BUS326GorajeckandTurner2010CapitalAequacyII - Australian Bank Capital and the Regulatory Framework Adam Goraiek and Grant Turneri The amount and quaiity

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Unformatted text preview: Australian Bank Capital and the Regulatory Framework Adam Goraiek and Grant Turner’i The amount and quaiity of the Australian banking sector’s capital has increased considerably over the past couple of years. As in a number of other countries, this is because the recent global financiai crisis has prompted both markets and regulators to reappraise their views on acceptable levels and forms of capital. National and international regulatory bodies have proposed a number of major changes to existing capital regulations, detaiis of which will be finaiised later this year.- Introduction A bank’s capital. in its simpiest form. represents its ability to withstand losses without becoming insolvent. As demonstrated in a number of North Atiantic countries during the recent financial crisis, bank failures w and fears of bank failure — can be highiy disruptive to the macroeconomy. National regulators therefore promote resilience in the banking sector by specifying a minimum amount of capital that banks must hold and the form that capital shouid takeihe financial crisis has prompted a rethink of how strict these requirements shouid be. This article expiains how the minimum capital requirement currentiy operates in Australia. discusses the Australian banking system’s capital position and now it has evolved over the recent crisis period, and briefly outlines some of the main regulatory changes that are being considered.1 Capital Regulation in Australia TheAustraiian Prudentiai Reguiation Authority (APRA) makes and enforces the ruies which govern the capltai adequacy of Australian banks. The current set of ruies are a conservative application oithe iatest set of international capital standards issued by the Base! Committee on Banking Supervision {BCBS}, which ” The authors are from Financial Stability Department. 1 While the same capital requirements also apply to other Authorised Deposit-raking imitur‘rons in Australia, such as credit unions and bonding societies, this article focuses on Australian banks oniy. are coilectively termed ’Basel llf2 APRA introduced these standards to Australia in 2008 as an update to the first set of Basel standards » 'Basel i‘ - that were implemented in 1988. Centrai to the design of the Basel capital standards is the idea that a bank should hold capital in relation to its iikeiihood of incmring losses. The standards focus heaviiy on the definition of capital and the measurement of risk. Measuring capital An Austraiian bank’s regulatory capital is the sum of its ‘Tier l' and 'Tier 2’ capitai, net of ali specified 'deductions’. Tier i capitai consists of the funding sources to which a bank can most freeiy allocate losses without triggering bankruptcy. This includes, for exampie. _ ordinary shares and retained earnings. which make up most of the Tier i capital heid by Australian banks {Table i). It can also include specific types of preference shares and convertibie securities but. since it is more difficult for banks to allocate losses to these instruments, A?RA currently specifies that no more than 25 per cent other 1 capital can be in this form.Total net Tier 1 capital of Austraiian banks as at March ZGTO was $13i billion. 2 ihe BCBS’ governing body comprises central bank governors and (noncential bank} heads of supervision from its 27 member countries, which include Australia and the rest of the (3-20. BU].'l..i~T.TiN 1 SEPTEMBER QUARTER 2010 43 AUSTRAI..lAN BANK (METAL AND THE REGULATORY FRAMEWORK Table ’i: Australian Banks” Regulatory Capitallatl As at end March 20“) OfWh’C’i. cassettesiwscsmmmwcsc.mesmsocioecmsmmmwmcmmmmmwccc W"-.-,...eteeit.ease.fo'j[_‘_.'._‘_.If.I...If.f.fff..flffff]':ff.1........flfflff'jjjjjij.I.]'..'ff.'..:If...'f'jj'.]'f..fff..ff.If...'“M"m Retained earnings _ lieserves and rninority interests Tierl preference from __ W2 W'fj.....Isis:._.s.seesis.%iss§éefl.I.1...I...1......1...:.fiiQIQI.21.....1....1.1.1...:1.....1.1:1.11.... “tweedsssenieces“commencememmsmmwmmmmmsms rotarcaifiisi ""”""" "" “"' m' '”"' Ossrfissitssseesem . .swmmmmmmwmc- ..ssommmwcmmwcm.- 164.0 (a) Locally lncorpota‘ted banks. consolidated global banking group,- all instruments are measured at book value Source: APRA Tier 2 capital is made up of funding sources that rank below a bank’s depositors and other senior creditors, but in many cases are only effective at absorbing losses when a bank is being wound up. In this way, Tier 2 capital provides depositors with an additional layer of loss protection after a bank’s Tier 1 capital is exhausted. Tier 2 capital of the Australian banking system primarily consists of subordinated debt, though it aiso comes in other varieties, such as preference shares. Total net Tier 2 capital of the Australian ioanking system as at March 2010 was $33 billion. Both Tier 1 and Tier 2 capital are measured net of deductions, which are adjustments for factors that lessen the loss absorption capabilities of capital. For example, banks often have equity balancing their holdings of intangible assets, like goodwill, 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 absorb other incurred losses. As at March 2010, there were $70 billion 44 RESERVE HANK OF AUSTRALIA of regulatory capital deductions on the books of Australian banks. Around $45 billion were generated by holdings of intangible assets, most of which were in the form ofgoodwill. 