Why do banks seem to have the ability to lend never ending amounts of money?

Welcome to Finance and Fury, the Furious Friday edition.

Today – discuss the topic of banking policy changes and how this opened the gates for the potential of never-ending money supply in the modern banking system

To start with – look at How does money get lent out in Australia?

Well – by a bank of course – you go to a bank to borrow money but what are they allowed to lend around? Well in basic economics – banks are treated as a financial intermediary – their role in a traditional sense is to connect savers to borrowers – they act as the middleman So a saver with surplus cash will put it into the bank – the bank will then use this as a reserve and lend out based around this Under this situation – a banks ability to lend is limited by how much they have of their customers savings – which act as the deposits Because in order to lend more money – they need more depositors – no depositors – no loans However – this theory is based around what is known as fractional reserve banking – where a commercial bank has a set reserve requirement and will lend out at a multiple of those reserves The classification of reserves was expanded upon over time – in addition to depositors funds - had treasury bonds and deposits at the RBA – but depending on monetary policy – lending could be limited As an example – say the reserve requirement is 10% - then the multiplier is 10 times – if the bank has $1m of deposits they can lend out $10m deposits - But this concept is rather misleading in the modern era of banking – I mentioned in Weds episode that Australia does not have an official fractional reserve banking system This was abolished when we brought in the Basel standards – ‘Basel I’ – which was implemented in 1988 Central to the design of the Basel capital standards is the idea that a bank should hold capital in relation to its likelihood of incurring losses In the modern era - A bank's capital simply represents its ability to withstand losses without becoming insolvent Hence – a capital adequacy requirement is set – monitored and regulated by APRA based around guidelines set by the BIS using the Basel standards I do see one reason why there was a need for this movement away from the reserve requirements – In the modern economy where deposit accounts are insured by governments – it is likely that banks would have found it tempting to take undue risks in their lending operations since the government insures deposit accounts So these regulatory capital requirements have at least removed this moral hazard But it has opened up the floodgates for lending – and skewed the traditional incentives of lending – so let’s look at it further

 

How does the Capital adequacy requirements work?

First – look at the capital that has replaced depositors’ funds as the reserve requirement – these are broken down into Tier 1 and Tier 2 capital – where the sum of these two make up the reserve requirements - net of any deductions on the banks balance sheets Tier 1 – Tier 1 capital consists of the funding sources to which a bank can most freely allocate losses without triggering bankruptcy – essentially - assets that can be liquidated (sold), written down or converted to cover losses quicky – hence it avoids a bankruptcy – includes: ordinary shares in the bank and retained earnings that the bank has on its balance sheet - makes up most of the Tier 1 capital held by Australian banks – But tier 1 capital also includes specific types of preference shares and convertible securities – such as capital notes – Convertible securities, for example, were included in the Basel II definition of Tier 1 capital on the premise that banks would exercise their option to convert them into common equity whenever additional capital was needed. however - since it is more difficult for banks to allocate losses to these instruments - APRA set a limit of 25% of Tier 1 capital being allowed in this form The APRA requirements set are 10.5% for the capital adequacy requirement – or 10.5% of its risk-weighted credit exposures – the loans that may not be able to be repaid Tier 2 – considered to be less liquid or convertible than tier 1 - in many some cases they may only be effective at absorbing losses when a bank is being wound up provides depositors with an additional layer of loss protection after a bank's Tier 1 capital is exhausted - primarily consists of subordinated debt - though it also comes in other varieties Both Tier 1 and Tier 2 capital are measured net of deductions This is an adjustments due to the way accounting measures are treated – sometimes the banks will have forms of equity used to balance their holdings of intangible assets – things like goodwill – so if a bank is going to go bankrupt – this loses all of its value Secondly – have to measure the risks that this capital requirement is set against - For capital adequacy purposes, Australian banks are required to quantify their credit, market and operational risks most significant of these risks is credit default risk – or bad loans emerging from people defaulting on their loans – which is part of a banks traditional lending activities This credit risk is measured as the risk-weighted sum of a bank's individual credit exposures, which gives rise to a metric called ‘risk-weighted assets’ Standardised approach for these risk weights are prescribed by APRA for smaller banks - based on the risks of default and other characteristics of each loan the bank is exposed to For example – take one residential mortgage – if it has a loan-to-valuation ratio of 70%, no mortgage insurance and the borrowers are managing to make repayments - APRA specifies a risk weight of 35% - so for every $100 of outstanding debt – the risk-weighted asset would be $35 However –the risk weight for corporate (business) loans is 100% - For the big 4 – they use an alternative Internal Ratings-based approach whereby risk weights are derived from their own estimates of each exposure's probability of default – so the bank can set the limits for the risk weight against each loan

