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Basel 3 bail-in rules apply in theory, unlikely in practice

31 August 2016 5:00PM
At yesterday's Actuaries Institute "Banking on capital" seminar in Sydney, Kevin Davis (a Melbourne financial studies academic and former member of the Financial Services Inquiry) presented highlights from a recent paper he co-authored with Michael Saba, from investment advisory firm Evans and Partners.The paper, titled "Hunting the BIRP: Is There a 'Bail-In Risk Premium' in Australian bank hybrids?" attempts to answer the question: "When it comes to bail-in risk premium for securities, does the market provide appropriate compensation for risk involved bail-in risk premium?" The instruments referring to in Australia are generally bank hybrids, although the asset class includes securities known as convertible contingent securities, or 'cocos'.In general, Davis was referring to securities that will mandatorily convert to shares, or be written off, if some trigger event occurs. What they do have in common is that they are characterised by uncertainty rather than by risk which can be modelled probabilistically.In the case of Australia, the securities are limited to those listed on the ASX, and have largely been directed to, and snapped up, by retail investors.  Davis also pointed out that in 2014 there was a re-rating of the bail-in risk downwards which he put down to an oversupply in the market.Davis also warned that there is complete uncertainty as to how the new bail-in rules will apply and if they normally apply at all, which further complicates matters, so he attempted to apply a number of empirical tests to determine to what extent 'bail-in' risks are measurable and deliberately priced in.The other big point Davis was keen to make to his audience was to question the rationale behind creating 'unquestionably strong' banks by boosting their balance sheets and capital structure."Why not have 'stronger and simpler' liquidity measures", he asked. That is, just mandate a leverage ratio of, say, five per cent. In a subsequent Q&A session, Davis suggested that a rate of 15 per cent might be a good starting point. Davis wouldn't be drawn on whether it is therefore inappropriate to market these securities to retail investors, arguing that the strength of Australian banking sector mean we should keep them all in perspective.

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