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 typically credit risk, reflecting Australian banks’ focus on traditional lending activities. Credit risk is measured as the risk-weighted sum of a bank's individual credit exposures, which gives rise to a metric called 'risk-weighted assets“, Under the Standardised approach employed by most of the smaller banks, the risk weights are prescribed by APRA and are generally based on directly observable characteristics of each exposure. For example, if a residential mortgage has a loan-tow valuation ratio of 70 per cent, full documentation and no mortgage insurance, APRA specifies a risk AUSTRALIAN BANK CAPETAL AND THE REGULATORY FRAMEWORK weight of 35 per cent. if the outstanding balance Some banks, inciuding the four largest, use an of that mortgage is $100, its corresponding alternativelnternal Ratings-based approach whereby risk—weighted asset is $35. Corporate exposure risk risk weights are derived from their own estimates of weights are based on external credit ratings and each exposures probability of default and loss given are generally higher than for residential mortgages default.4 APRA grants approval to use this approach because the exposures are usuaily riskier.3 oniy after a bank has met strict governance and risk modeiling criteria. Table 2: Austraiian Banks’ Risk—weighted Assetsial As at and March 2010 meemmwwwmmwmmeeammw“Newswmeenmsummem- -meeeeflfi;mmMQ;;;L;;;WWWLMWQL§;mmmfl;fifi;;mmmwsW C"qeemWWW-WWWWmeewmsummemmm-Wsaemwmmmsaem -raaee.;mwian;.;mmge1;::ggewL;w;;am- _WemWehmm "Wei m;fifimmwmmeffmmmwgea ;eek;;;mwummemaemuswfmW“' Wflflfe;;;mg;wtfl NeweemmwwmmmmmmeWWWmmWWLWW meme .meeeeeeeeWWHWW.éesmm--waev. mwae-..swmmem -aee:;;;u;;;;ua;mmg;;e;;;m;aa:;;uma;- mffie%%¥T:I:LIXCffiIZLICIfoffflfffefiffTZLIELI wwemmmw'”WT:;;Q;QLTXILLI;IQTK WWWWWWMW .feeeeeeeeW- Wsflmmwwwgwmfljmewmmmw;nmm {a} Locaiiy incorporated banks, consolidated globai banking group (1)) includes exposures to individuals for smaii busineSS purposes, credit card exposures. and other personai exposures (c) Exciudes risks associated with seiiing securitised assets; exposure amount is on an on-baiance sheet equivaient basis (d) includes, for instance. fixed asset investments and margin lending exposures (e) Charges for risks associated with the buying or seiiing of assetbacked securities (f) Charges that are applied to banks using the internal Ratings—based approach to credit risk to ensure that there are no unintended iaiis in banking system capital during the transition to Basel li SourCe1APRA “WmmmwmwmmmwwwflwmmWmuwrpwwwwywwwwuwww rvmmemnw‘wm mmw-mv—v-wmw-ww-a InvhwmeWnmmuMimww-MW-wo-mr-flndh-Ulmmw 3 Corporate exposures that are unrated are assigned a risk Weight of 4 One bankopemresunderadifferent iriternai Ratings—based approach, iOCi per cent. whereby internai models are used to estimate defauit probabilities but supervisory rules are used to determine each exposures loss given deiauit. BULLETEN | SEPTEMBER QUARTER 2030 45 45 AUSTRALYAN BANK. CAPITAL AND THE REGULATORY FRAMEWCJRK These methodologies together give rise to $1200 biliion in credit risieweighted assets at Austraiian banks (Table 2}. This compares with (unweighted) assets of around $2 700 biilion. Within the risk—weighted total, corporate exposures account for $370 biilion, while residential mortgage exposures are iowerat around $300 billion, reflecting their reiatively lower risk weightsThere are atso $200 biilion in credit risk—weighted assets that are generated from oit—baiance sheet exposures. These are predominantiy in the form of' corporate credit commitments, interest rate derivatives. and foreign exchange derivatives "ihe 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 underlying measurement process. For instance, as part of market risk, APRA requires some banks to consider interest rate risk in the banking book {lRRBB), which refers to the potential for loss arising from timing and size mismatches in the repricing of a bank's funding and lending instruments. Measuring this risk requires a holistic approach to the bank’s balance sheet rather than the granular use of risk weights for each exposure.5 As at March 20H), total market and operational risks accounted for 5 per cent and 7 per cent of the Australian banking system’s totai riskwweightecl assets. Minimum capital requirements APRA requires all locaily incorporated banks to hold total capitai of at least 8 percent of their riskwweighted assets. At ieast half of their total capital must be the better-quality Tier i, implying a minimum Tier l ratio of 4 per cent.6 APRA can and does also increase these minima for individual banks where considered necessary on account of their risk profile. 