I ve been asked to talk about what Basel III means for ordinary bank customers and shareholders.

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1 SPEAKING NOTES Conference on Systemic Risk, Basel III, Financial Stability and Regulation 28 June, Shangri-La Hotel, Sydney (20 min) What does Basel III mean for banks customers and their shareholders? Steven Münchenberg Chief Executive, Australian Bankers Association I ve been asked to talk about what Basel III means for ordinary bank customers and shareholders. It is tempting to say not much and sit down, but I suspect the Conference organisers might be a bit disappointed, even if the audience is relieved to get to morning tea earlier. So if not much is the short answer, what is the long answer? The essence of the question, What does Basel III mean for bank customers and shareholders? is really this is Basel III and its implementation in Australia an issue that will affect retail customers on a daily basis. Will they notice their banking experience change or a sudden spike in their mortgage interest rate, or a sudden drop in the interest paid on their savings? Will retail shareholders notice a big difference when they receive their dividend cheque or attend the AGM? Or is this really an issue for the pointy heads the technical experts in APRA and the banks that worry about esoteric things like Tier I capital, leverage ratios and counter-cyclical buffers. My first answer that Basel III means not much for customers and shareholders was a bit glib. Document Number:

2 AUSTRALIAN BANKERS ASSOCIATION INC. 2 The proper answer is really it could have meant a lot, and it still might. Let me explain. To do that, I ll first touch on why we are even talking about a Basel III, and then look briefly at what this beast, Basel III, is. We have Basel III because one of the absolutely clear messages from the global financial crisis was the extent to which the global financial industry is strongly interconnected. It is a mesh or network of interrelated and interdependent connections, through which contagion spreads rapidly and uncontrollably. We d all been aware of this interconnectedness over the years, but the sight of once large and well respected institutions tottering and in some cases even falling, like dominos, has been indelibly etched in our collective consciousness if one falls, we can all stumble. This has heightened our awareness of a particular type of risk, systemic risk. Basel II was also a response to risk. It sought to establish an international approach to regulating the quality and level of capital banks should carry to protect them from their operational and financial risks. But Basel III goes well beyond just capital, to cover liquidity, macro-prudential measures and more. Basel II was concerned with the solvency of individual institutions. Basel III is concerned with the financial system writ large. And Basel II was largely a product of regulators working in the background.

3 AUSTRALIAN BANKERS ASSOCIATION INC. 3 Basel III has come from the very top. With Basel III, while the hard work has been done by regulators, the whip hand has been held firmly by the world s political leaders, driving the focus and speed of Basel III s development. Political leaders around the world saw up close the havoc that the financial system could wreak and they had to deal with the consequences when the financial crisis turned into an economic crisis. Their response was simple. They said Never again! The G20 Declaration on Financial Markets in November 2008 makes this very clear. Leaders stated that they intended to: implement reforms that will strengthen financial markets and regulatory regimes so as to avoid future crises. And that this was necessary to protect against adverse cross-border, regional and global developments affecting international financial stability. None of this is a revelation for you, but it is important to keep reminding ourselves how Basel III and related measures came about, and what, ultimately, in the minds of our political leaders, they are intended to achieve. Because Basel III is not just a set of technical obligations on banks, but a conscious decision by governments to de-risk the financial system, that interconnected network I mentioned a moment ago. So what is Basel III?

4 AUSTRALIAN BANKERS ASSOCIATION INC. 4 I won t bore you all with running through the details as most of you will have spent a lot more time poring over them that I ve been able to but what Basel III aims for is: the very first global liquidity and funding standards; a substantial increase in global minimum capital requirements and a considerable strengthening of the quality of capital, which itself has the effect of increasing the minimum capital requirement even further; the introduction of a formal corrective action regime into the capital framework, in the form of the capital conservation buffer; the introduction of a macro-prudential component into the framework, in the form of the counter-cyclical buffer; and the addition of a simple leverage ratio as a backstop to the risk-based regime. This is what we know. What we don t know is exactly what this means for Australia s banks, because Basel III is not a law that applies here. It is a regulatory framework that APRA now has to turn into Australian requirements. The Basel Committee formulates broad supervisory standards and guidelines and recommends statements of best practice, in the expectation that individual authorities will take steps to implement them through detailed arrangements statutory or otherwise which are best suited to their own national systems.

