Top regulator drubs bail-in

Weighing into the debate about sizeable increases in Australian and New Zealand bank holdings of bail-in capital, financial expert Lord Adair Turner has criticised the assumptions behind the Bank of England and Bank for International Settlements' post-2008 model for preventing financial collapse.

Lord Turner chaired the UK Financial Services Authority— the forebear of the Prudential Regulation Authority and Financial Conduct Authority—from the time of the 2008 collapse until late 2013. For four years from mid-2009 he also headed the Standing Committee for Supervisory and Regulatory Cooperation at the BIS's Financial Stability Board (FSB), established at the 2009 G20 summit in London.

The FSB devised the "bail-in" scheme to stop too-big-tofail banks from falling over, Lehman Brothers-style, and setting off a chain reaction of derivatives defaults worldwide. Instead, regulators would put a bank into "resolution", with new categories of bail-in debt expropriated to ensure the bank did not fold. In most countries under the FSB's bail-in regime, deposits over the amount insured by governments, junior bonds, and in some cases senior bonds, can be confiscated.

Lord Turner told the Australian Financial Review on 17 March that the introduction of bail-in capital has undermined the importance of the regular operating capital of banks. While he believes today's financial system is generally safer, he slammed the complexity of the BIS-FSB model which relies on new forms of capital used as "loss-absorbing capacity" (Total Loss Absorbing Capacity or TLAC) to save banks.

"Ideally, we should have a much simpler approach to regulating banks, that wouldn't necessarily involve a whole load of detailed supervision and complex bail-in debt," he told AFR.

"The best thing would be to just have enough equity in the banking system that you could be pretty confident that in almost all states in the world the only people who would suffer in a crisis would be bank equity owners. That would provide a powerful incentive for them to keep an eye on what management was doing and not take risks."

Turner is referring to regular bank capital such as bank shares, a.k.a. common equity tier 1 (CET1). By Australian Prudential Regulation Authority (APRA) standards, the Big Four Australian banks must hold CET1 equal to least 10.5 per cent of risk-weighted loans outstanding. These are the first investments to go in a crisis, followed by "bail-inable" debts, including hybrid bonds, which reside in the second tier of bank capital (tier 2), and are written off or converted into shares when the equity of a bank falls below 5.125 per cent. "If you want to have equity in a crisis, why not just have equity to start with?" Turner asked. "Because there are real questions about whether we'll be able to convert this debt to equity in a crisis without that in itself creating problems."

Turner described the situation as akin to a truck careening down a highway without brakes or crash barriers, but instead a "whole load of supervisors looking over the driver's shoulder telling him how to drive". He concluded: "Let's make the crash barriers really good, let's just have a very high level of equity and we could then actually reduce the complexity of banking supervision."

This is a far simpler solution, but to ensure it does work it would have to be combined with a Glass-Steagall separation of commercial banks from securities trading, which will prevent retail banks from exposing themselves to speculative losses in the first place.

The TLAC drive

On 8 November 2018 bank regulator the Australian Prudential Regulation Authority (APRA) issued a consultation paper telling banks they would need to increase their loss-absorbing capacity within five years. The plan would increase the total capital buffer of Australian banks to 19 per cent from 14.5 per cent. APRA estimated the increase of liquidity would drive up bank funding by 5 basis points; others claim that is understated.

This means more bail-inable debt—some $75 billion worth of additional tier 2 capital.

Ratings agency S&P declared the plan was indicative of the Australian government's intention to "be highly supportive of systemically important banks"—i.e., to do anything to save too-big-to-fail banks. Australian law now allows all but the most senior bonds to be converted into shares or written off if a bank is put into resolution. So loosely written is the law, under crisis conditions it could be interpreted to include deposits as well. As for deposit insurance to the value of $250,000 per person per institution, Australia's Financial Claims Scheme only kicks in if a bank fails; but the resolution process keeps banks alive so they don't set off other dominoes.

The banks have protested the APRA proposal, concerned that there is not a big enough market for the new bail-in debt. A major factor is that the majority of such debt is raised overseas, and international capital is increasingly nervous about investment in Australia. Instead of an increase in tier 2 capital, banks are suggesting an increase of tier 3 capital—a category created to be slightly more secure than tier 2, while still falling below senior bonds on the hierarchy.

In January the Reserve Bank of New Zealand (RBNZ) demanded Australia's banks also put aside extra capital to back their New Zealand subsidiaries, increasing tier 1 equity from 13 per cent to 16 per cent, which could amount to an extra $20 billion. The Aussie big four control nearly 90 per cent of NZ bank assets. This caused a frenzied reaction, with UBS warning the "excessive" requirements could be damaging to Australian bank profits and put the "unquestionably strong" capital ratios of Australia's banks at risk.

RBNZ Deputy Governor Geoff Bascand told the Sydney Morning Herald on 14 March that NZ banks had been "disproportionately profitable relative to their parents", so the Aussie banks can withstand the extra expense. To critics who said NZ did not need its own provision given Australia's banks are already undergoing a capital increase, he replied: "[E]ach country has to have its own capacity to resolve its own banking crisis. You could get a banking crisis that Australia and NZ are both hit concurrently with, and we need to make sure our banks stand strong in it."

Whether this apparent fissure between the Australian and NZ banking sectors will have implications for the IMF Financial System Stability Assessment's call for closer integration between the two nations on bail-in—which was warmly welcomed by APRA chairman Wayne Byres—remains to be seen.