The Capital Adequacy Requirement in Two Australian Banks

Capital requirement relates with the amount of capital that banks and financial organizations are expected to maintain by the financial regulators. Capital requirement of financial institution is expressed in terms of capital adequacy ratio of equity which needs to be held as the percentage of risk weighted assets. This is a requirement that has been set in place to make sure that all financial organizations won’t take access of leverage and be insolvent in the long run. The capital requirement does govern the ratio of equity to debts which are maintained in the liability and equity side of the company’s balance sheets.
This paper will explore what it means by Capital Adequacy Requirement in consideration of two Australian Bank institutions.
Capital Adequacy Requirement
Capital Adequacy Ratio is part of the modern Cash Adequacy Requirements and tends to be defined as a measure for the banks capacity of absorbing losses via calculation of the ratio of capital to risks (Arnold, et al 2012). In other terms, Capital Adequacy Ratio may be considered as a bank airbag. There are various ways in which bank capital may be interpreted. Generally, this tends to be the difference between the assets and liabilities of the financial organizations (Simshauser 2010).
Capital Adequacy Ratio (CAR), “Determines the capacity of the bank in terms of meeting the time liabilities and other risks such as credit risk, operational risk, etc (Simshauser 2010). CAR below the minimum statutory level indicates that the bank is not adequately capitalized to expand its operations. The ratio ensures that the banks do not expand their business without having adequate capital,” (Altman and Sabato 2005).
Capital adequacy requirements are an approach that is utilized by the Australian Prudential Regulation Authority (APRA) in assessment of capital adequacy for the Australian Banks (as well as that of their consolidated groups) (Simshauser 2010). The guideline tends to be focused on the credit risks. Other factors that are accounted for are separate matters when it comes to assessment of the entire capital adequacy for the banks. Such factors incorporates the quality of assets, liquidity, market risks, profitability, adequacy of provisioning, effectiveness of bank management systems to monitor and control risks and credit risks (Altman and Sabato 2005).
The bank board as well as the management team has the responsibilities of making sure that the bank has set in place adequate systems that would be relevant for identifying and measuring the risks and setting the required capital cover against the available risks (Simshauser 2010). APRA has attached great significance to make sure that capita resources for individual bans are adequate in terms of size, quality and the type of business. At this end, APRA was able to adapt to the risk based approach which measures the bank’s capital adequacy. This approach is in line with the entire substantial respects and the approach recommended by Basle Committee on Banking Supervision (Altman and Sabato 2005).
Generally, the main focus of the guideline targets the bank’s holdings of adequate enough capital that would meet the credit risks (actually, the potential risks associated with defaulters or counterparties) as well as the aspect associated with country’s transfer risks. Account may be considered within limited ways of guarantees and collaterals (Simshauser 2010). For the balance sheets and the off-balance sheet exposures, they are measured in accordance to the wider categories of relative uncertainties which are based largely on the nature of counterparty (Arnold, et al 2012). Actually, the total sum of the risk weighted assets as well as risk weighted off-balance sheet in business tends to be connected with bank capital and resulting risk ratio is utilized as the measure of capital adequacy (Williams 2007).
Actually, the risk weightings tend to consider portfolio basis on the relative chances of counterparties that are not in good position to meet the obligation of a bank. The risk weights that are utilized are reflection of broader judgments on potential risks for the type of counterparties and have no intention of providing detailed guide on assessment of the credit risks related with the exposure of individual counterparties (Altman and Sabato 2005). Each bank has the responsibility of taking individual assessments on credit risks that are related with deals of counterparty with an aim of allocating the required amount of capital that would cover the risks and have suitable pricing of the transaction that reveal risks. Additionally, off-balance sheet transactions have to be converted to balance sheet’s equivalents before they are allocated with the risk weights (Anandarajan, Hasan and McCarthy 2007).
This guide is applicable to all the Australian banks. However, for the foreign banks that have operations via branches in Australia are not subjected to this guide but they are expected to be subjected to other equivalent capital adequacy standards from their home country. The core focus for the guideline tends to have a look on global operation of banks and the subsidiaries that are consolidated in line with Australian Accounting Standards (Altman and Sabato 2005). For the Australian Banks, they are expected by the standard to maintain minimum ratio of total capital to risk weighted assets for the consolidated group and the stand-alone basis which is 8 percent (where at least 4 percent should be Tier 1 Capital (Simshauser 2010). However, the levels are maintained under constant reviews. As well, APRA may expect a bank to maintain high minimum ratio such as the case of newly established bank or any bank deemed to have excess deliberation of credit risk coverage or any significant risk exposure (Arnold, et al 2012).
