Module 4 Prudential Supervision, Basel Accords & Capital Managment

Prudential Supervision
The Australian Prudential Regulation Authority (APRA) prudential regulator of financial institutions since 1998.

Prudential regulation - requirements that limit the risk-taking of banks and other FIs in order to protect depositor’s funds,
the funds of other creditors, and to maintain financial system stability.

Why have prudential Supervision?

 To protect the posters fund and stop backgrounds on financially sound institutions.
 To enhance financial system stability and avoid crisis.
 To avoid moral hazards posed by the posted insurance and when an ATI is considered “too big to fail”.

Moral Hazard: Bank managers may take too much risk with depositors’ funds if the government guarantees the funds or if
they believe they are so important the government will always bail them out in a crisis.

APRA’s approach to prudential supervision

APRA aims to encourage responsible behaviour by financial institutions and ensure that managers are responsible for their
decisions. The prudential framework consists of:

1. Prudential statements that aim to ensure ADIs effectively manage their risks.
2. The capital adequacy requirements (CAR) including minimum prudential capital ratios (PCRs)

The role of the standards is to reduce the likelihood of illiquidity or insolvency. The current list of prudential standards is
included in your additional reading 4.1.

Capital adequacy requirements

CARs Role is to ensure that an ADI how sufficient equity capital to sustain its solvency should it incur losses.

 Used internationally - the Basel Committee on Banking Supervision developed a capital adequacy model (the
Basel Accord or Basel 1) in 1988
 It was revised and Basel 2 began operation in 2008.
 New revisions, termed Basel 3 were introduced in 2013 and the staged role-out is continuing.

The Basel Accords

Basel 1 and Basel 2

Total qualified capital

CAR: Total risk - weighted assets  8%

Capital: provides a cushion to absorb losses

Risk adjustment: different assets have different risk exposures, more capital should be required where the risk is greater.
Qualified Capital: Tier 1 (high quality) and Tier 2 (lower quality) capital

Total risk-weighted assets

 1988: banks estimated only credit risk: on-balance-sheet + off-balance-sheet.

 1996 amendment: banks also measure market risk (interest rate risk + exchange rate risk + equity price risk +
commodity price risk).
 2008 Basel 2: banks also estimate operational risk.
Basel 2 amendments
Key changes:

 revision to risk weightings, including the use of credit ratings by agencies such as Standard & Poors. Credit ratings
affect the risk weighting applied to loans.
 the inclusion of operational risk in the calculation of the risk adjusted capital ratio for a financial institution.
 the possible inclusion of Tier 3 capital as part of the capital base. Tier 3 capital Consisted of:
subordinated debt with, among other qualities, a minimum initial maturity of at least 2 years. It must also be
unsecured. Used to cover market risk only. Was later abolished in Basel 3.

Measuring Operational risk

Operational risk: Based on gross income earned by each business line weighted by a β factor
β factors for business lines are contained in the following table:

Calculating risk-weighted capital ratio

 The risk weightings in the formula sheet reflect the Standardised Approach, which is used by medium and smaller
banks in Australia.
 The big 4 banks and Macquarie have employed an internal-ratings based approach, which resulted in them
applying lower risk weightings than banks using the standardised approach, especially for mortgages; 18% on
averaged compared to 39% for smaller banks.
 The recent Financial System Enquiry recommended increased risk weightings for the 5 banks.
 APRA responded by requiring an increase to an average of at least 25% risk-weighting for mortgages. This
reduced the competitive advantage of the big banks.

Basel 3
Basel 3 is a response to the Global Financial Crisis and implementation began on January 1, 2013. Basel 3 changes include:

1. Tier 3 capital has been abolished. The reason is to ensure that market risks are covered with the same quality of capital
as credit and operational risks.

2. Minimum PCRs:

 Common equity Tier 1 capital (CET1 – comprising ordinary shares and retained earnings, which are main
components of Tier 1 capital) must be at least 4.5% of risk adjusted assets.
 Total Tier 1 capital must be at least 6% of risk adjusted assets.
 And total capital (Tier 1 + Tier 2) must be at least 8% of risk adjusted assets.
 APRA implemented these strict minimums capital on January 1, 2013
3. Conservation buffer: outside periods of stress, banks hold capital above the regulatory minimum, large enough to
remain above the minimum even in a sector-wide downturn. The recommended or benchmark size of the buffer is 2.5% of
risk-adjusted assets and the buffer should be comprised of Common Equity Tier 1 Capital (CET1). (APRA implemented it in
Australia on January 1, 2016.)

