Analysis of Two Australian Banks in Matter of the Capital Risk Requirements - Example

Table of Contents Introduction 2 2. Analysis 4 3. Conclusion 9 References 10 List of Figures List of Tables Introduction Banks have the obligation to hold regulatory capital assessed according to their specific condition towards credit, market, and operational risks. Regulatory capital is composed by the following tiers. Tier 1 capital is comprised from paid-up common shares, reserves, retained earnings, and preference shares, less specified reductions. In what concerns the tier 2 capital, this includes general provisions for doubtful debts, asset revaluation reserves, mandatory convertible notes, and similar capital instruments. In many studiesi it was confirmed that regulations are a factor in reinforcing the capital, profitability and cost of equity in determining banking strategy. In this case, regulation and the addition of capital to the bank’s balance sheet reduce the overall riskii. The cost of holding risk is an important issue for banks due to the fact that risk management represents their core area of business i.e. managing multiple and opposing needsiii. This paper will discuss the capital risk on the examples of two banks: Commonwealth Bank of Australia (CBA) and Australia and New Zeeland Banking Group (ANZ). In both annual reports for the year 2011, it is made a distinction between economic capital and regulatory capital (which was explained earlier in the paper). It is mentioned that ANZ follows that the available capital to exceed the level of economic capital necessary to maintain the credit agency’ rating of ‘AA’. Economic capital can be defined as an internal indicator of capital levels necessary to sustain risk and unexpected losses above a target solvency value. In order to measure their exposure to risk, both CBA and AZN compute capital adequacy ratios, which need to be compared with a minimum threshold established by regulators. The capital adequacy ratio for CBA and ANZ for the year 2011 is shown in the following table. Table no. 1.1 Capital adequacy ratios, 2011 CBA ANZ Risk weighted assets (millions $) 281711 279964 Total capital (millions $) 32962 33790 Capital adequacy ratio 11.70 % 12.07 % Source: CBA (2011) & ANZ (2011). The capital adequacy ratios for the two banks are over the minimum requirement of 8%. A comparison between the risk weighted averages for 2010-2011 is provided in the following graph. Figure no. 1.1 Comparison of risk weighted assets (millions $) between ANZ and CBA Source: CBA (2011) & ANZ (2011). For CBA, risk weighted assets have decreased relative to 2010, whereas for ANZ it is observed the reverse. In the case of CBA, this result can be attributed to credit risk, which was driven over by an increase in exposure in residential mortgages portfolio, downturned by risk improvements in the bank’s corporate portfolioiv. 2. Analysis Capital adequacy requirements consider two principal types of risks: credit risk and market risk and additional considered are interest rate risk and operational risk. This paper will consider further a comparison of these types of risks for the two banks. Credit risk can be defined as the risk that borrowers will not repay their debtv. The following two figures are an overview of the ANZ and CBA’s lending in different sectors, which can be characterized by a lower or higher level of risk. Figure no. 2.1 The composition of ANZ’s lending as at June 2011 Source: ANZ (2011). As it can be seen from the graph, personal lending has the highest percentage, mostly because ANZ has its core business focused on this area of service. Figure no. 2.2 The composition of CBA’s lending as at June 2011 Source: CBA (2011). In the case of CBA, the situation differs because its primary lending was focused on home loans, a factor of an increased level of risk. Further, it was necessary to analyze the credit related instruments i.e. contingent liabilities and off-balance sheet business for CBA and ANZ, provided in the following tables. These values represent the maximum potential loss for the bank if the counterparty defaults or does not have sufficient resources to meet its financial obligationsvi. Table no. 2.1 Credit risk related instruments (millions $), CBA 2011 2010 Guarantees 4462 3658 Standby letters of credit 931 817 Bill endorsements 28 57 Documentary letters of credit 50 71 Performance related contingents 1996 1240 Commitments to provide credit 128007 109420 Other commitments 660 478 Source: CBA (2011). The commitment to provide credit could determine the highest loss for the CBA, mostly because its primary lending is for home sector, which has a higher degree of risk. Table no. 2.2 Credit risk related instruments (millions $), ANZ 2011 2010 Guarantees 6923 6313 Standby