As discussed in Section 1, the Basel Committee on Banking Supervision sees it as important that adequate capital buffers are held in good times that can be drawn upon in periods of stress, and are looking to introduce buffer requirements in Basel III. It was also discussed in Section 1 how a mark to market approach of a bank’s assets can provide a measure of how much capital needs to be raised to restore confidence in a bank’s capitalisation. Let us take the take the BOE example, whereby UK banks held capital (total balance sheet equity to total assets) of 3.3% prior to the GFC. We see in Appendix 1 that European banks experienced an approximate doubling in asset volatility during the GFC.
Let us also assume that this capital position position held by the banks provided a DD which was acceptable to regulators in pre-GFC circumstances. Given that volatility in assets is the denominator of the DD equation, in order to restore UK DD to the pre-GFC position, capital needs to be doubled in line with the volatility increase. This means a capital buffer of 3.3% (resulting in a total ratio of 6.6%). Applying the same rationale to Australian banks, they would require a much lesser increase, as their capital ratio is already 6.2%. Thus, provided a benchmark DD (and hence PD) is provided by regulators (or banks themselves), and increases in asset volatility are modelled during downturns, the extent of the capital buffer required can be determined.
8. Conclusions and Implications
Despite the lower volatility of Australian banks in comparison with their US and European peers, Australian bank default risk still increases dramatically during the GFC when we include market asset value fluctuations as compared to the static external ratings. On a CPD basis, Australian banks fare only slightly better than the US and UK during the GFC, with all 3 of these regions showing extremely high default probabilities. Banks typically have much lower equity levels than other industries, and the combination of this and market asset value fluctuations leads to increased default probabilities.
This paper has provided a range of evidence to show that the risk of Australian banks deteriorated during the GFC, in contrast to the static external ratings. Firstly, although impaired assets are much lower than those of global peers, they nonetheless increased five- fold. Secondly, share prices have been extremely volatile, dropping 58% over the GFC period, with highly significant increases in VaR and CVaR. Thirdly, banks show highly significant increases in default probabilities on both DD and CDD measures. Fourthly, sensitisation of the Merton DD and CDD measures, through calibration to EDF, still results in extremely high default probabilities during the GFC. Fifthly, the relative default rankings of Australian banks in relation to other industries has deteriorated. Finally, CDS spreads have shown a strong increase.
This reduction in bank equity values, increase in impaired assets and provisions for bad debts, increasing credit default swap spreads, and the shift in relative default rankings of banks as compared to other industries, all support the findings of significantly increased risk based on market values. In conclusion, contrary to the low static default probabilities indicated by external credit ratings, there has been a significant increase in Australian bank default probabilities during the GFC when taking into account market asset value fluctuations.
These findings have implications for lenders to banks in assessing default probabilities and regulators in determining capital adequacy. The Basel standardised capital approach is based on external credit ratings, which sees capital requirements in respect of loans to these banks remaining static during the GFC as compared to pre-GFC. This is not consistent with the increased default probabilities shown in this paper. The findings support including an assessment of fluctuating asset values in lending and capital adequacy buffer decisions.
