Overview of Capital Risk - Essay Example

Introduction Overview of capital risk Capital risk in the banking context is the risk or probability that those who have invested in the bank for running the bank. Those who face capital risk include the bank’s shareholders who are its owners as well as the depositors who have entrusted their money with the bank. It is in a bid to minimize capital risk and hence protect the investors’ interests that the Australian Prudential Regulatory Authority (APRA) requires all financial institutions to come up with risks management framework. This means that banks should come up with measures of identifying, measuring, evaluating, monitoring, reporting and controlling risks that have an impact on their ability to effectively perform their obligations to investors including creditors, depositors and shareholders. APRA (2013) requires the banks to plan for their appropriate bank size, level of complexity and the type of business they carry out in a bid to be and remain effective. It is in this regard that this paper aims at analyzing the level of compliance to the new standards as imposed by APRA by banks with respect to Westpac bank and Bendigo and Adelaide bank. The paper will also aim at comparing and analyzing the level of capital risks that the two banks are exposed to. Overview of Australian Prudential Regulation Authority’s (APRA) risk management framework In discharging its mandate for ensuring improved safety and quality of banking operations in Australia, APRA has come up with a risk management framework with a number of features to be observed by all financial institutions. In line with Basel III capital reforms, APRA increased the capital requirement for tier 1 common equity by 2.5% to 4.5% of the bank’s risk weighted assets (RWA). Similarly, the capital requirement for capital ratio (tier 1) has been increased by 2.0% to 6.0% according to APRA (2012). The increased minimum capital requirements serve to boost investors confidence by making Australian financial institutions more resilient to sudden increases in capital risk than before. Analysis Analyzing the adherence of Westpac bank and Bendigo and Adelaide Bank to APRA’s risk management framework requirements; Sharma (2008) states that the bank’s capital is composed of tier1 and tier 2 capital with tier 1 capital being referred to as core capital owing to its being composed by instruments that are highly relevant. These instruments include disclosed reserves from after tax retained earnings as well as paid up capital by shareholders. Ledger wood and White (2006) on the other hand refer to tier 2 capitals as non-core capital owing to its being composed of supplementary instruments. The instruments include subordinated term debt as well as revaluation and general reserves among others. In their trading, banks only have core capital at their disposal while the non-core capital is only available in an event of the bank being liquidated. This explains why capital ratio is mostly calculated on the basis of tier 1 capital. Capital adequacy ratio is defined as the proportion of the Banks core and non-core capital to its risk adjusted assets. APRA has put in place 8% as the minimum capital adequacy ratio for every bank in its effort to shield banks from sudden increases of risk as stated by Sharma (2008). The minimum capital requirements for all banks as well as the degree of compliance by Westpac and Bendigo and Adelaide Bank have been displayed in the table below; Capital APRA Bendigo and Adelaide bank Westpac Common Equity Ratio 4.5% of weighted risk 7.86% 9.1% Tier 1 Capital Ratio 6.0% of weighted risk 9.24% 10.7% Table 1: showing banks compliance on APRA’s capital adequacy ratio requirements NB// the values contained in the table above have been sourced from Westpac 3 pillar report 2013 for Westpac and Basel III pillar disclosures 2013 for Bendigo and Adelaide bank . The table above shows that the two banks ie. Westpac and Bendigo and Adelaide bank have achieved minimum capital requirements that are above those imposed by APRA for all deposit taking financial institutions in Australia (ADIs). As can be seen from the table above, Bendigo and Adelaide bank has a common equity ratio of 7.86%. This has greatly surpassed the APRA’s 4.5% minimum capital requirement. Similarly, Westpac has a common equity ratio of 9.1% which is above the APRA’s requirement of 4.5%. This demonstrates that both the banks have been successful in complying with the new APRA standards on capital aimed at reducing the resultant capital risks that the banks are exposed to. The fact that the banks have a higher minimum capital means that they can still operate efficiently and effectively even in conditions of sudden increases in risk resulting from occurrence of negative events. It should also be observed that Westpac has higher total adequacy ratio at 12.3% which implies a better propensity to manage capital risk in comparison to Bendigo and Adelaide bank ‘s 10.72%. Basic capital ratio for Westpac and Bendigo and Adelaide bank It is also possible to use the market approach in measuring the degree of