Australian Bank Capital and the Regulatory Framework | Bulletin – September 2010 (2024)

Introduction

A bank's capital, in its simplest form, represents its ability to withstand losseswithout becoming insolvent. As demonstrated in a number of North Atlantic countriesduring the recent financial crisis, bank failures – and fears of bankfailure – can be highly disruptive to the macroeconomy. National regulatorstherefore promote resilience in the banking sector by specifying a minimumamount of capital that banks must hold and the form that capital should take.The financial crisis has prompted a rethink of how strict these requirementsshould be.

This article explains how the minimum capital requirement currently operates in Australia,discusses the Australian banking system's capital position and how it hasevolved over the recent crisis period, and briefly outlines some of the mainregulatory changes that are beingconsidered.^[1]

Capital Regulation in Australia

The Australian Prudential Regulation Authority (APRA) makes and enforces the ruleswhich govern the capital adequacy of Australian banks. The current set of rulesare a conservative application of the latest set of international capital standardsissued by the Basel Committee on Banking Supervision (BCBS), which are collectivelytermed ‘BaselII’.^[2]APRA introduced these standards to Australia in 2008 as an update to the firstset of Basel standards – ‘Basel I’ – that were implementedin 1988. Central to the design of the Basel capital standards is the idea thata bank should hold capital in relation to its likelihood of incurring losses.The standards focus heavily on the definition of capital and the measurementof risk.

Measuring capital

An Australian bank's regulatory capital is the sum of its ‘Tier 1’and ‘Tier 2’ capital, net of all specified ‘deductions’.

Tier 1 capital consists of the funding sources to which a bank can most freely allocatelosses without triggering bankruptcy. This includes, for example, ordinaryshares and retained earnings, which make up most of the Tier 1 capital heldby Australian banks (Table1). It can also include specific types of preferenceshares and convertible securities but, since it is more difficult for banksto allocate losses to these instruments, APRA currently specifies that no morethan 25 per cent of Tier 1 capital can be in this form. Total net Tier 1 capitalof Australian banks as at March 2010 was $131 billion.

Tier 2 capital is made up of funding sources that rank below a bank's depositorsand other senior creditors, but in many cases are only effective at absorbinglosses when a bank is being wound up. In this way, Tier 2 capital providesdepositors with an additional layer of loss protection after a bank's Tier1 capital is exhausted. Tier 2 capital of the Australian banking system primarilyconsists of subordinated debt, though it also comes in other varieties, suchas preference shares. Total net Tier 2 capital of the Australian banking systemas at March 2010 was $33 billion.

Both Tier 1 and Tier 2 capital are measured net of deductions, which are adjustmentsfor factors that lessen the loss absorption capabilities of capital. For example,banks often have equity balancing their holdings of intangible assets, likegoodwill, which can automatically lose value as a result of the threat of bankruptcy.That part of a bank's gross capital is therefore unavailable to absorbother incurred losses. As at March 2010, there were $70 billion of regulatorycapital deductions on the books of Australian banks. Around $45 billion weregenerated by holdings of intangible assets, most of which were in the formof goodwill.

Measuring risk

For capital adequacy purposes, Australian banks are required to quantify their credit,market and operational risks. The most significant risk of these is typicallycredit risk, reflecting Australian banks' focus on traditional lendingactivities.

Credit risk is measured as the risk-weighted sum of a bank's individual creditexposures, which gives rise to a metric called ‘risk-weighted assets’.Under the Standardised approach employed by most of the smaller banks, therisk weights are prescribed by APRA and are generally based on directly observablecharacteristics of each exposure. For example, if a residential mortgage hasa loan-to-valuation ratio of 70 per cent, full documentation and no mortgageinsurance, APRA specifies a risk weight of 35 per cent. If the outstandingbalance of that mortgage is $100, its corresponding risk-weighted asset is$35. Corporate exposure risk weights are based on external credit ratings andare generally higher than for residential mortgages because the exposures areusuallyriskier.^[3]

Some banks, including the four largest, use an alternative Internal Ratings-basedapproach whereby risk weights are derived from their own estimates of eachexposure's probability of default and loss givendefault.^[4]APRA grants approval to use this approach only after a bank has met strict governanceand risk modelling criteria.

These methodologies together give rise to $1,200 billion in credit risk-weightedassets at Australian banks (Table2). This compares with (unweighted)assets of around $2,700 billion. Within the risk-weighted total, corporateexposures account for $370 billion, while residential mortgage exposures arelower at around $300 billion, reflecting their relatively lower risk weights.There are also $200 billion in credit risk-weighted assets that are generatedfrom off-balance sheet exposures. These are predominantly in the form of corporatecredit commitments, interest rate derivatives, and foreign exchange derivatives.

