with common equity.  In fact, reform of Australia’s financial system should really be largely about bank capital.

Mike and Lindsay, in your respective roles as CEO of ANZ and Chairman of Westpac, no-one expects you to represent or defend the interests of the Australian taxpayer.  But please refrain from propagating myths about bank capital.  Because by continuing to narrowly promote the interests of your shareholders, the risk is that the next crisis of confidence will expose the fragile and still under-capitalised domestic banking system.