4. Countercyclical buffer: in addition to the conservation buffer, APRA may, by notice in writing to all ADIs require them to
hold an additional common equity tier 1 capital of between zero to 2.5% of total risk weighted asset as a countercyclical
capital buffer.

 Hence, there will be a capital buffer (CB) comprising the conservation buffer plus any counter cyclical buffer.
CB = conservation buffer + countercyclical buffer.
 It is not mandatory that banks meet the capital buffer (CB) fully, but they will face restrictions if they do not.
Eg. Restrictions on dividend issues, staff bonuses etc.
 Assuming there is no countercyclical buffer in place, banks will generally need to hold a benchmark level of
7% CET1 capital from Jan 2016 (4.5%+2.5%)
 However, our 4 largest banks will need to hold a benchmark level of 8% of CET1 because they have been
designated ‘systemically important banks’.

5. Leverage ratio: a supplementary (or back-stop) ratio measure to further limit risk. The trial minimum leverage ratio is:
LR = (Tier 1 Capital/Total exposure) ≥3%

6. Liquidity coverage ratio (LCR) introduced on January 1, 2015. Larger banks must maintain an adequate level of
unencumbered, high-quality liquid assets (HQLA) that can be converted into cash to meet its liquidity needs for a 30
calendar day time horizon under a significantly severe liquidity stress scenario specified by supervisors.

 LCR = (High quality liquid assets/30-day net cash outflows) ≥100%

 Committed Liquidity Facility (CLF) - Because Australia has had relatively low levels of HQLAs in recent years,
the Basel Committee permitted Australia to alter the definition of HQLAs so as to allow banks to access
liquidity from their central bank.
 Hence, the RBA has initiated a Committed Liquidity Facility. Banks will pay an ongoing access fee of 15 basis
points of the size of their facility and borrowed liquidity will incur interest of 25 basis points above the cash
rate.
 Hence, the LCR requirement in Australia could be re-written as:
 LCR = ((High quality liquid assets + CLF funding)/30-day net cash outflows) ≥100%

7. Net stable funding ratio: As of a January 1, 2018, banks under the LCR rules must adhere to a second, longer term
liquidity measure. The time horizon for this ratio is 1 year. Stable funding includes: Capital, Preferred stock with maturity
>= 1 year, Liabilities >= 1 year etc.
NSFR = (Available stable funding/required stable funding) >100%

(Extra: Included in the continuation of the financial claims scheme is that depositors are covered up to a maximum of
$250,000 per account holder per ADI. It will continue to be funded in an ex-poste manner rather than through a bank
deposit tax.

That is, the government will initially supply the funds in the event of insolvency, and these will be recovered in the
liquidation process)

Banking system stability

Banking systems have always experienced crises. The RBA promotes stability through:

 Monetary policy to influence inflation and economic growth.

 Overseeing the payments system.
 Acting as lender-of-last resort.
 Monitoring financial and economic data – it reports half-yearly.

The RBA’s approach to reviewing financial stability, is through examination of the following key indicators of financial performance:

1. Profitability of Australian banks - A direct indicator of viability. Losses by an ADI can trigger runs on deposits in that and
similar institutions.
2. Asset quality of Australian banks - look at the proportion of impaired assets and losses on loan defaults.
3. Capital holdings of Australian banks - the amount of a bank’s capital relative to its size indicates its ability to withstand
losses.
4. Liquidity of Australian banks - does the ADI hold adequate liquid assets?
 5. The share market’s assessment of Australian banks - share prices (and debt yields) provide an independent assessment of
an ADIs prospects.
6. Ratings agencies of Australian banks - ratings provide an independent assessment of ADIs
7. Global financial environment - crises in major financial centres can destabilise financial systems in other countries. The
RBA monitors these financial indicators for the major financial systems.

The international financial regulatory architecture

Other countries have similar regulatory org. to Australia. There are also international bodies:
The Bank for International Settlements (BIS)
An intergovernmental organization of 60 central banks, based in Basel, Switzerland. Its role is to "foster international monetary and
financial cooperation and serve as a bank for central banks.”

The international Monetary Fund (IMF)

The IMF’s stated objectives are to promote international economic cooperation, international trade, employment, and exchange rate
stability. It can provide resources to member countries to meet balance of payments needs. The IMF has 189 member countries and its
headquarters are in Washington, D.C..