5 AUSTRALIAN BANKERS ASSOCIATION INC. 5 APRA has said that it will follow Basel III, while using, to the extent it deems appropriate, the discretions available in the Basel III framework. APRA supports the transnational goal of convergence towards common approaches and common standards. And APRA is in the process of updating and augmenting its prudential standards to meet Basel III. There has been a lot of consultation already, but the new standards are not expected before the end of this calendar year. The ABA and our member banks have been closely engaged with APRA, the Reserve Bank and the Basel Committee itself since early 2009 on the proposals which led to Basel III, and that engagement will continue over the whole implementation period all the way out to So there is still much to be done before we can determine what Basel III really means for Australia s banks, and therefore, what it may mean for customers and shareholders. But again, this isn t really a very satisfactory answer. So let me come at it in another way. We do know one thing. Whatever the impact in Australia, the consequences of Basel III on Australian banks could have been much greater. The initial global proposals proto-basel III if you like were of great concern to us. The draft requirements suggested banks would need to double their holdings of high quality liquid assets and hold significantly more capital.

6 AUSTRALIAN BANKERS ASSOCIATION INC. 6 In April last year, when we made our submissions on the Basel Committee s consultative documents, we were very concerned that the draft liquidity and capital requirements, when added together, could result in a slowdown in credit availability and an increase in costs, pushing up interest rates, impeding our economic recovery and stifling further growth. There was a danger that Australia might have won the war withstanding the worst of the Financial Crisis but lost the peace, by being weighed down with measures that responded to problems that we never had. We argued at the time and it remains relevant that a balance needs to be struck between responding to the financial crisis by strengthening the resilience of the financial system, and ensuring credit continues to flow through the veins of the economy that banks can continue to serve effectively the purpose for which they were created namely to intermediate between those that have money they want to see grow and those that need money, to invest in anything from a new home or an expanding business. Fortunately, today we seem to be much closer to that balance. Certainly, the Basel Committee and Financial Stability Board argue the impact of the new rules on the broader economy will be marginal. Along with the capital and liquidity rules released in December, they published the final report on their macro-economic analysis of the impact of the proposed changes to capital rules. They concluded that: annual growth rates will be reduced by 0.03 percentage points for 35 quarters that s nearly 9 years for those, like me, not so quick with the

7 AUSTRALIAN BANKERS ASSOCIATION INC. 7 maths followed by a period during which annual growth will be 0.03 percentage points higher. The report went on to say, however, that: If banks choose to implement the new requirements ahead of the schedule set out by supervisors, the impact on the overall level of GDP will be somewhat greater and compressed into a shorter time period, resulting in a greater impact on growth rates. These effects would also be accentuated to the degree that banks choose to hold an additional voluntary equity capital buffer above the new standards. Of course, it might not be entirely down to banks to choose to implement more quickly or to hold an additional buffer. The market may have a bit of an influence on that, but I will let that pass. To give some context to the 0.03 percentage point, or 3 basis point quarterly decrement Australia s GDP fell by a seasonally adjusted 120 basis points in the March quarter. This was an aberration, driven largely by the natural disasters, but it puts a 3 basis point drop into context. So the Basel Committee and Financial Stability Board are arguing that, at a global level, the impact of the capital rules should be fairly minimal. Unfortunately, the Working Group didn t update its initial analysis of the impact of the liquidity requirements, which was released in August last year and was based on the draft rules from December What that preliminary analysis found, however, was that: The cost of meeting the [Net Stable Funding Ratio] depends on assumptions about the structure of banks balance sheets and the strategies banks are assumed to follow when adjusting.

