RBNZ makes 'in-principle' decision for ANZ, ASB, BNZ & Westpac to be required to report credit risk through both their current internal models approach and the standardised approach

RBNZ makes 'in-principle' decision for ANZ, ASB, BNZ & Westpac to be required to report credit risk through both their current internal models approach and the standardised approach

The Reserve Bank says ANZ NZ, ASB, BNZ and Westpac NZ will have to start reporting their risk weighted assets (RWA) and associated credit ratios using both the internal models approach they currently use, and the standardised approach other New Zealand banks use.

The prudential regulator details this in a response to submissions on the calculation of risk weighted assets, which is part of its biggest ever review of bank capital adequacy requirements.

The decision confirms what the Reserve Bank proposed in a consultation paper late last year, as reported by interest.co.nz here. Not surprisingly, all of ANZ, ASB, BNZ and Westpac argued for the status quo to be retained, that they just keep using internal models, in submissions to the Reserve Bank.

Nonetheless the Reserve Bank has revealed five "in-principle" decisions. They are:

- the capital framework will continue to permit qualifying banks to use internal models to estimate credit-risk related RWA (the IRB or internal ratings based approach), although there will be more restrictions on modelling;

- the IRB approach will not be permitted for any credit exposure with an external rating (for example, sovereigns, banks, some large corporates);

- there will be a RWA floor imposed on IRB models. This floor will be a proportion of the equivalent standardised calculation RWA value;

- all banks will calculate the RWA arising from operational risk in the same way, using the Basel Standardised Measurement Approach; and,

- IRB banks will be required to report RWA (and associated credit ratios) calculated using the standardised approach alongside those arising from the IRB approach (‘dual reporting’).

The big four banks using the internal models approach means credit risk weights calculated using it account for about 90% of NZ banking sector exposures. All other NZ banks use the so-called standardised approach for credit risk, through which their credit risk weights are prescribed by the Reserve Bank and are typically higher than those of the big four banks, who set their own models which they must get approved by the Reserve Bank.

Simplicity and clarity demanded in times of stress

The Reserve Bank says it'll consult stakeholders next year on the details of its decisions. And the next stage in the capital review will be a quantitative impact study to shape the central bank's analysis of the potential costs and benefits of its in-principle decisions. Additionally submissions will be sought on the minimum capital ratio settings, likely in the fourth quarter of 2018.

"We continue to believe that credit risk models need to be constrained more in the light of our experience with the IRB framework. This is consistent with the view about internal models held by the Basel Committee and many overseas regulators," the Reserve Bank says.

"On balance, the Reserve Bank prefers an approach that retains IRB models in the New Zealand framework, while putting in place restraints on IRB modelling to mitigate the disadvantages of internal modelling (competitive neutrality and the opaqueness of internal models)."

It goes on to point out it's not clear to external parties how IRB banks arrive at their model RWA values, with this lack of transparency reducing the effectiveness of market discipline, which is one of the three pillars of the Reserve Bank's regulatory regime.

"The recent example of the Global Financial Crisis also provided strong evidence that in times of stress, market participants and other stakeholders quickly demand simplicity and clarity about the measurement of capital, which is a clear advantage the standardised framework has over the IRB approach," the Reserve Bank adds.

The Reserve Bank doesn't believe compliance with dual reporting will be onerous for ANZ NZ, ASB, BNZ and Westpac NZ. However, it acknowledges it hasn't yet calculated the costs and benefits, but suggests private costs to banks should be balanced against potential net social benefits.

APRA watch

The Reserve Bank notes the Australian Prudential Regulation Authority (APRA) is considering making changes to the standardised approach. For example, it points out APRA has identified four characteristics of residential mortgages associated historically with relatively high probabilities of loss being interest-only loans, poorly documented loans, high debt-to-income loans, and investment property loans. APRA is proposing to classify mortgages with one or more of these characteristics as non-standard, which means they'll have a 100% risk weight, versus 25% normally.

APRA's expected to finalise its policy next year. The Reserve Bank says it'll then assess whether or not to adopt the same approach in New Zealand, and may seek submissions.

"...there may be compliance efficiencies for the large four banks if some aspects of New Zealand's standardised approach are modified in order to facilitate dual reporting," the Reserve Bank says.

*This article was first published in our email for paying subscribers early on Monday morning. See here for more details and how to subscribe. 

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What a rort, how the big four banks are allowed to use their own models to calculate RWA's is beyond me. Even the standardized approach is far too lenient, in my book bank's should be 100% equity financed. https://johnhcochrane.blogspot.com/2016/05/equity-financed-banking.html

And we wonder why a) the smaller banks can't compete and b) why the big four (correctly) believe they will be bailed out as they are too big to fail.

I'm going to go out on a limb and guess that you're not in finance

100% wrong

ok, substitute "in" with "understand" in that case.

Ha, stop digging while you're ahead.

If you don't trust me or a Chicago School economist like John Cochrane try Mervyn King's Pawnbroker for All Seasons model. Whatever way you cut it allowing bank's to leverage themselves up 20x while using short term money market funding is a recipe for disaster.

Btw I used to calculate RWA's for RBS so I think I have a fair handle on the subject.

What do you think the western world would look like if banks were restricted to equity funding? Should every transaction be restricted to equity? Have you ever borrowed money (mortgage, credit card, car finance, student loan). What about other firms, can they borrow?

This is good , we dont want Banks holding our savings, facing even a whiff of trouble

Furthermore, Internal RWA calculations by The Big Banks have been controversial for years!

CBA (ASB's parent) has (in 2014) 1.4% capital against residential mortgage risk or a gearing of almost 75:1