The Financial Stability Board (FSB)

The (FSB) was formed in April 2009. It has a mandate to assess the vulnerabilities affecting the financial system, identify and oversee
action to address them, and promote co-operation and information sharing among authorities responsible for financial stability. Its
members include the G20 nations and a number of international organizations.

PART 2 Managing capital from an institutional perspective

The remainder of the presentation is based on chapter 8 of Hogan which focuses on the management of capital from the
perspective of a bank.

The importance of capital

Ideal characteristics of capital:

1. a permanent commitment of funds.

2. no unavoidable charges.
3. available to absorb losses.
4. ranks behind claims of depositors and other creditors in the event of a wind-up.

Defining capital
There are two approaches to defining ADI capital: equity capital and regulatory capital.

Equity capital = Assets – Liabilities

 where assets and liabilities are measured as book values i.e., it is the net worth of the ADI.
 Equity capital consists of issued shares, retained profits, reserve accounts etc. These have some/all
characteristics of capital.

Regulatory capital = (Tier 1 + Tier 2) capital

 Tier 1 has characteristics of capital, Tier 2 has some, but not all characteristics.
 Regulators set a minimum risk weighted total capital ratio, which is regulatory capital as a percentage of risk-
weighted assets.
 The minimum is 8%, but there is also a conservation buffer of 2.5%.

Functions of capital
Main function: to absorb risk in the form of unexpected losses. Capital protects depositors and other creditors. When
loans are written off, assets fall. On the other side of the equation, equity falls to balance this, leaving liabilities unaffected
(provided there is sufficient equity).

Second function: to maintain community confidence. As noted, capital absorbs risk. Also, shareholders are last to receive
compensation in the case of insolvency. This gives confidence to creditors, depositors and borrowers.

Third function: a source of long-term investment funds. Hogan et al. notes that this is particularly important if the ADI
wishes to expand by way of merger or takeover.

Fourth Function: strong capital (and in particular, equity) holdings contribute to higher credit ratings which lowers the cost
of funds. Eg. bond sellers with higher credit ratings pay lower coupon interest. Stronger capital reduces the risk of loss for
creditors.
Capital targets and allocation
There are two general questions to be answered:

 How much capital should be held? i.e. What is the target level?
 What capital mix should be employed & how should it be apportioned across the business?

1. Determining the target level

The two main determining factors are:
(i) Risk–return trade-off
Capital risk is the risk that the ADI will have insufficient capital to absorb losses, and hence become insolvent.

 Consider a simple scenario: a bank has $110 assets, and $100 liabilities (all deposits) and $10 equity. If it suffers
asset losses of $20, it will be insolvent: Assets = $90; Liabilities = $100. Depositors will receive only 90 cents in the
dollar.
 Capital risk is affected by the probability of losses (increase probability, increase risk) and the amount of capital
held (increase capital, decrease risk).
 Why not reduce risk to a minimum?

Decreasing risk tends to decrease returns. E.g increasing capital reduces risk, but it raises the average cost of funds & may
therefore limit investments.

 Why not aim for maximum ROE?

If an ADI increases risk, depositors and other creditors will require higher returns (credit rating falls). Increasing leverage
could result in a fall in share price due to risk concerns and worsen the credit rating. Regulatory constraints limit the
amount of leverage that ADIs can employ.

(ii) Regulatory requirements

As we have seen, banks must hold sufficient capital to cover credit risk, market risk and operational risk. The capital
adequacy formula is: Risk-asset Ratio = Qualified capital/(total risk-weighted assets)
Total risk-weighted assets is the sum of:

 credit-risk-weighted balance sheet assets

 credit-risk-weighted off-balance sheet asset equivalents
 asset equivalents of the capital charges for market risk and operational risk

2. Capital allocation for line of business risk

Capital is a scarce resource and hence must be allocated carefully among the various viable alternatives. Capital is allocated
to absorb risk in the various lines of business. ADIs try to quantify the risk of each line of business in terms of the capital
needed to absorb the risk.

i. Capital required: We call this a loss bearing or risk-based allocation.

Capital (for absorbing loss) is assigned to each line of business based on 2 things: expected losses and unexpected losses.

 Expected losses are based on historical loss data. Banks analyse past loss patterns in order to forecast future
likelihoods.
 Unexpected losses involve contingencies for certain scenarios such as fire or flood or some regional catastrophe
(eg. one that shuts down electronic banking), or nationwide downturn leading to a major default crisis. Models
are developed based on probability distributions and used to help assign capital for such contingencies.
 For example, a major downturn leading to widespread credit card default might be classified as a 3 sigma event,
i.e. 3 standard deviations from the mean or average outcome, with a chance of 1 in 400. Based on this, capital
will be assigned to the consumer banking line.
(ii) Revenues generated and funds used
In terms of allocation of capital, lines of business can be compared in terms of the revenue they generate and the cost of
raising funds. This helps to determine where capital is most efficiently used. i.e., Revenue generated per dollar of funds
used.