5 it is also worth noting that Austraiia is the only country in which IRRBB is explicitly inciuded in banks risieweighted assets, That said, IRRBB is a reiativeiy smaii risk in Australia because most lending is made is at variable rates and interest rate mismatches are usuaily reiatively minor. 6 Foreign banks operating in Austraiia as branches are not required to hold capital in AustraliaThey are capitaiised through their head office, offshore. RESERVE BANK OF AUSTRALIA Graph 1 Australian Banks’ Capital" Per cent of risk-weighted assets 0 2010 ‘ tensity incorporated banks, consolidated global banking group; break in March 2008 due to lhe introduction of Basel II for most banks Source: APRA 1990 1994 1998 2002 2006 As at March 201 0 the Australian banking system had an aggregate total capital ratio of i l .8 per cent and an aggregate Tier l capitaé ratio of 9.4 per cent, with both ratios having increased significantly over the past couple of years (Graph i). Recent Developments in Australian Banks’ Capital The recent global financial crisis has prompted much greater focus on banking system capital. Notably, large and sudden losses incurred by some of the worid's largest banks prompted investors, reguiators and rating agencies to reappraise the prospect of bank tosses and appropriate levels of capital. ln addition, some of the lowenguality forms of capital were not as avaiiabie to absorb tosses as anticipated, and were subsequently looked upon less favourabiy as a source of financial strength. Convertibie securities, for example, were included in the Basel ll definition of Tier i capital on the premise that banks would exercise their option to convert them into common equity whenever additional capital was needed. These securities have not been as widely used in Australia as in a number of other countries. but some domestic and internationai banks have recently opted to raise capital in other ways rather than convert, fearing the negative signal that conversion might send to markets. AUSTRALIAN BANK CAPITAL AND ”Hill; REGUI.,A'I"OKY FRAMEWORK Australian banks have responded to the change in global attitudes by significantly increasing the level and quality of their capital. Changes to the growth and composition of their ioan portfolios have also limited increases in their riskmweigintecl assets. As a resoit, the Austratian banking system’s tote? capital ratio rose by 0.9 percentage points from September 2008 to March 2010 (it rose by 1.3 percentage points from March 2008 to March 2030, though this figure is clouded by data issues associated with some banks’ delayed transition to Sasei ii and the introduction of the lRRBB charge in September 2008). Moreover, the system’s Tier 1 capital ratio rose by 1.8 percentage points during this time, to its highest ievel since at teast the 39805 (when comparable data first became avaiiable). The sizes of these capital ratio increases are simiiar to the experience of the early 1990s, during which Australia had a recession and the banking sector also faced strong market pressures to improve its capital position. Holdings of capital “the amount of capital held by the Australian banking system rose by $13.7 biliion from September 2008 to March 2010. Within this total, there was a rise in Tier 'i capitai of $26 biélion and a decline in Tier 2 capital of Si 2.4 biliion {Table 3). The rise in the banking system’s Tier 1 capitat mostéy reflects a large amount of new equity that was issued in iate 2008 and the middie of 2009 (Graph 2). The major banks issued $30 billion during this time, largely through a combination of new share issuance and dividend reinvestment pians. the regional banks issued a further $2.l biilion. in contrast to some of their internationai peers, these issues were at only modest discounts to the market price, and were entirely to the private sector; there was no injection of pubiic money into Australian bank capitai. New equity raisings were Graph 2 Major Banks’ Equity Raisings" Cumulative from 1 January 2007 Sb $b New issues“ 20 memmmw-w 20 2007 2009 2010 " Includes 31. George; excludes raisings specifically used to fund acquisitions ” Includes new placements and employee share purchase plans Source: ASX 2808 Table 3: Change in Australian Banks’ Capitai and Risk-weighted Assets‘al September 2008 torMarch 2030 ' Total capital , semen W,%% H. -_-;. so-smw-m lil.eeiem. ...s-s.wms- ”scams. s as sweefiegssmmmwsmssssmwmsosswsmmms Risk-weighted'assets , -9enei asseeietfT[;;WL[LQ;;;;MWWWMMfICL-sm , W,T?