The market and operational risks are also measured in terms of risk-weighted assets,though this is more of a naming convention than being indicative of the underlyingmeasurement process. For instance, as part of market risk, APRA requires somebanks to consider interest rate risk in the banking book (IRRBB), which refersto the potential for loss arising from timing and size mismatches in the repricingof a bank's funding and lending instruments. Measuring this risk requiresa holistic approach to the bank's balance sheet rather than the granularuse of risk weights for eachexposure.^[5]As at March 2010, total market and operational risks accounted for 5 per centand 7 per cent of the Australian banking system's total risk-weighted assets.

Minimum capital requirements

APRA requires all locally incorporated banks to hold total capital of at least 8per cent of their risk-weighted assets. At least half of their total capitalmust be the better-quality Tier 1, implying a minimum Tier 1 ratio of 4 percent.^[6]APRA can and does also increase these minima for individual banks where considerednecessary on account of their risk profile.

As at March 2010 the Australian banking system had an aggregate total capital ratioof 11.8 per cent and an aggregate Tier 1 capital ratio of 9.4 per cent, withboth ratios having increased significantly over the past couple of years (Graph1).

Recent Developments in Australian Banks' Capital

The recent global financial crisis has prompted much greater focus on banking systemcapital. Notably, large and sudden losses incurred by some of the world'slargest banks prompted investors, regulators and rating agencies to reappraisethe prospect of bank losses and appropriate levels of capital. In addition,some of the lower-quality forms of capital were not as available to absorblosses as anticipated, and were subsequently looked upon less favourably asa source of financial strength. Convertible securities, for example, were includedin the Basel II definition of Tier 1 capital on the premise that banks wouldexercise their option to convert them into common equity whenever additionalcapital was needed. These securities have not been as widely used in Australiaas in a number of other countries, but some domestic and international bankshave recently opted to raise capital in other ways rather than convert, fearingthe negative signal that conversion might send to markets.

Australian banks have responded to the change in global attitudes by significantlyincreasing the level and quality of their capital. Changes to the growth andcomposition of their loan portfolios have also limited increases in their risk-weightedassets. As a result, the Australian banking system's total capital ratiorose by 0.9 percentage points from September 2008 to March 2010 (it rose by1.3 percentage points from March 2008 to March 2010, though this figure isclouded by data issues associated with some banks' delayed transition toBasel II and the introduction of the IRRBB charge in September 2008). Moreover,the system's Tier 1 capital ratio rose by 1.8 percentage points duringthis time, to its highest level since at least the 1980s (when comparable datafirst became available). The sizes of these capital ratio increases are similarto the experience of the early 1990s, during which Australia had a recessionand the banking sector also faced strong market pressures to improve its capitalposition.

Holdings of capital

The amount of capital held by the Australian banking system rose by $13.7 billionfrom September 2008 to March 2010. Within this total, there was a rise in Tier1 capital of $26 billion and a decline in Tier 2 capital of $12.4 billion (Table3).

The rise in the banking system's Tier 1 capital mostly reflects a large amountof new equity that was issued in late 2008 and the middle of 2009 (Graph2).The major banks issued $30 billion during this time, largely through a combinationof new share issuance and dividend reinvestment plans. The regional banks issueda further $2.1billion. In contrast to some of their international peers,these issues were at only modest discounts to the market price, and were entirelyto the private sector; there was no injection of public money into Australianbank capital. New equity raisings were the key driver of increases to the Australianbanking sector's Tier 1 capital in the early 1990s as well.

Having reported solid profits throughout the turmoil, the Australian banking sectorwas also able to generate Tier 1 capital organically, through increases inretained earnings. Some banks supported this process by making cuts to theoverall value of dividend payments, which contributed to higher retained earningsthan would have otherwise been the case (Graph3).

The effect of these initiatives in increasing Tier 1 capital was somewhat offsetby a rise in deductions, partly because a number of acquisitions generatednew goodwill through the purchase price exceeding the book value of assets.There was also a $1 billion fall in the outstanding amount of Tier 1 convertiblesecurities. The financial crisis has highlighted that there can be strong disincentivesfor banks to use them as loss absorption tools, so they have become less highlyregarded as sources of bankruptcy protection by markets and regulators. TheBCBS has signalled that the status of these securities is being reviewed inforthcoming revisions to international capital standards.

With a number of governments overseas having recently demonstrated their willingnessto shore-up banks' balance sheets before their Tier 2 capital takes losses,markets are also placing less emphasis on this form of capital. Most notably,the outstanding balance of Australian banks' term subordinated debt hasfallen by around $10 billion since September 2008, after strong issuance inthe earlier part of the decade.

Exposures to risk

The Australian banking sector's total risk-weighted assets rose by $16.3 billion,or 1.2 per cent, from September 2008 to March 2010. There was a $11.3 billionrise in the charge for market risk, with the IRRBB charge increasing as a resultof rises in long-term interest rates from early in 2009 and the amortisationof past IRRBB gains. The operational risk charge rose by $11.7 billion.