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Appendix 1
Table 9. Global Bank Fluctuations Australian Banks Market Cap USD $m Daily VaR Daily CVaR Daily VaR Daily CVaR Daily VaR Daily CVaR Daily Stdev Daily Cstdev ANZ 54,366 0.0192 0.0261 0.0351 0.0630 1.83 2.41 2.25 2.12 COMMONWEALTH 52,468 0.0181 0.0253 0.0308 0.0516 1.71 2.03 1.69 1.47 NATIONAL AUSTRALIA 56,071 0.0205 0.0296 0.0361 0.0587 1.76 1.98 2.07 1.77 WESTPAC 68,424 0.0186 0.0252 0.0327 0.0537 1.76 2.13 2.32 1.85 SUBTOTAL MAJOR BANKS 231,330 0.0191 0.0265 0.0337 0.0566 1.76 2.14 2.10 1.80 OTHER BANKS (10) 33,097 0.0249 0.0432 0.0420 0.0717 1.69 1.66 2.16 1.54 TOTAL 264,427 0.0198 0.0286 0.0347 0.0585 1.75 2.05 2.10 1.76
Volatiliy Significance Testing: F Test:
GFC / Pre GFC - Major Banks Other Banks / Major Banks - Pre GFC
VaR CVaR
Asset Stdev
Asset
Cstdev VaR CVaR Asset Stdev Asset Cstdev F 3.1150 4.5588 4.3903 3.2566 1.7079 2.6517 1.2873 1.6077 p <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 Significance ** ** ** ** ** ** ** **
GFC / Pre GFC - Other Banks Other Banks / Major Banks - GFC
VaR CVaR
Asset Stdev
Asset
Cstdev VaR CVaR Asset Stdev Asset Cstdev F 2.8431 2.7578 4.6680 2.3638 1.5588 1.6041 1.3687 1.1669 p <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 0.0002 0.0425 Significance ** ** ** ** ** ** ** * Canadian Banks Market Cap USD $m Daily VaR Daily CVaR Daily VaR Daily CVaR Daily VaR Daily CVaR Daily Stdev Daily Cstdev BANK OF NOVA SCOTIA 44,523 0.0225 0.0323 0.0366 0.0561 1.63 1.74 1.92 2.26 ROYAL BANK CANADA 74,466 0.0214 0.0317 0.0380 0.0602 1.77 1.90 1.99 2.43 TORONTO-DOMINION 50,852 0.0234 0.0336 0.0362 0.0572 1.54 1.70 1.69 2.10 SUBTOTAL MAJOR BANKS 169,841 0.0223 0.0324 0.0371 0.0582 1.66 1.80 1.87 2.28 OTHER BANKS (6) 60,969 0.0228 0.0330 0.0406 0.0625 1.79 1.90 2.13 2.41 TOTAL 230,810 0.0224 0.0326 0.0380 0.0594 1.70 1.82 1.92 2.30
Volatiliy Significance Testing: F Test:
GFC / Pre GFC - Major Banks Other Banks / Major Banks - Pre GFC
VaR CVaR
Asset Stdev
Asset
Cstdev VaR CVaR Asset Stdev Asset Cstdev F 2.7614 3.2253 3.4958 5.1972 1.0409 1.0336 2.6102 2.6706 p <0.0001 <0.0001 <0.0001 <0.0001 0.2012 0.2448 <0.0001 <0.0001 Significance ** ** ** ** - - ** **
GFC / Pre GFC - Other Banks Other Banks / Major Banks - GFC
VaR CVaR
Asset Stdev
Asset
Cstdev VaR CVaR Asset Stdev Asset Cstdev F 3.1899 3.5935 4.5301 5.8226 1.2024 1.1516 2.0143 2.3838 p <0.0001 <0.0001 <0.0001 <0.0001 0.0199 0.0576 <0.0001 <0.0001 Significance ** ** ** ** * - ** ** Pre-GFC GFC VaR/ CVaR increase (times) Asset Value Fluctuation increase (times) Pre-GFC GFC VaR/ CVaR increase (times) Asset Value Fluctuation increase (times)
Appendix 1 (continued) European Banks Market Cap USD $m Daily VaR Daily CVaR Daily VaR Daily CVaR Daily VaR Daily CVaR Daily Stdev Daily Cstdev BANCO SANTANDER 121,617 0.0335 0.0482 0.0430 0.0699 1.28 1.45 1.52 1.64 BARCLAYS 48,519 0.0322 0.0473 0.0651 0.1018 2.02 2.15 3.84 4.17 BNP PARIBAS 84,755 0.0313 0.0476 0.0503 0.0812 1.61 1.70 2.68 2.92 CREDIT SUISSE 76,650 0.0393 0.0620 0.0607 0.1006 1.54 1.62 2.08 2.16 HSBC 192,500 0.0241 0.0369 0.0354 0.0588 1.47 1.60 1.68 1.90 LLOYDS TSB 50,130 0.0310 0.0455 0.0617 0.0985 1.99 2.16 3.00 2.93 SOCIETE GENERALE 45,040 0.0350 0.0511 0.0575 0.0873 1.64 1.71 2.49 2.52 UBS 72,326 0.0291 0.0435 0.0658 0.1072 2.26 2.46 3.36 3.64 UNICREDIT 50,240 0.0267 0.0411 0.0544 0.0933 2.03 2.27 3.35 3.88
SUBTOTAL MAJOR BANKS 741,777 0.0303 0.0456 0.0503 0.0818 1.66 1.79 2.05 2.22
OTHER BANKS (7) 153,969 0.0340 0.0523 0.0653 0.1118 1.92 2.14 3.61 3.92
