The risk weighting predominantly reflects the risk of non-payment of an asset, what’s called the credit risk. However, the calculation also includes the risk of loss from the failure of a process or its procedures (operating risk); the risk of loss as a result of movements in market prices (market risk); or the risk of loss due to interest-rate mismatches which are structural on the bank's balance sheet (interest rate risk in the banking book or IRRBB, for example due to a bank lending based on a 3-month base rate but borrowing at different rate based on a longer tenor).
Importantly, the risk-weighting on an asset can fluctuate as the riskiness of that asset or the borrower changes. Therefore, a capital ratio can increase or decrease as a result of a movement in the risk weighted assets, even if the actual amount of capital or the structure of the balance sheet doesn’t change. This is known as "pro-cyclicality" and can arise during a crisis where the risk of loss on a bank’s assets increase, so increasing the risk weighting, resulting in a reduction of a bank’s capital ratios.
The Prudential Standards require that capital is managed by a bank at three levels:
- Level 2 is the most commonly reported capital ratio for Australian banks and broadly represents the banking ‘group’ - including a bank's offshore banking subsidiaries (especially in New Zealand) but excluding its insurance subsidiaries and offshore associates. This is different to the accounting view of the consolidated group. APRA is focused on the Australian broader banking group to ensure offshore banking operations do not impact the stand alone bank.
- Australian banks also report their capital ratios on a stand-alone basis at Level 1 (which includes their branches and some single-purpose funding entities). This is APRA’s primary focus to ensure Australian depositors are protected.
- For some Australian banks, APRA may require them to report on a fully consolidated (or Level 3) basis. The major Australian banks are not currently required to report on a Level 3 basis and are awaiting further guidance from APRA.
A bank is required to hold and calculate its capital ratio at each level and those ratios may be different at Level 1 and Level 2 for a variety of reasons. For example, in the case of ANZ, its Level 1 ratio is lower than its Level 2 ratio for a number of reasons but largely due to the amount of dividends it recieves from its foreign banking subsidiaries (in particular New Zealand).
Therefore, at different times a bank’s Level 1 or 2 capital ratio may become the binding constraint in determining how much capital a bank has to hold and this may differ between banks.
The highest form of regulatory capital for a bank is its ordinary shares. Together with retained earnings, this is referred to in a prudential sense as Common-Equity Tier 1 (CET1) capital. It is contained on a bank’s balance sheet as shareholder’s equity and forms the largest component of a bank’s capital (following the BIS’s reforms to bank capital known as Basel III which came into effect as a result of the 2008 financial crisis).
Whether an instrument will count as capital depends on the inclusion of a number of loss-absorbing characteristics:
- Subordination: the degree of subordination refers to the order of priority when determining whether a holder of that form of capital has access to a bank’s residual assets in a winding-up. The most loss-absorbing forms of capital are the last to have a claim.
- Repayment: whether there is an obligation to repay the capital and any conditions on that repayment or whether they are perpetual.
- Distributions: the extent to which there is an obligation to pay distributions, whether in the form of a dividend or interest payment, or whether they are discretionary.
CET1 capital is the most loss absorbing form of capital because it is perpetual – that means it does not have a maturity date so the bank has no obligation to repay it and the bank has no obligation to pay any dividends: they are fully discretionary.
CET1 capital is also the most subordinated and riskiest form of capital for investors and so shareholders will demand the highest return on a bank’s shares given they are the first line of defence for a bank and will suffer any loss first. We are currently seeing the impact of the increased risk through the crisis with the collapse of bank share prices.
APRA also allows additional lesser forms of capital instruments to be included in a bank’s capital.
After CET1 capital, the next highest form of capital is Additional Tier 1 (AT1) capital. For Australian banks, this is predominately in the form of capital notes and preference shares which are mostly issued into the Australian domestic market to both wholesale and retail investors.
These instruments rank above CET1 capital in the capital structure and absorb losses to the extent CET1 capital is not able to. They are also loss absorbing in that they are perpetual and the distributions are at the discretion of the Board and APRA, and so are likely not to be paid in a time of stress.
So what makes these instruments perpetual? Most capital notes issued by Australian banks have no fixed maturity date and, if they are not redeemed earlier on a specified call date, they are converted into the bank's ordinary shares. Further, these instruments also convert to ordinary shares or can be written-off in certain circumstances where the bank is suffering significant financial stress, particularly where APRA determines the bank is otherwise non-viable or the CET1 capital ratio is reduced to 5.125 per cent.
AT1 capital is also referred to as ‘going-concern’ capital because it is intended to allow the bank to continue to operate and maintain its solvency once the holders absorb the losses the bank has incurred.
The final form of capital is Tier 2 (T2) capital, which for Australian banks is generally issued as subordinated notes or bonds into the global wholesale market. These instruments rank above AT1 capital instruments and are subordinated as they represent the final capital buffer to absorb loss to protect senior creditors. While subordinated notes require repayment on a fixed date and the interest is not discretionary, as with AT1 capital, they are loss absorbing as they convert into ordinary shares or are written-off if APRA determine the bank is otherwise non-viable.
T2 capital is also referred to as ‘gone-concern’ capital as it is intended to protect depositors and other senior creditors when the bank is insolvent or is likely to enter insolvency and buys time for the regulator to manage the failing bank.
The cost of capital for each instrument generally reduces relative to the risk and level of subordination of that instrument.
Whilst capital can be considered an asset of a company, AT1 and T2 capital can often be accounted for as debt or a liability of the bank.
How much is enough?
APRA requires banks to maintain minimum capital requirements for:
- CET1 capital;
- Tier 1 capital (being the aggregate of CET1 capital and AT1 capital); and
- Total capital (being the aggregate of Tier 1 capital and T2 capital).