8 AUSTRALIAN BANKERS ASSOCIATION INC. 8 But that Each of these changes either reduces interest income or raises interest expense, thereby lowering net income. Banks avoid a fall in their ROE by raising lending spreads. The estimates of increased lending spreads in the report varied, ranging up to 50 basis points. However, we know that the liquidity ratios are subject to long observation periods out to 2015 for the Liquidity Coverage Ratio and 2018 for the NSFR and to possible re-calibration, so the true impacts may yet vary significantly. We also know that liquidity treatment in Australia will be different from other parts of the world. Not easier, but different. The original proposals assumed that banks could buy sufficient government bonds to meet the stringent new liquidity requirements under Basel III. The assumption, not unreasonable given the levels of government debt around the world, was that banks had access to deep and liquid government bond markets. Obviously, that is not the case in Australia. A decade of careful fiscal management meant that Australia had negligible government debt by the time of the Crisis, and consequently, fewer bonds on issue. This has been recognised by the international community it would be more than ironic if those countries with strong fiscal histories were to be disproportionately punished under the Basel III requirements especially given how sovereign debt now looms over the world as the next great systemic risk.

9 AUSTRALIAN BANKERS ASSOCIATION INC. 9 So, it would seem that the view of the Basel Committee, of which Australia is a member, is that the new rules will have an impact on the world s banks, but one that is only marginal. But again, this fails to really answer the question of what that impact will be on Australian customers and shareholders. It is an aggregated, high level view, so let me turn now to look at how Australia s own banks sit. In relation to the whole Basel package, we think Australia s banks are relatively well positioned on capital, not least because we started out before the GFC with well capitalised banks. Our banks will also meet the bar on the leverage ratio. And with the benefit of the Reserve Bank s liquidity facility, and the time available to meet the possible LCR and NSFR requirements, we should be able to get there on liquidity. Our banks have said publicly that they are well positioned to transition to the new Basel III capital and liquidity requirements, although time to do so will be critical. But it is significant that APRA has warned that banks will need to demonstrate that they have taken all reasonable steps towards meeting their Liquidity Coverage Ratio requirements through their own balance sheet management before they will be able to take advantage of the RBA facility. So once more, all of this really suggests that any impact on customers and shareholders will be marginal. But that is not to say there will be no impact. You cannot bring in major new capital and liquidity rules around the world and not have an impact.

10 AUSTRALIAN BANKERS ASSOCIATION INC. 10 In fact, if you didn t have an impact, you d have to ask why we have the new rules at all. But forecasting the precise impact of the new capital and liquidity requirements is very difficult. We don t have the Australian standards as yet, and many of these requirements will not come into effect for some years. And what impact these rules will have depends on a number of variables, including: how the re-calibration process works and its results; any changes to demand and supply in financial and capital markets, including markets for short and long-term debt and returns on liquid assets; the behaviour of investors who participate in those markets; growth in loans and deposits; growth in major funding economies; the linkage between bank lending and economic growth; the actions taken by banks to meet the proposed requirements; and the actions taken by other parties in response to any or all of the above. To give you some examples of possible impacts, we expect there will be higher costs for banks in holding more capital and more liquid assets and we anticipate that shareholders will require banks to pass on at least some of these additional costs to customers, in order to ensure a reasonable return on equity.

