Hands up if you tuned in to the Financial System Inquiry's discussion of bank capital – but felt you didn't really understand the basics well enough to follow it closely? To paraphrase one of our (numerous) recent prime ministers, this article is 'here to help'.

If you are brave enough to crack open APRA's prudential standards on bank capital, you will find this opening sentence: 'Capital is the cornerstone of an ADI's financial strength'. This is because good quality capital allows a bank to deal with the losses it suffers when the risks it faces eventuate.

To understand APRA's capital requirements for banks, you need to understand three things:

  • the different types of capital that count as prudential capital;
  • the capital ratios that apply under those requirements; and
  • how those ratios apply to the circumstances of a particular bank.

Prudential capital

There are three types of capital that count as prudential capital.

The first type is the highest quality and is called Common Equity Tier 1 Capital. It is the highest quality because it is the best able to absorb losses. Ordinary share capital is an example. If a company fails, ordinary shareholders 'rank last', so that, if there is nothing left after everyone else (eg employees, secured creditors, unsecured creditors) has been paid, they get nothing. This illustrates what is meant by the ability of capital to 'absorb' a company's losses.

Next is Additional Tier 1 Capital, and the last type of capital recognised as prudential capital is Tier 2 Capital.

The rules governing these three types of capital are very complex and detailed, and we do not need to consider them here. The important point for now is that there are three types and Common Equity Tier 1 Capital is the highest quality.

Capital ratios

Under the primary prudential capital ratios as they currently stand, a bank must have:

  • Common Equity Tier 1 Capital of at least 4.5 per cent of the bank's 'total risk-weighted assets';
  • Common Equity Tier 1 Capital plus Additional Tier 1 Capital of at least 6 per cent of the bank's 'total risk-weighted assets'; and
  • Common Equity Tier 1 Capital plus Additional Tier 1 Capital plus Tier 2 Capital of at least 8 per cent of the bank's 'total risk-weighted assets'.

The concept of a bank's 'total risk-weighted assets' is obviously critical. I will return to it later.

In addition to these primary ratios, there are also 'buffer' ratios that apply from 1 January 2016:

  • a 'capital conservation buffer' requiring a bank to hold an additional 2.5 per cent of Common Equity Tier 1 Capital (this bringing the total required amount of such capital to 7 per cent); and
  • a 'countercyclical capital buffer' requiring a bank to hold an additional 0 per cent – 2.5 per cent of Common Equity Tier 1 Capital (this will only apply if APRA so determines).

These are the prescribed capital ratios. However, the prudential standard also says APRA can determine different ratios for any bank. In other words, the required level of capital is, ultimately, whatever APRA decides.

Applying the ratios

In applying these capital ratios, the main task is to determine a bank's 'total risk-weighted assets'.

The first point is that a bank's 'total risk-weighted assets' bears little relation to its assets (as understood according to ordinary concepts). This may sound counter-intuitive but it is a critically important point. A bank's 'total risk-weighted assets' is, instead, simply the outcome of a detailed process of quantifying the risks faced by the bank.

The process differs, depending on whether the bank is classified as 'standardised' or 'accredited' for capital adequacy purposes. The 'big four' domestic banks and Macquarie are classified as 'accredited' (or 'IRB model') because they have internal ratings-based models that have been approved by APRA. The rest are 'standardised'. As discussed below, being classified as 'accredited' helps a bank to reduce its 'total risk-weighted assets' and therefore to reduce the amount of prudential capital it must hold. (Prudential capital is expensive and affects returns to shareholders.)

Consider operational risk as an example. The relevant prudential standard specifies how to work out an operational risk 'charge' for the bank. This turns on matters that are largely unrelated to the nature of the bank's assets. The operational risk charge is ultimately converted into a 'risk-weighted asset' but only as a mechanism for determining the capital that must be held on account of operational risks.

A different approach is taken to credit risk. Here, the bank's assets are relevant. In particular, what credit risk does any particular asset pose to the bank?

A 'standardised' bank's assets are subject to 'risk weights', including (remember, the lower the risk weight, the better it is for the bank):

  • cash has a risk-weight of 0 per cent (except where it is yet to be collected); and
  • residential mortgages have a risk-weight of 35 per cent – 100 per cent depending on the loan-to-value ratio and whether lender's mortgage insurance is in place.

An 'accredited' bank is subject to more favourable risk weights. For example, the average risk weight for residential mortgages is about half the average that applies to 'standardised' banks.

There are also processes for determining contributions to 'total risk-weighted assets' for:

  • market risk arising from a bank's trading activities (if any);
  • where applicable, interest rate risk arising from normal financial intermediation, as distinct from trading activities (relevant for 'accredited' banks only); and
  • risks associated with securitisation.

Conclusion

So there you have it. But, of course, it is not that simple. For example, I have not touched on the significance of regulation at 'Level 1', 'Level 2' and 'Level 3'. Nor have I touched on the Financial System Inquiry's recommendations concerning bank capital – although I will do that in the next edition of Unravelled. For now, I will leave you to ponder the likely meaning of the following equation, to be found in Prudential Standard APS 112 Capital Adequacy: Standardised Approach to Credit Risk.

Click here to view image.