At a time of exceptional economic and financial uncertainty, banks are also having to respond to funding pressures, significant infrastructure costs, declining financial returns, extra-territorial regulatory demands, new consumer credit protection laws and reputational risks. Regulatory change in general, and the Basel III framework in particular, is driving and shaping many of the response choices being made by banks.
The liquidity and capital consequences of these changes cannot be ignored.
A new report produced by KPMG’s Global Financial Services Risk and Regulatory Centre of Excellence crystallises many of these issues. The paper, Liquidity: a bigger challenge than capital, concentrates on the new liquidity ratios proposed by the Basel Committee on Banking Supervision. The paper reaches several important conclusions.
- Banks face high adjustment costs to satisfy the new liquidity ratios. Additional costs will emerge from the assembling and reporting of the necessary data, running stress and scenario tests and formulating recovery plans (already underway in some Australian banks).
- In many instances, satisfying liquidity requirements will hurt profitability, particularly from the need to hold more high quality but low yielding liquid assets on the balance sheet.
- Problems will be compounded because many banks will be making similar adjustments at the same time. Changes to business models and organisational structures will be the inevitable consequence in many cases.
Domestically, publication of the liquidity paper is a useful resource in preparing for the release of APRA’s final prudential standard on liquidity (APS 210).
Also at the local level, APRA has released two proposed reporting standards covering bank capital issues, ARS 110.0 Capital Adequacy and ARS 111.0 Fair Value. The final standards are planned to take effect from the start of 2013. Download KPMG’s explanation of these draft reporting standards.
APRA’s proposals also state that:
- most capital adjustments are to be made to Common Equity Tier 1 capital (CET1) instead of the current deductions from Tier 1 or Tier 2 capital
- dividends declared in accordance with Australian Accounting Standards will be excluded from current year earnings and banks’ measurement of total capital
- assets held in a covered bond pool in excess of eight percent of a deposit taking institution’s assets in Australia will be deducted from CET1.
The main challenge arising from these proposals is to identify and understand the potential consequences of the changes, both intended and unintended. For some banks the requirement to report unrealised fair value gains separately from losses could challenge existing systems. It is also clear that the recognition of these gains/losses within Common Equity Tier 1 capital under the Basel III framework will mean increased regulatory focus on the fair value policies and procedures of banks, including their consistency with APS 111 requirements as well and the adequacy ICAAPs with respect to scenario testing.
For all banks there is still a lot of work to be done.