11 AUSTRALIAN BANKERS ASSOCIATION INC. 11 These higher costs will be incurred regardless of what the Reserve Bank does with the official cash rate, but how these costs are distributed is still very unclear. They might be spread uniformly across banks lending portfolios or be passed on to particular segments of the market, such as the more risky segments. Ultimately, changes to bank balance sheets and lending rates will also transmit to the real economy. Significant restructuring of bank balance sheets to meet the proposals (particularly the NSFR), coupled with supply constraints in financial markets, may require banks to reduce their lending. Higher lending interest rates, passed on to borrowers, all else being equal, will reduce household disposable incomes and increase the cost of business investment. Downward pressures on bank equity returns may have implications for consumer wealth. These and other factors will impact economic growth. But other factors will influence the final impact on GDP. These include monetary policy responses to higher lending rates, with the Reserve Bank adjusting its official rate to reflect the actual prices it wants in markets. There may also be a response from the unregulated sectors of the economy in meeting any credit supply gap left by the banking sector which could in itself be an issue. So what does this mean for individual customers and shareholders? Well, our view is that, at a customer level, the vast majority of customers will not experience a significant

12 AUSTRALIAN BANKERS ASSOCIATION INC. 12 step-change in the availability or price of bank products, and that, from day to day, their bank will look just the same. For low risk customers and they are the majority of Australian bank customers any increase in borrowing cost or reduction in credit availability will be very subtle, even imperceptible over the period of time that these changes are being made. But higher risk borrowers will find credit less available and more expensive. Or will be required to provide better security for their lending. It is not clear what broad economic impact this may have. Will it, for example, be harder for entrepreneurs to raise money to pursue their innovations and challenging new business visions? Will some existing businesses in more risky markets find banks less interested or willing to maintain their finance? We don t know, and we may never be able to distinguish cause and effect, but we need to be conscious of these potential impacts. But I have to emphasis the point that these will be neither dramatic nor sudden changes. Nor should they come as a surprise. After all, the whole purpose of Basel III is to better manage the risks within the financial system. And we have to balance the costs of the new rules against the benefits of a more robust, resilient financial system. But given the potential impacts, it is in Australia s interests to manage our transition to Basel III in such a way that we minimise any negative economic consequences.

13 AUSTRALIAN BANKERS ASSOCIATION INC. 13 That s why we must continue to work closely with the regulators on the framework for Australia and the transition path to the new standards. And there are still challenges to be met. There is still much uncertainty on the detail, as well as at the higher level. For example, it is still unclear what APRA s plans are for bank balance sheet transitions so that they qualify for the RBA facility. There is also a question about the availability of government bonds for banks for their liquidity holdings. A recent research note by ANZ says that 1 : it is still not clear if there will be sufficient [Australian dollar] government bonds on issue to ensure liquidity heading into the new Basel III accords that are due to be fully implemented from 2015, especially if a strong [Australian dollar] continues to underpin offshore demand for bonds. Overseas ownership of CGS is already above 80% according to RBA data. To deal with these issues, we need consultation periods that are sufficiently long to analyse and respond to the detail of draft prudential standards. It is true that some milestones are some years out, but there is a lot of work to be done and we need to see the draft Australian standards as early as possible. But even as APRA and the banks are working together on the Australian regulatory process, there is the threat of more regulation to come. 1 See

14 AUSTRALIAN BANKERS ASSOCIATION INC. 14 Internationally, there are some, particularly in the northern hemisphere, who want to continue this journey on to a Basel 3.5 or 4 or some other destination, and at warp speed, factor 3.5 or 4. Our view is that the world needs to get Basel done first, and then re-assess stability and resilience before embarking on another major reform programme. Otherwise, we may be faced with some serious economic consequences. So finally, let me go back to the original question. What does Basel III mean for banks customers and their shareholders? My glib first answer was not much and really, for individual bank customers and retail shareholders, that is probably all they need to know. For the rest of us, we do know that you cannot significantly increase the capital and liquidity requirements of banks around the world without it having some impact. But as far as individual customers and shareholders go, that impact will be very subtle, and spread over a number of years. I mentioned at the outset that we need to strike the right balance between the resilience of our banking system and the ability of banks to ensure credit continues to flow through the veins of the economy. So far as Australia is concerned, and so far as we know, given that the details are yet to be fully revealed, Basel III seems to have struck that balance reasonably well. Thank you for your time.

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