letters of credit 2672 1991 Documentary letters of credit 2964 2498 Performance related contingents 17770 16103 Other commitments 881 580 Source: ANZ (2011). In the case of ANZ, commitments to provide credit are not mentioned in the annual report, and the performance related contingents could bring the higher loss for the bank. When analysis the credit risk, it is important to take into consideration the impaired assets, which are divided in the following categories: non-performing facilities, restructured facilities and assets acquired through security enforcement. An overview of net impaired assets is provided in the following table. Table no. 2.3 Net impaired assets (millions $), 2011 CBA ANZ Impaired assets 4640 2807 Less specific provisions -2031 -909 Net Impaired assets 2609 1898 Source: CBA (2011) & ANZ (2011). The net impaired assets register a higher value in the case of CBA due to an increase in residential mortgages portfolio, shown also in the level of credit risk. Market risk is related to the unfavorable movements in market prices, and the losses occurred by thisvii. Further, it is a price risk and is not related to the credit risk which is a default risk. An overview of the market risk levels and also of interest rate and operational risks is provided in the following table. Table no. 2.4 Market, interest rate, and operational risks (millions $), 2011 CBA ANZ Market risk traded 3162 3046 Interest rate risk/Market risk IRRBB 9699 8039 Operational risk 22108 19651 Source: CBA (2011) & ANZ (2011). For both banks, the market risk has the lower level, followed by interest rate risk and finally by operational risk. Operational risk is related with losses from inadequate internal events (e.g. legal risk) or from external eventsviii. The higher level of operational risk can be explained by the recent crises of the banking system all over the world, which steered more regulation and probably a higher precaution in quantifying this risk. Earlier in the paper it was mentioned the regulatory capital with the two tiers. The following figure provides a comparison of common equity for the two banks. Figure no. 2.3 Comparison of common equity between ANZ and CBA, 2011 Source: CBA (2011) & ANZ (2011). In the case of ANZ, both common equity and tier 1 capital register higher values than CBA’s stated percentages, whereas in the case of tier 2 capital (includes subordinated debt instruments with a minimum maturity of five years) the situation is reverse. The annual reports for the two banks show the new perspective of regulators on common equity. 3. Conclusion This paper provided an analysis of two Australian banks i.e. CBA and ANZ in matter of the capital risk requirements. An important conclusion which can be depicted is that both banks have been conservative with their capital (e.g. the capital adequacy ratios are over the threshold required). Through this analysis, there were compared issues as credit risk, market risk, interest rate risk and operational risk, and pointed out differences where they appeared. A major difference was for the case of risky weighted assets that registered higher values in the case of CBA, compared with ANZ probably due to this bank lending policy. As shown in the annual reports, both banks give a major consideration for the capital management and regulators requirements. References Australia and New Zeeland Banking Group (ANZ): Annual Report 2011. (2011). Retrieved from http://www.shareholder.anz.com/phoenix.zhtml?c=96910&p=irol-reportsannual Amidu, M., & Hinson, R. (2006). Credit Risk, Capital Structure and Lending Decisions of Banks in Ghana. Banks and Bank Systems, 1 (1), 93-101. Commonwealth Bank of Australia (CBA): Annual Report 2011. (2011). Retrieved from http://www.commbank.com.au/about-us/shareholders/financial-information/annual-reports/ Gupp, B. E., Avram, K., Beal, D., Lambert, R., & Kolari, J. (2007). Commercial banking: The management of risk. Milton: John Wiley & Sons Australia Ltd. Hooda, D., & Stehlík, M. (2011). Portfolio Analysis of Investments in Risk Management. The Open Statistics and Probability Journal, 3 (1), 21-26. Howells, P., & Bain, K. (2007). Financial Markets and Institutions. Harllow: Pearson Education Limited. Khoen, M., & Santomero, A. (1980). Regulation of Bank Capital and Portfolio Risk. The Journal of Finance, XXXV (5), 1235-1246. Price WaterHouse Coopers (PWC): Growth Prospects on Corporate Lending Slowly Returning.. (2011). Retrieved from http://www.pwc.com.au/industry/banking-capital-markets/assets/APS300_Aug11.pdf Thirwell, J. (2002). Operational risk: the banks and the regulators struggle. Balance Sheet, 10 (2), 28-31. Viney, C. (2003). Financial institutions, instruments and markets (4th ed.). Sydney: The McGraw-Hill Companies Inc. Read More