Within the Tier 1 and Total capital ratios, APRA limits the amount of capital which can be held as AT1 capital and T2 capital. While these ratios could be held purely as CET1 capital, this is less cost effective than holding the maximum amounts of AT1 and T2 capital.
CET1 capital is the largest component of a bank’s regulatory capital and is broken down into different components:
- A minimum capital requirement of 4.5 per cent;
- A capital conservation buffer of 2.5 per cent;
- An additional capital buffer of 1 per cent for those banks which APRA considers to be a domestic systemically important bank (DSIB), in order to reduce the risks arising from "the interconnectedness of systemic institutions through an array of complex transactions". This covers the largest Australian banks; and
- A counter-cyclical buffer of between 0 to 2.5 per cent at APRA’s discretion. This buffer is intended to be built up by banks in good economic periods and run-down in times of stress. APRA have currently set this requirement at 0 per cent.
For a bank like ANZ, which is classified as a DSIB, the prudential standards currently identify a minimum CET1 capital requirement of 8.0 per cent.
As noted above, in its prudential standards, APRA also currently applies a minimum Tier 1 and Total capital requirement:
- The minimum Tier 1 capital requirement is 9.5 per cent of which a maximum 1.5 per cent can be AT1 capital; and
- The minimum Total capital requirement is 11.5 per cent of which 2 per cent can be T2 capital.
Each bank will also run its own stress testing and capital forecasting process and as a result hold additional amounts over and above these minimum capital requirements set by APRA as a cushion to protect against a diminution of its capital or an increase in the risk-weighted assets and a s a result its capital ratios falling into these capital buffers.
Mr. Pablo Hernandez de Cos, the Chairman of the Basel Committee has said that the reason for these buffers is threefold. “First, it gives bank’s flexibility to absorb buffers in times of stress, thus enhancing their resilience. Second, it mitigates negative macroprudential externalities (eg fire sales or deleveraging). And third, it prevents imprudent depletion of capital resources, by setting constraints on the amount of capital distributions.”
As one of the aims of the Basel III rules was also to reduce the build-up of excessive leverage in the financial sector during the GFC, banks are also required to meet a minimum leverage ratio of 3.5 per cent. This is a cruder ratio and purely measures a bank’s capital against the value of its actual (non-risk adjusted) assets. This is meant more as a supplementary test, like a backstop, to ensure that the risk adjusted approach or modelling is not being manipulated or arbitraged in some way although, at this point, it is not a major constraint for Australian banks.
However, following Australia’s recent Financial Services Inquiry (FSI) there have also been a number of important capital announcements by APRA requiring regulated banks to hold even more capital - building on the Basel III capital reforms.
APRA announced in July 2017 the four major Australian banks will need to have CET1 capital ratios of at least 10.5 per cent to meet the FSI’s requirement that bank capital ratios are ‘unquestionably strong’. Given the strength of the four major Australian banks, APRA concluded that it would be necessary to raise minimum capital requirements by around 1.5 percentage points to 9.5 per cent so that their actual capital ratios “would be consistent with the goal of ‘unquestionably strong’”.
Whilst APRA has delayed the implementation date of its ‘unquestionably strong’ capital requirements and the upcoming review of its capital requirements (including the calculation of risk weights) for a year, the major Australian banks already hold CET1 capital ratios in excess of 10.5 per cent and APRA’s ‘unquestionably strong’ benchmark.
APRA Chairman Wayne Byres said “APRA’s objective in establishing unquestionably strong capital requirements is to establish a banking system that can readily withstand periods of adversity without jeopardising its core function of financial intermediation for the Australian community”.
This “is the culmination of nearly a decade’s financial reform work aimed at building capital strength in the financial system following the global financial crisis …. Capital levels that are unquestionably strong will undoubtedly equip the Australian banking sector to better handle adversity in the future and reduce the need for public sector support.”
In July 2019, also in response to the FSI and APRA’s proposed changes to the capital adequacy framework to support the orderly resolution of banks, APRA announced that it would require the four major Australian banks to hold an additional 3 percentage points of Total capital by 2024.
APRA expects banks will raise this additional capital requirement in the form of T2 capital. It has indicated that it is looking to increase the Total capital ratio by up to another 2 per cent but at this stage it is considering the most feasible alternative to source this further amount of capital, taking into account the particular characteristics of the Australian financial system.
APRA Deputy Chair John Lonsdale said “the measures were an in important step in minimising the risks to depositors and taxpayers should the bank experience a future bank failure”.
“The global financial crisis highlighted examples overseas where taxpayers had to bail out large banks due to a lack of residual financial capacity,” he said. “Boosting loss-absorbing capacity enhances the safety of the financial system by increasing the financial resources that an ADI holds for the purpose of orderly resolution and the stabilisation of critical functions in the unlikely event that it fails.”
It is important for banks to ensure they manage their capital ratios efficiently and prudently because there are severe impacts if the capital ratios drop into the APRA specified capital buffers. If a CET1 capital ratio drops into the buffers required to be held by APRA, the bank starts to be constrained in the amount of its earnings it can pay out to its shareholders as a dividend.
The capital buffers are divided into four quartiles. A bank can continue to pay 100 per cent of its earnings as a dividend if its capital ratio is in the top quartile of the capital buffer - but the percentage of earnings it can pay out falls by 20 per cent as the ratio drops into each quartile.
However, if a bank’s CET1 capital ratio falls below its buffer requirements, there is an expectation that it will only be for a limited period and it will put in place capital management actions to increase its capital ratios to ensure that it is ‘unquestionably strong’.
A breach of its minimum capital requirements would be considered by APRA to be a significant prudential concern and signal deficiencies in the bank’s financial management.