(iii) Overheads consumed

Overheads such as personnel, buildings and furniture can also be used to compare the efficiency of each line of business.
i.e., Revenue generated per dollar of overheads.

3. Reconciling different capital allocations

Three approaches to determining overall capital levels:

(i) Optimal level based on risk and return considerations

(ii) Regulatory requirements
(iii) Total amount based on allocation to individual lines of business

How does management reconcile the 3 approaches?

The ADI will set a capital target that reflects to some extent each of the 3 approaches, though some flexibility will be
needed. Regulatory requirements would set a lower general limit. Line of business considerations would help to allocate
capital to specific uses. Risk/return considerations would help to analyse the overall effectiveness of capital allocation and
perhaps to set an upper capital limit.
Over time regulatory requirements have become comparatively more influential.

Planning to meet the capital target

How does an ADI meet its capital target?
A plan is needed that will enable the estimation of required capital based on sustainable internal growth.
Note: the focus is on the simple capital ratio: Equity/Assets

1. The planning process

The planning process involves a number of steps. You can read about those on pp. 254-6.

(i) Analyse current performance - this can be based on the key risk return measures outlined in module three. Industry
comparisons will be useful here.

(ii) Predict key variables - a 3-5 year planning for cost should be made. Key variables to forecast include loan and deposit
levels, interest spread, non-deposit liabilities, non-interest revenue and cost etc. Endogenous and exogenous factors
should be considered.

(iii) Determine the target level of capital - estimate the required level for each forecast year. The level will be affected by
the forecast asset value and the asset mix.

(iv) Project and assess planning targets - develop estimated statements of financial position and performance for the first
year. Include only major asset and liability categories. Build on this allowing for growth in deposits, retained earnings etc.
to develop statements for subsequent years. Estimate asset growth and growth in profits and retained earnings. Sensitivity
analysis will be useful here e.g., how will capital needs be affected if deposit growth is 10% more than forecasted?

(v) Modify plans to achieve the target - how do the projected capital needs compare with the target the ADI has
established? Are projected retained profits adequate to meet the target? If not the ADi must make strategic adjustments,
issue new capital etc.

2. Sustainable Internal Growth

General rule: If an ADI can finance all of its capital needs internally (i.e. retained profits), without hurting its shareholders
or its share price, it should do so.
Four variables determine how much growth can be sustained through retained earnings:

 The target capital level.

 Profits generated.
 Proportion of profits retained by the ADI.
 Projected level of assets.
Example: ADI assets = $200M, Current capital ratio = 10%, Predicted asset growth for the year = 5% To retain a capital ratio
of 10%, retained profits will need to be:
10% x 5% x 200 million = 1 million

(ROA )(1-D)
SG =
EC/TA-(ROA )(1-D ) Where:

 SG = sustainable growth rate

 ROA = return on total assets, or net revenue after taxes divided by average total assets
 D = percentage of after-tax net revenue paid in cash dividends
 EC = average equity capital
 TA = average total assets

If retained profits is the only addition to capital (no shares issued, no restructuring of assets etc.), we can estimate what
will happen to the capital ratio based on our forecasted values.

EC + TA(1+ AGR )(ROA )(1 - D)

PCR=
Projected capital ratio = TA (1 + AGR ) Where:

 PCR = projected capital ratio when retained profits is the only source of additional capital
 AGR = planned asset growth rate
 (other terms as defined above)

An ADI can estimate capital needs by calculating the PCR and comparing with the target.

E.g., if an ADI plans rapid growth, the projected capital ratio may decline below the target. To prevent this, the ADI will
need to make adjustments. For example, it could reduce the proportion of profits paid as dividends. But if this will affect
share price, it could alternatively issue new ordinary shares. A list of possible management actions is contained in Table 8.6

In relation to Table 8.6, a question could be expressed in various says. Eg.:

a) SG over the next 3 years is 8%. Planned asset growth is 10%. What actions could the bank take to stabilise the capital
ratio?

This means that equity is likely to be growing at 8% through retained profits. Since planned asset growth is 10%,
the assets are growing faster than its equity. It will have insufficient equity to sustain that growth and there will
be a shortage. Therefore, the possible actions are the ones listed on the left-hand side of the table above.

b) Equity is expected to grow 8% per year over the next 3 years. Assets are expected to grow 6% per year. What actions
could the bank take to stabilise the capital ratio?

