FURTHER READING: the A-Z of bank capital

Gareth Lewis
Senior Manager, Capital Management – Group Treasury, ANZ


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).

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‚Äôs financial strength.‚ÄĚ – APRA

The financial strength of a bank (also referred to as an “approved deposit taking institution (ADI) by the Australian Prudential Regulatory Authority) 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, the Australian Prudential Regulation Authority’s (APRA) 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:

‚ÄúCapital is the cornerstone of an ADI‚Äôs financial strength. It supports an ADI‚Äôs 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.‚ÄĚ

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 Рincluding the risk of unexpected losses such as payment defaults arising during the COVID-19 crisis.

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 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‚Äôs ‚Äėrisk-weighted assets‚Äô, 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‚Äôs asset won‚Äôt 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‚Äôs 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‚Äôt change. This is known as “pro-cyclicality” and can arise during a crisis where the risk of loss on a bank‚Äôs assets increase, so increasing the risk weighting, resulting in a reduction of a bank‚Äôs 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 ‚Äėgroup‚Äô – 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‚Äôs 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 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‚Äôs 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 ‚Äď 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 ‚Äėgoing-concern‚Äô 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 ‚Äėgone-concern‚Äô 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). This covers the largest Australian banks; and
  • A counter-cyclical buffer of between 0 to 2.5 per cent at APRA‚Äôs 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 its capital ratios falling into these capital buffers.

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 Рbuilding 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‚Äôs requirement that bank capital ratios are ‚Äėunquestionably strong‚Äô. 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 ‚Äúwould be consistent with the goal of ‚Äėunquestionably strong‚Äô‚ÄĚ.

Whilst APRA has delayed the implementation date of its ‚Äėunquestionably strong‚Äô 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‚Äôs ‚Äėunquestionably strong‚Äô benchmark.

APRA Chairman Wayne Byres said ‚ÄúAPRA‚Äôs 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‚ÄĚ.

This ‚Äúis the culmination of nearly a decade‚Äôs financial reform work aimed at building capital strength in the financial system following the global financial crisis ‚Ķ. 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.‚ÄĚ

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 ‚Äúthe measures were an in important step in minimising the risks to depositors and taxpayers should the bank experience a future bank failure‚ÄĚ.

‚ÄúThe global financial crisis highlighted examples overseas where taxpayers had to bail out large banks due to a lack of residual financial capacity,‚ÄĚ he said. ‚ÄúBoosting 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.‚ÄĚ

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‚Äôs 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 ‚Äėunquestionably strong‚Äô.

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.

The aim was to improve 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, the actual amounts of the core, or highest form of, capital held and the loss absorbency of capital securities.

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

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).

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.

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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