Where does the market currently stand –

Banks have been busy – the amount of capital held by the Australian banking system has been increasing – rather rapidly since 2014 – went from a capital adequacy ratio of 12% to 16.3% in June – this is a combination of Tier 1 and Tier 2 capital The rise in the banking system's Tier 1 capital mostly reflects a large amount of new equity in the form of share issuances as well as capital notes that have been issued to the market Covered this as part of the bail in topic a while back – but the banking system has been preparing for some downturn in loans for some time Over time – it was also through dividend reinvestment plans occurring over the years the banks Tier 1 capital has been growing – up until recently Also – with a lot of banks cutting back on dividends – their retained earnings have also boosted the Tier 1 capital more than the reinvestment of dividends normally would Another major trend over the years – thanks to recommendations from the Basel Standard – lend more to households over businesses – that way your risk There has been a large shift in the composition of banks' loan portfolios towards housing lending - attracts much lower risk weights than business and personal lending Reversal in lending trends – Busines loans used to make up the lion share – in 1990s – Housing accounted for about 25% business loans about 65% - today these are reversing – It makes sense from a risk weighted asset point of view - As an example - The RBA released a paper back in 2010 - $3.9 trillion of lending by the banks with all kinds of loans – based around these risk weighted methodologies – there was $1.2 trillion in credit risk-weighted assets – then $2.7 trillion was unweighted assets Within the risk-weighted total, corporate exposures account for $370 billion, while residential mortgage exposures are lower at around $300 billion, reflecting their relatively lower risk weights To expand this example further – on the $1.2 trillion in RWA – banks would need about $126bn by todays standards in Tier 1 capital Bit of a side note – but was interesting reading a paper from the RBA back in 2010 – was talking about the forthcoming regulatory developments that are now in place – Increase the quality, international consistency and transparency of the capital base - This includes enhancing a bank's capacity to absorb losses on a going concern basis, such that more of its Tier 1 capital is in the form of common shares and retained earnings – which has occurred with massive capital raisings in shares of the banks over the years Ensure that even if a failed or failing bank is rescued through a public-sector capital injection, all of its capital instruments are capable of absorbing losses. This includes a requirement that the contractual terms of capital instruments allow them to be written off or converted into common equity if a bank is unable to support itself in the private market – which has been achieved by the capital notes which are convertible and form part of the bail in legislation

 

So what really affects banks’ ability to lend?

if bank lending is not restricted by the reserve requirement then do banks face any constraint at all? As we have seen – it isn’t the reserve requirements – looking at the household debt to GDP over the years – back when it was constrained by deposits and central bank reserves – struggled to get over 40% of household debt to GDP – after these requirements were removed – started to rise by quite a bit – by 2008 was about 110% - today is about 120% - so it has slowed over the past 10 years – but still second highest in the world But – they have to keep their capital adequacy in line with the minimum requirements – however this is rather subjective – in essence – banks are only constrained by three factors First – you have the demand for loans - banks base their lending decisions on their perception of the risk-return trade-offs – so as long as there are consumers out there with the deposit requirements (or existing equity in property) and the incomes needed to service the loans based around their lending standards- then the banks will lend There has been no shortage of demand – property markets have been a competitive environment – and with lowering interest rates – the amount people can afford by the borrower in the banks eyes (especially since the benchmark for the serving got dropped over a year ago) has goes up dramatically Second – the amount of Tier 1 capital they can raise – the sequence of how this works in practice is that it works in opposite direction of what most people would think – in reality - banks first make their lending decisions (lend the money out) and then go looking for the necessary capital through issuing it to the market to make sure they remain within the requirements Finally – the measurements of the risk weighted assets – which is a nominal establishment of how much per loan is consider risky – for example – 35% of a home loan And since the capital requirements are specified as a ratio whose denominator consists of risk-weighted assets (RWAs) – the level of capital that needs to be retained is dependent on how the risk is measured in turn – this level – say the 35% is dependent on the subjective nature of human judgment – and any subjective judgment from coming from regulators with close ties to those who work for the banks that they regulate – sometimes comes with the ever-increasing profit desire - which may lead the financial system down the road of underestimating the riskiness of their assets – especially in situation with bubbles in asset prices

In summary –

If bank lending is constrained by anything at all, it is how much tier 1 capital they can raise as well as how much the population can afford to borrow But the changes from 1988 has created a situation where banks were adapting to the changes in the monetary systems around the world – lending in a fiat world In reality – why wouldn’t the banking system do this? The reserve requirements were the foundation to banking under the gold standard – but under the fiat system where money can be created out of thin air – as long as there is somewhere to soak it up – such as the property market through additional mortgages – why wouldn’t the bank continue to lend as much as possible? Loans to them are assets – so the more they can lend – the more money they can make But I hope this episode helps to explain how the modern banking system works

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