That means the ratio will be increasing because in this case you got your equity growing at 8% and your assets
growing at 6%. You're likely to find that you equity on asset ratio is going to rise. That means you will have a
surplus situation. Therefore, the possible actions are the ones listed on the right-hand side of the table above.

Internally generated capital

This refers mainly to retained profits. As noted, the level depends on the profit generated (after tax net revenue) and the
amount paid as dividends. Dividend policy involves setting a payout ratio.

Payout ratio = dividends/after tax net revenue

Dividend policy: two main goals
(i) Send positive signal to investors regarding management’s expectations about future earnings.

(ii) Ensure a stable level of dividends, i.e., a steady income flow – i.e., a form of dividend smoothing is recommended. Also,
increases in dividends should lag increases in revenue

Factors affecting dividend level and timing:

 Investor requirements
 ADI capital target
 Rate of return ADI can earn compared with what investors could make elsewhere
 Earnings stability of ADI
 ADI’s plans for future growth.

External sources of capital

There are 3 main forms of external capital:

(i) Ordinary shares: give right to elect board of directors. Have residual claim on profit and assets behind all other
claimants. Variable dividends.

(ii) Preference shares: Rank ahead of ordinary shareholders, but behind other claimants. Dividend normally a fixed percent
of the investment. Do not mature, but may be retired or redeemed by the ADI (if redeemable). Can be cumulative (holder
has right to any dividends in arrears) or non-cumulative. Generally no voting rights.

(iii) Subordinated debt: generally fixed interest obligations that rank ahead of ordinary and preference shares but behind
other claimants. Examples are corporate bonds and long-term debt that meet eligibility requirements. Some may be
convertible to shares, i.e., hybrid instruments.

External share issues

 Issued when a new ADI is formed.

 Issued to raise external capital to finance growth
 Issued as part of a dividend re-investment plan
 ADIs take various measures to improve share price: operating efficiency, dividend policy, marketing etc.

Should all capital be ordinary equity?

Ordinary shares versus senior capital, i.e., preference shares and subordinated debt.
Issues to consider:

 Availability of various forms of capital

 Potential need for flexibility in the future: the benefit of choice
 Financial implications of various forms of capital: leverage, dilution of EPS etc.
 Size of ADI – a large ADI will need more capital and sources of capital

Financial effects of senior capital (Senior capital refers to forms of external capital other than ordinary shares)
Benefits of senior capital over ordinary shares:

 Lower immediate dilution of earnings per share (as long as financing costs are not too high).
 Can improve earnings per share over time because it introduces favourable financial leverage.
 See Tables 8.7 and 8.8 for an illustration of this.

Disadvantages of senior capital over ordinary shares:

 However, senior capital does entail higher risk, eg. increased variability of earnings, increased risk of bankruptcy,
may not be permanent etc.
 Basic rule of thumb: ADI should use debt within reasonable limits as long as earnings on total capital exceed the
current cost of debt by about 50%.
Newer forms of senior capital
Three examples are convertible securities, variable rate debt and option rate debt
1. Convertible securities:

 fixed interest securities that are convertible into ordinary shares at the option of the holder.
 Normally have lower interest or dividend costs than non-convertibles.
 A call provision gives the ADI flexibility (callable bond – ADI can buy back the bond).
 Can improve the marketability of the fixed interest securities.
 Regulators prefer a variation termed mandatory convertibles, where the fixed interest securities must be
converted. Hence, they will never mature. They sell for less favourable terms due to reduced flexibility.
 Mandatory convertibles are considered upper Tier 2 capital for this reason.

2. Variable rate debt: eg. bonds with variable coupon rates. This limits interest rate risk.

3. Option rate debt:

 variable rate debt that can be converted into fixed rate debt at the option of the debt-holder. This option
increases the price of the debt, which reduces the yield.

Share Buyback Schemes

In the 1990s, the four major banks implemented share buyback schemes. They can be a valuable capital management tool
but must be implemented within fairly strict guidelines. According to Hogan et al., buybacks should only be implemented if:

 the share price is forecast to rise on average over the foreseeable future.
 there are no good acquisition opportunities.
 capital market spreads are narrow – less than 50bps.

Note that with tighter capital regulations under Basel 3, ADIs will be less likely to engage in share buybacks and must seek
permission from APRA before engaging in a buyback.