TOTAL 895,746 0.0310 0.0468 0.0529 0.0869 1.71 1.86 2.15 2.34
Volatiliy Significance Testing: F Test:
GFC / Pre GFC - Major Banks Other Banks / Major Banks - Pre GFC
VaR CVaR
Asset Stdev
Asset
Cstdev VaR CVaR
Asset Stdev Asset Cstdev F 2.7459 3.2146 4.2014 4.9261 1.2582 1.3162 8.5943 7.0611 p <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 Significance ** ** ** ** ** ** ** **
GFC / Pre GFC - Other Banks Other Banks / Major Banks - GFC
VaR CVaR
Asset Stdev
Asset
Cstdev VaR CVaR
Asset Stdev Asset Cstdev F 3.6873 4.5682 13.0506 15.3323 1.6896 1.8705 2.7668 2.2686 p <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 Significance ** ** ** ** ** ** ** ** US Banks Market Cap USD $m Daily VaR Daily CVaR Daily VaR Daily CVaR Daily VaR Daily CVaR Daily Stdev Daily Cstdev BANK OF AMERICA 130,273 0.0268 0.0407 0.0778 0.1326 2.91 3.26 6.04 8.34 CITIGROUP 94,280 0.0306 0.0462 0.0895 0.1566 2.92 3.39 6.04 7.64 JP MORGAN 154,621 0.0361 0.0549 0.0666 0.1075 1.84 1.96 2.09 2.33 US BANCORP 43,062 0.0294 0.0460 0.0479 0.0756 1.63 1.64 1.95 2.09 WELLS FARGO 139,771 0.0213 0.0316 0.0648 0.1019 3.05 3.22 3.28 4.02
SUBTOTAL MAJOR BANKS 562,006 0.0288 0.0437 0.0711 0.1177 2.47 2.69 3.22 3.93
OTHER BANKS (46) 125,900 0.0241 0.0361 0.0638 0.1024 2.65 2.84 3.06 3.59
TOTAL 687,906 0.0279 0.0423 0.0698 0.1149 2.50 2.72 3.19 3.86
Volatiliy Significance Testing: F Test:
GFC / Pre GFC - Major Banks Other Banks / Major Banks - Pre GFC
VaR CVaR
Asset Stdev
Asset
Cstdev VaR CVaR
Asset Stdev Asset Cstdev F 6.0948 7.2621 10.3795 15.4100 1.4353 1.4624 1.3362 1.1596 p <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 0.0010 Significance ** ** ** ** ** ** ** **
GFC / Pre GFC - Other Banks Other Banks / Major Banks - GFC
VaR CVaR
Asset Stdev
Asset
Cstdev VaR CVaR
Asset Stdev Asset Cstdev F 7.0377 8.0475 9.3722 12.8910 1.2430 1.3197 1.2066 1.0308 p <0.0001 <0.0001 <0.0001 <0.0001 0.0076 0.0010 0.0181 0.3673 Significance ** ** ** ** ** ** * - Pre-GFC GFC VaR/ CVaR increase (times) Asset Value Fluctuation increase (times) Asset Value Fluctuation increase (times) VaR/ CVaR increase (times) GFC Pre-GFC
VaR is calculated on a parametric basis, whereby the standard deviation of daily returns is multiplied by 1.645 (being 95% confidence level based on a normal distribution). Annual VaR can be obtained by multiplying Daily VaR by the square root of 250. Figures are undiversified and represent the weighted average of the individual bank VaRs. CVaR is calculated as the average of the worst 5% of actual returns (those beyond the 95% VaR). The pre- GFC category calculates daily VaR for the 2 year window including data from 2007 and 2008. The GFC category calculates daily VaR for the 7 year period from 2000-2006. Major banks for the purposes of this table are defined as all banks with market capitalization exceeding USD $40billion. The four columns on the right of the table show the increases (GFC as compared to pre-GFC) in VaR, CVaR Asset Stdev and Asset CStdev. Market asset value of returns is (Stdev) calculated as the standard deviation of all asset returns for the period, whereas CStdev is based on the worst 5% of asset returns. F testing is undertaken to test for variance in volatility. F is 21/ 22, where 1 and
2 are the standard deviations of returns for the two samples being compared. An F value of 1 shows no difference between the samples and a value of 3 shows variance of 3x higher in the one sample as compared to the other. * denotes significance at the 95% level and ** at the 99% level.