The initial bank capital has to incorporate the permanent shareholders of equity and disclosed reserves (developed or created due to appropriation of retained earnings and extra excess reserves). Maintaining such element does meet the essential characters of capita and account for the capital resources that has contribution to resilience and flexibility of the bank that has faced financial challenges (Duncan and Elliott 2002).
For the case of Australian Bank organization, banks such as Greater Bank and Hume Bank have maintained Tier 1 capital which consists of share capital and non cumulative irredeemable preference shares (Simshauser 2010). As well, the capital incorporates the innovative capital instruments which include capital issued via special purpose subject on the condition of Attachment IB. In addition; the partly paid shares in the two banks are part of this capital for the value of the funds that have been received (Sheridan and Jang 2012). On the other hand, general reserves and retained earnings (incorporating the measured current year earnings total of anticipated dividends and taxation payments. There are minorities’ interests that are held in the subsidiaries and they are in line with other capital instruments and are part of Tier 1 capital (Blundell-Wignall and Atkinson 2010).
The bank non-cumulative irredeemable preference shares as well as the innovative capital instruments that are incorporated by the firm as part of Tier 1 have to meet the conditions set under Attachment IA (Simshauser 2010). However, in case an instrument has chances of resulting to aggregate the amount of innovative capital instruments and the non-cumulative irredeemable preference shares that would be more than 25 percent of net Tier 1 capital, it would be illegible (Otchere and Chan 2003).
In relation to the servicing of Tier 1 capital, the banks have considered the requirement that, aggregate dividend payments in one year do not exceed the earnings of the bank in the same year (the banks have not to pay dividends from the retained earnings). Despite this, APRA has been set towards modification of this requirement, on case by case basis, if there are believes that the expected level of dividend to be paid would justify the reference of other justifications (Arnold, et al 2012). These justifications are such as assessing the banks on-going capital position incorporating obligation of raising capital and bank core profit. Any other claim on non-bank private sector counterparties attracts 100 percent weight from the banks. These are part of all other property loans which incorporate the loans secured against the commercial property, corporate and personal loans, industrial and commercial loans, bill acceptances and lease finance (Simshauser 2010).
The regulation authorities have the duties of keeping an eye to Capital Adequacy Ratio of bank institutions to make sure that they are in a position of absorbing the loses and are able to meet the capital requirements. Introducing a ceiling on Capital Adequacy Ratio do hinder the banks from taking excess amount of leverage which would have probable increment to risks of insolvency. Hence, banks possessing higher capital adequacy ratio tends to be less likely to be insolvent due to unexpected losses since they are in a position of absorbing them.
Altman, E.I. and Sabato, G., 2005. Effects of the new Basel capital accord on bank capital requirements for SMEs. Journal of financial services research, 28(1-3), pp.15-42.
Anandarajan, A., Hasan, I. and McCarthy, C., 2007. Use of loan loss provisions for capital, earnings management and signalling by Australian banks. Accounting & Finance, 47(3), pp.357-379.
Arnold, B., Borio, C., Ellis, L. and Moshirian, F., 2012. Systemic risk, macroprudential policy frameworks, monitoring financial systems and the evolution of capital adequacy. Journal of Banking & Finance, 36(12), pp.3125-3132.
Blundell-Wignall, A. and Atkinson, P., 2010. Thinking beyond Basel III. OECD Journal: Financial Market Trends, 2010(1), pp.9-33.
Duncan, E. and Elliott, G., 2002. Customer service quality and financial performance among Australian retail financial institutions. Journal of Financial Services Marketing, 7(1), pp.25-41.
Otchere, I. and Chan, J., 2003. Intra-industry effects of bank privatization: A clinical analysis of the privatization of the Commonwealth Bank of Australia. Journal of Banking & Finance, 27(5), pp.949-975.
Sheridan, N. and Jang, B., 2012. Bank capital adequacy in Australia.
Simshauser, P., 2010. Resource adequacy, capital adequacy and investment uncertainty in the Australian power market. The Electricity Journal, 23(1), pp.67-84.
Williams, B., 2007. Factors determining net interest margins in Australia: domestic and foreign banks. Financial Markets, Institutions & Instruments, 16(3), pp.145-165.

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