‘?F,I3§'S..... (a) Locally incorporated banks, consoiidated gEobal banking group Source: APRA Operational risk and other its , 7 21.9 , i 1.7 8.6 __ eegflQ;mwwmmwsmssm 47 BULLETIN E SEPYEMBER QUARTER 2010 48 AUSTRALIAN BANK" {Irfi’fTAL AND THE REGULATORY FRAMEWORK the key driver of increases to the Australian banking sector‘s Tier 1 capital in the eariy i9905 as weli. Having reported solid profits throughout the turmoil, the Australian banking sector was also able to generateTrer i capital organicaliy, through increases in retained earnings. Some banks supported this process by making cuts to the overali vaiue of dividend payments, which contributed to higher retained earnings than would have otherwise been the case {Graph 3). Graph 3 Major Banks‘ Dividend Payments” Rolling sum of interim and final dividend payments 2604 2006 2003 2010 ‘ Contains reinvested dividends; includes St, George Source: Bloomberg Graph 4 Domestic Bank Credit?” Year-ended percentage change“ Per-sober Mus-w...“ mun-hum"ma.s..~i.,...vm__l__m, 1990 1994 1995 2002 2006 2010 " Includes securillsation "‘ Adlusled for series breaks; prior to 2002 includes all domestic credit extended by Australian financial institutions “' Series break in 2002 is due to change in reponlng requirements Sources: Al’RA: REA RESERVE BANK OF AUSTRALIA The effect of these initiatives in increasing Tier 1 capital was somewhat offset by a rise in deductions, parity because a number of acquisitions generated new goodwill through the purchase price exceeding the book value or" assets. There was also a Si biliion fall in the outstanding amount of Tier 1 convertible securities. ”the financial crisis has highiighted that there can be strong disincentives for banks to use them as loss absorption tools, so they have become iess highly regarded as sources of bankruptcy protection by markets and regulators. The BCBS has signalled that the status of these securities is being reviewed in forthcoming revisions to international capital standards. With a number of governments overseas having recently demonstrated their willingness to shore—up banks“ balance sheets before their ”tier 2 capitai takes losses, markets are also placing less emphasis on this form of capital. Most notabiy, the outstanding balance of Australian banks’ term subordinated debt has fallen by around $10 billion since September 2008, after strong issuance in the earlier part of the decade. Exposures to risk The Australian bahk'tng sector's total risk—weighted assets rose by $i63 biliiort, or i2 per cent, from September 2008 to March ZOiO. There was a $i i3 billion rise in the charge for market riskr with the IRRBS charge increasing as a resuit or” rises in long-term interest rates from early in 2009 and the amortisation of past IRRBB gainsThe operational risk charge rose by $1 i .7 billion. Partly counteracting these rises was a $6.6 billion fail in credit risk-weighted assets. One reason for this decline is the relativeiy slow growth in Australian bankéng sector lending over this period, as banks tightened their lending standards and businesses worked to reduce their leverage.w The sector's total domestic credit has grown at an annuallsed rate of 4.5 per cent since September 2008, compared with an average of around i4 per cent over the previous five years (Graph 4). There has aiso been 7 See, for example, Black. Kirkwood and Shah idil (2009). AUSTRALIAN BANK CAPITAL AND THE REGULATORY FRAMEWORK a shift in the composition of banks' loan portfolios, towards housing iending, which typically attracts much lower risk weights than business and personai lending. The amount of banks' off~balance sheet credit commitments has been falilng recentiy as weil. "the siower growth in credit and the change in its composition are simiiar to the patterns of the early 1990s recession, when credit growth of the Australian banking sector feil significantly and the share of credit devoted to housing increased strongly. Credit riskwweighted assets, though measured differently at the time, fail by 6.4 per cent from December l990 to December l993. These recent size and compositional changes to bank tending have been partly offset by an increase in the average risk weight of banks' business exposures. tor the major banks. whose credit risk weights are derived using internai rnodeis, estimates of the average probabiiity of default for iarge corporate counterparties increased by around 72 of one percentage point to W2 per cent (Graph 5). Their average probabiiity of default estimates for residentiai mortgages have increased only very siightly and remain at a iittie over i per cent. There were aiso some rises in loss given default estimates across these categories, Forthcoming Regulatory Developments With the financial crisis revealing a number of inadequacies in the capital held by banks globaliy, there has been a strong push by national regulators to tighten global capital regulations, particularly in those countries most affected by...
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