FURTHER READING: demystifying bank capital

Capital means different things in different contexts. For many companies, at its most basic, capital is considered to be the excess of its assets (what it owns) over its liabilities (what it owes).

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Another way of thinking about a company’s capital is the aggregate of the amount invested by its shareholders (its owners) and the retained earnings that a company has accumulated.

The more capital a company has, the greater its financial strength.

"Capital is the cornerstone of an approved deposit taking institution’s financial strength.” - APRA

The financial strength of a bank (also referred to as an "approved deposit-taking institution (ADI) by the Australian Prudential Regulation Authority (APRA)) is especially important given the central function banks have in supporting the financial system. The amount of capital a bank holds, and its resulting strength, forms a central tenet (together with liquidity) of prudential requirements.

In particular, APRA's prudential standards specify minimum amounts of capital a bank is required to hold. Globally, these standards are determined by the Basel-based Bank for International Settlements (BIS) but local supervisors have the final say.

In Australia, APRA provides a useful definition of capital in its bank prudential standards:

Capital is the cornerstone of an ADI’s financial strength. It supports an ADI’s operations by providing a buffer to absorb unanticipated losses from its activities and, in the event of problems, enables the ADI to continue to operate in a sound and viable manner while the problems are addressed or resolved.”  

APRA’s mandate is to protect the financial system and a bank’s Australian depositors. In doing so, it requires banks in Australia to maintain capital to absorb losses they may incur - including the risk of unexpected losses such as payment defaults arising during the COVID-19 crisis.

As the Bank for International Settlements (BIS) has stated, “A strong and resilient banking system is the foundation for sustainable economic growth, as banks are at the centre of the credit intermediation process between savers and investors.”

There are different types of capital, with different loss absorbing characteristics, which are permitted to be issued by banks.

Calculating capital

APRA focuses on both the amount of capital held by a bank and the adequacy of this amount relative to the riskiness of its assets. To do this, a bank also reports its capital ratios (as a percentage) which are calculated by dividing its capital by its risk-weighted assets.

  • Capital: The amount of regulatory capital a bank has is first calculated by adding up the paid up equity capital received from its shareholders, its retained earnings and the other capital instruments issued by the bank which are permitted by APRA and which have loss absorbing characteristics.

APRA then requires a bank to reduce its stated base capital amount by deducting from it certain assets on its balance sheet which either have no value in an insolvency (such as intangible assets, for example good will, deferred tax assets and capitalised software) or which represent a transfer of equity to another regulated entity (eg an investment in an insurance subsidiary, an offshore banking subsidiary or an offshore associate).

While these are considered assets for accounting purposes, they are removed from the capital base to more accurately reflect those assets which are available to support depositors in an insolvency.

  • Risk-weighted assets: In order to calculate a bank’s ‘risk-weighted assets’, the value of its assets (including its loans) are effectively weighted (by applying a percentage factor) to reflect the risk of loss to the bank. So, the greater the risk a bank’s asset won’t be repaid, the higher the risk weighted asset number will be. Less risky assets such as a government bond or a mortgage secured by a residential property will have a lower risk weighting than riskier assets such as an unsecured loan to a small business.

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.

Capital management

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.

Different kinds?

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.

Recent changes

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.

Why are published capital levels different in different jurisdictions?

Following the fall-out from the global financial crisis, the Basel Committee on Banking Supervision (part of the BIS) which is the primary global standard setter for the prudential regulation of banks, set about reforming the international rules governing bank capital to strengthen the resilience of banks, enhance global financial stability and reduce the spillover from the financial sector into the real economy.

The aim was to improve and simplify the regulation, supervision and risk management of the banking sector. In particular, these reforms, known as the Basel III rules, required banks globally to increase their minimum capital requirements (quantity), the actual amounts of the core, or highest form of, capital held and the loss absorbency of capital securities (quality).

The original intention behind the Basel III rules was that they apply equally to all banks globally (consistency) and would enable greater transparency of a bank’s capital position, allowing the capital ratios of different banks to be compared easily (reliability).

However, the reality has been different. This is partly due to banks in different jurisdictions being structured differently and having different balance sheets but also because the Basel III rules allow local regulators to use their discretion in implementing a number of the capital requirements and as a result some jurisdictions have only applied the minimum requirements, rather than the full impact, of the Basel III rules on their local banks.

In Australia, APRA took a different view and modified its prudential capital framework so that it was better tailored to Australian risks. This has resulted in an application of the capital rules in Australia that is more conservative than the Basel III rules and across international jurisdictions in general. An example of this is where APRA requires Australian banks to take a full deduction against their CET1 capital for certain regulatory adjustments (for example deferred tax assets and certain investments) whereas the Basel III rules allow a concession up to a threshold before the deduction applies. In other cases, APRA applies more conservative risk weightings.

The consequence of this approach is that Australian bank capital ratios are not always directly comparable with other banks outside Australia. It can, in many cases, make Australian banks appear more risky. This arises because APRA’s capital framework often means the headline capital ratio may be lower than that of an offshore peer, even where the Australian bank is more strongly capitalised or has lower leverage (in terms of actual dollar amounts of capital or the volume of capital relative to its actual total assets). 

The chart below shows the four major banks’ actual reported CET1 capital ratios on an APRA basis and what they would look like (i.e. the higher number) if they were calculated on an internationally comparable basis.