Partly counteracting these rises was a $6.6 billion fall in credit risk-weightedassets. One reason for this decline is the relatively slow growth in Australianbanking sector lending over this period, as banks tightened their lending standardsand businesses worked to reduce theirleverage.^[7]The sector's total domestic credit has grown at an annualised rate of 4.5 percent since September 2008, compared with an average of around 14 per cent overthe previous five years (Graph4). There has also been a shift in thecomposition of banks' loan portfolios, towards housing lending, which typicallyattracts much lower risk weights than business and personal lending. The amountof banks' off-balance sheet credit commitments has been falling recentlyas well. The slower growth in credit and the change in its composition aresimilar to the patterns of the early 1990s recession, when credit growth ofthe Australian banking sector fell significantly and the share of credit devotedto housing increased strongly. Credit risk-weighted assets, though measureddifferently at the time, fell by 6.4 per cent from December 1990 to December1993.

These recent size and compositional changes to bank lending have been partly offsetby an increase in the average risk weight of banks' business exposures.For the major banks, whose credit risk weights are derived using internal models,estimates of the average probability of default for large corporate counterpartiesincreased by around ½ of one percentage point to 1½ per cent(Graph5). Their average probability of default estimates for residentialmortgages have increased only very slightly and remain at a little over 1 percent. There were also some rises in loss given default estimates across thesecategories.

Forthcoming Regulatory Developments

With the financial crisis revealing a number of inadequacies in the capital heldby banks globally, there has been a strong push by national regulators to tightenglobal capital regulations, particularly in those countries most affected bythe crisis. The BCBS has been the main driver of international reforms in thisarea over the past year or so and has released a number of consultative documentssuggesting major changes to its Basel II capitalstandards.^[8]There are several proposed key reforms (some of which are now closed to consultationand have aspects on which broad agreement seems to have been reached).

• Increase the quality, international consistency and transparency of the capital base.This includes enhancing a bank's capacity to absorb losses on a goingconcern basis, such that more of its Tier 1 capital is in the form of commonshares and retained earnings.
• Strengthen the risk coverage of the capital framework, with more capital being requiredfor counterparty credit risk exposures arising from derivatives and repurchaseagreements. This would strengthen the resilience of individual banks and reducethe risk that shocks might be transmitted from one institution to anotherthrough the derivatives and financing channels.
• Introduce a non-risk-weighted simple leverage ratio requirement as a supplement tothe Basel II risk-weighted capital adequacy rules. The stated advantages ofthis methodology are that it would help contain the build-up of excessiveleverage in the banking system and introduce additional safeguards againstattempts to ‘game’ the risk-based requirements.
• Reduce procyclicality by promoting the build-up of capital buffers in good timesthat can be drawn down in periods of stress. Based on one of the current proposals,this would work in the form of a system-wide capital surcharge that nationalauthorities would put into effect when they judge that there is a build-upof system wide risk.
• Ensure that even if a failed or failing bank is rescued through a public-sector capitalinjection, all of its capital instruments are capable of absorbing losses.This includes a requirement that the contractual terms of capital instrumentsallow them to be written off or converted into common equity if a bank isunable to support itself in the private market.

Most of these reforms will inevitably raise the cost of intermediation above pre-crisislevels, and it will be important to ensure an appropriate balance between thiscost and the benefit of financial systems being subject to stronger standards.In order to help policymakers assess this balance, the BCBS undertook a detailedquantitative impact study of some of these proposed changes during the firsthalf of 2010. APRA led Australia's contribution to this work and consultedwith Australian banks involved in the study. APRA and the Reserve Bank alsoparticipated in international working groups that took a ‘top-down’look at the capital proposals by determining benchmarks against which theywill be judged, and assessed their likely macroeconomiceffects.^[9]

APRA will consider the agreed international timetable when implementing the new standards,which on the basis of the latest proposals would see the first of the new requirementsin place from the start of 2013, with some longer phase-in periods for certainelements of the package. The BCBS has committed to issue details of finalisedcapital reforms and transition arrangements later this year. APRA will providefurther guidance on Australian transition arrangements around that time, butcurrently does not expect that banks in Australia will need an extensive transitionperiod to meet the new capital requirements. Australian banks appear to bebetter placed to meet the new capital criteria than banks in a number of othercountries, partly because APRA's existing capital rules are based on arelatively more conservative application of the Basel II standards.

Conclusion

The Australian banking system has significantly increased its capital buffer againstpotential losses in recent years. To a large extent this has been driven bythe financial crisis, which prompted markets, regulators and rating agenciesto reappraise appropriate levels and forms of capital. Australian banks respondedby issuing considerable amounts of new equity – the highest quality formof capital – while changes to the growth and composition of their loanportfolios limited increases in their risk-weighted assets. Unlike banks ina number of other countries, at no point was there any injection of publicmoney into Australian bank capital.

National and international regulatory bodies have proposed major changes to capitalregulations, which include: increasing the quality, consistency and transparencyof the capital base; strengthening the risk coverage of the capital framework;implementing a leverage ratio; and introducing countercyclical capital requirements.The details of the new global capital standards will be finalised, along withother reforms, later in the year.