Trends in Australian Bank Capital
Essay by review • December 14, 2010 • Research Paper • 2,227 Words (9 Pages) • 1,636 Views
LETTER OF TRANSMITTAL
This reportÐŽ¦s topic is Trends in Australian Bank Capital. The content is as following:
1. The explanation of why ÐŽ§Regulators usually want more equity capital whereas shareholders usually favour less equity capitalÐŽÐ
2. The differences between bank equity capital and bank regulatory capital
3. A discussion of the functions of bank capital and the role of the risk-return trade-off
4. The differences between tier 1 and tier 2 capital
5. The components of tier 1 and tier 2 capital and the cost and risk implications of them
6. Details of the trends in the four major Australian banks for the last five years.
1.
In Hogan et al (2004) Page 249 states that ÐŽ§from the shareholdersÐŽ¦ point of view, the appropriate amount of capital is an amount that is small enough to produce at least an adequate return on capital and yet is large enough to absorb risk.ÐŽÐ However, bank regulators have the responsibility of protecting depositorsÐŽ¦ funds and the safety of the financial system, which requires ÐŽ§banks with higher credit risk to hold higher minimum capital.ÐŽÐ
The following table shows the capital ratios for the four major Australian banks over the last five years:
2004 2003 2002 2001 2000
Westpac Banking Corporation Tier 1 6.9 7.2 6.5 6.3 6.6
Tier 2
Total 9.7 10.5 9.6 9.9 9.6
Commonwealth Bank of Australia Tier 1 7.43 6.96 6.78 6.51 7.49
Tier 2 3.93 4.21 4.28 4.18 4.75
Total 10.25 9.73 9.8 9.16 9.75
ANZ Banking Group Limited Tier 1 6.9 7.7 7.9 7.5 7.4
Tier 2 4.0 4.0 2.8 3.2 3.4
Total 10.4 11.1 9.5 10.3 10.2
National Australia Bank Limited Tier 1 7.3 7.7 7.6 7.5 6.6
Tier 2
Total 10.6 9.6 10.0 10.2 9.3
Sources: http://www.anz.com; http://www.commbank.com.au; http://www.westpac.com.au; http://www.nabgroup.com
The Australian Prudential Regulation Authority (ÐŽ§APRAÐŽÐ) has set minimum regulatory capital requirements for banks that are consistent with the Basel Accord. These requirements define what is acceptable as capital and provide for standard methods of measuring the risks incurred by the Bank. APRA has set minimum ratios that compare the regulatory capital with risk weighted on and off balance sheet assets. The minimum risk-weighted capital ratio is 8%. The following formula is used to calculate the risk-weighted capital ratio:
Risk-weighted capital ratio = Qualifying capital .
Total risk-weighted assets
The numerator of the ratio is qualifying capital, which includes Tier 1 capital such as paid-up ordinary shares and retained profits, and Tier 2 capital such as term subordinated debt after making required deductions for items such as goodwill and equity holdings in other banks.
Equity capital is a permanent commitment of funds which earns the residual income of the firm after all interest and other costs have been paid. In Orgler/ Wolkowitz Bank Capital 1976, bank equity capital represents ÐŽ§all claims on the bankÐŽ¦s profits, and in the Report of Condition it is divided into several accounts that include preferred stock, common stock, surplus, undivided profits, and reserves for contingencies and other capital reservesÐŽÐ. Whereas regulatory bank capital is bank funding which qualifies as bank regulatory capital under the regulatorÐŽ¦s rules. The regulatory capital is divided into two parts which will be mentioned later in this report.
Functions of bank capital:
ÐŽP Absorbing Losses
Capital is not held as a reserve against all losses under all circumstances. Extensive difficulties in the general economy may well result in individual bank losses, but banks are not expected to insulate themselves against this type of loss. Losses that capital should absorb result from one or a combination of several sources of risk, they are:
1. Credit Risk
2. Investment Risk
3. Liquidity Risk
4. Operating Risk
5. Fraud Risk
6. Financing Risk.
Losses resulting from these risks are either charged off to the appropriate reserve account or deducted from net earnings, and if earnings are not adequate, the net loss is deducted from retained earnings. CapitalÐŽ¦s function of absorbing losses is instrumental in avoiding failure, thus contributing to the publicÐŽ¦s confidence in the banking industry. For this reason high capital ratio, other things being equal, are generally considered as indicators of bank soundness.
ÐŽP Protecting Uninsured Depositors and Creditors
If a bank fails, the Federal Deposit Insurance Corporation protects the majority of depositors. However, the remaining depositors and creditors are dependent on the bankÐŽ¦s resources for recouping their funds. As the protection of these creditors depends on the bank capital that includes equity, reserves, and long-term debt, it adds to the effectiveness of capital in promoting public confidence in banking.
ÐŽP Financing Assets
Capital also provides a source of funds particularly suited to the financing of plant and equipment for both new and existing institutions. This function does not require a large amount of capital, because plant and equipment in banking represent on the average less than 2 percent of the total assets as compared to an average of 45% in manufacturing. Additionally, the more a bank depends on its capital, the less prone it is to the
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