When the capital ratios of the four major Australian banks are calculated under the standardised Basel III rules (as opposed to the stricter APRA regime), they have broadly fallen within the top quartile of global banks on an internationally comparative basis.

This emphasises the capital strength of the major Australian banks and the conservatism of APRA when determining the minimum capital requirements and calculation of capital.

What are the dynamics around how capital is generated and used during a time of stress?

During a time of stress, such as COVID-19, a variety of factors apply at different stages to impact the capital ratios of Australian banks. The importance of each factor and its impact on the ratios fluctuate at different points during a crisis. However, each crisis is different and the way banks, customers, governments and regulators are each affected and respond will have varying impacts on the bank’s capital ratios.

With the COVID-19 crisis, we generally saw an initial reduction in capital ratios. This was primarily driven by:

  • Losses: In a time of financial stress, we see a pick up in defaults as borrowers are unable to repay their loans and make interest payments. Further, a bank may be required to estimate and take up additional provisions for potential future credit losses under the current accounting framework. Losses and provisions reduce the current year profit and hence the ability of a bank to generate capital organically through retained earnings.
  • Additional Request for Liquidity Facilities & Drawdowns: At the start of a crisis it is common to see borrowers, especially in the corporate and institutional space, requesting additional liquidity facilities and/or drawing down the undrawn portion of their loan facilities to strengthen their balance sheet. These have the impact of increasing the risk weighted assets of the bank and reducing the capital ratios.
  • Risk Weighted Asset Migration: As a bank’s risk weighted asset calculation is based on the likelihood of loss (i.e. the borrower’s credit risk), the value of those assets can fluctuate in a stress with a corresponding impact on the capital ratios. Therefore, as a crisis develops and the credit risk of borrowers is continually re-evaluated and downgraded, the bank’s risk weighted assets will usually increase, resulting in a ‘pro-cyclical’ reduction of the capital ratios and a requirement for the bank to hold more capital against the borrower.
  • Market Volatility: The impact of increased market risks, such as volatility in interest rates, credit spreads and other derivative products, may also lead to higher risk weighted asset requirements for banks.

As we have seen during the current crisis, there may still be some capital generation and other offsets to the drivers of the reduction in the capital ratios, such as:

  • Government support or stimulus measures: In response to COVID-19, the Federal and State governments have injected unprecedented amounts of support into the economy. Some of these measures are intended to support individuals and businesses and help to reduce the likelihood of default but also to support banks in continuing to lend. APRA has also temporarily relaxed the application of the capital rules, including advising banks they do not need to treat all deferrals of the repayment of loans as a default. Together these measures reduce the adverse impact on the risk weighted asset calculation (which could otherwise be significant) and the pro-cyclical impact on capital ratios. However, there is always a risk that the temporary relaxation of the capital rules by APRA merely defers the impact of payment defaults and resulting losses on the capital ratios if defaults pick up as the government support package wears off. 
  • Profit and Dividends: Banks in most cases continue to generate capital through profit, albeit that profit is likely to be significantly lower and will be reduced by any losses or provisions the bank applies. The impact on the capital ratios of the reduced capital generation can also be offset if the bank decides to reduce, or cancel, its dividend. Dividends otherwise decrease the capital ratios as capital is returned to shareholders. APRA have recently announced a limitation on the amount of profits it will allow Australian banks to pay out as dividends, in order to both protect capital but also ensure that banks can continue to support growth.
  • Growth & Demand: As a result of the government and regulatory measures during COVID-19 and the banks’ strong capital ratios coming into the crisis, banks are in a position to continue to fund credit growth. However, the demand for loans often reduces in times of stress and economic downturns and this is typically the primary driver of a reduced need for capital growth to support the extra lending – this crisis has been no different. Whilst this would result in lower profits for banks in general, it will also mean lower risk weighted asset growth and therefore may improve the capital ratios overall. Apart from ensuring the ongoing availability of credit, banks have relatively little influence on demand beyond lower interest rates and current rates are already historically low.

Additionally, there may be some modification by banks of their risk appetite under stress. In such a scenario, banks may reduce, or where possible remove from the balance sheet, some exposures to certain higher risk borrowers or industries or low returning assets, which could also lead to further reduction in growth.

Therefore, while in most cases a bank will see a drop in its capital ratios during a crisis, counter intuitively, there may be circumstances or periods where a bank’s capital ratio actually stabilises or increases – particularly where there is some capital generation but limited asset growth to spend it on.

There are other actions that a bank could take to repair its capital position, including a capital raising, sales of businesses or investments or reducing expenses, however, we have not examined them in this article.

Further, banks have been building their capital buffers with the intention that they could utilise those buffers and negate the pro-cyclical impact of risk weighted asset changes. APRA has recently clarified that banks should make use of their capital buffers to absorb the impacts of stress while continuing to lend to support households and business.

APRA said: “The years spent building up the capital strength of Australia’s banking sector to historical highs have been precisely for a time such as this. Further, APRA is committed to ensuring any rebuild of capital buffers, if required, will be conducted in an orderly manner.”

Ultimately, the impacts of the COVID-19 crisis appear to have a long way to go but the Australian banking system is well capitalised, well positioned to continue to lend and well prepared for further defaults and losses (which have been further impacted by the recent developments in Victoria). 

Gareth Lewis is Senior Manager for Capital Management in Group Treasury at ANZ

* Based on various information and publications contained on APRA's website

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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