capital risk and hence putting capital risk at adequate levels in addition to the APRA’s regulatory framework requirements. Also known as the basic capital ratio, the approach uses the relationship between the bank’s common equity and its total assets. It is possible to use this ratio in measuring capital risk given higher basic capital ratio is a sign that banks have higher level of safeguards against risk according to Khan and Jain (2008). The basic capital ratio for the two banks has been calculated as shown below; Basic Capital Ratio = Equity/Total Assets West Pac: =$47,481/$696,603 = 6.8% Bendigo and Adelaide bank = $4,434.0/$60,282.2 = 7.4% NB// The above figures are in terms of million dollars and have been adopted from the 2013 financial statements for the two banks respectively. The above calculations indicate that Bendigo and Adelaide bank has higher basic capital ratio at 7.4% compared to Westpac’s 6.8%. This is an indication of that Bendigo and Adelaide bank has lower degree of capital risk in comparison to Westpac. Thus, it is an indication that stakeholders interests are better protected in Bendigo and Adelaide bank in case of sudden increase in risk though this is a departure from the observation above on APRA’s requirements. Capital risk ratio This is another measure of assessing capital risk by comparing capital to total assets in assessing the adequacy of the bank’s capital. It should be noted that shareholders are interested as much as possible in safeguarding themselves against default risk and hence would need the bank to hold adequate amount of capital in a bid to guard against possible loss. This is despite the fact that holding capital carries with it cost for the bank and hence the relevance of identifying the risk absorbed by the bank by virtue of holding capital in its operations according to Shroek (2002). Capital is determined through subtracting liabilities from the bank’s total assets. Note that the amount of capital risk the bank holds could be both advantageous and disadvantageous. On one hand, a higher capital ratio implies lower rate of returns for shareholders hence threatening their goals for profit. On the other hand, a higher capital ratio implies reduced insolvency risk for the bank. As such, the bank could decide to reduce capital ratio thus increasing its leverage to total assets thus enhancing the rate of return for shareholders. While returns will increase however, the bank will be exposed to higher solvency risk and hence the need for the bank to determine an optimal ratio between satisfying shareholders interest for higher returns and ensuring the bank is relatively free from insolvency in accordance to Thomas (2006). The banks’ capital risk ratio is calculated as shown below; Capital Risk Ratio = Total Capital/Total Assets = (Total assets-Total Liabilities)/Total assets West Pac : =$47,481/$696,603 = 6.8% Bendigo and Adelaide bank = $4,434.0/$60,282.2 = 7.4% NB// The above figures are in terms of million dollars and have been adopted from the 2013 financial statements for the two banks respectively. The calculations above show Bendigo and Adelaide bank to have a higher capital risk compared to Westpac . This implies a better protection against insolvency but lower rates of returns for the shareholders. On the other hand, the calculations indicate a higher rate of returns for Westpac shareholders though with a higher solvency risk. Total assets to total capital ratio of Westpac and Bendigo and Adelaide bank Also known as the TAC multiplier, it measures capital risk by using the relationship between the banks total assets and total capital. It is useful in determining the level of leverage on the bank on its total assets rate of return. The ratio limits the amount of debt that the bank can issue thus preventing its long-term growth. The higher the ratio, the higher the capital risk for the bank and vice versa as stated by Thomas (2006). The banks’ TAC ratio has been calculated as shown below; TAC Ratio = Total Assets/Total capital Westpac bank = 696,603/$32,738+4,918 = 18.5 Bendigo and Adelaide bank 31,097.60/2,873.7+460.0 = 9.32 The calculations above reveal that Westpac has a greater TAC ratio compared to Bendigo and Adelaide bank. This means that Westpac has greater capacity for issuing more debt securities while Bendigo and Adelaide bank faces greater solvency risk. Westpac’s and Bendigo and Adelaide Bank’s Return on Equity Capital risk could also be measured using the bank’s return on equity. Given that shareholders face the risk associated with the money they invest as capital and hence they are interested in the bank’s profitability as a return to their equity. The higher the return on equity, the low the risk to the shareholders while the vice versa is true according to Ledgerwood (1999). The two banks’ return on equity has been calculated in the figure below; Bank 2013 2012 Westpac 6,437/44,356 =14.51% 6,890/47,481=14.51% Bendigo and Adelaide bank $352.3/4,434 =7.95% $195.0/4,217.7=4.62% The table below shows the change in returns on equity for the banks for the two years; ROE 2013 2012 % change Westpac 14.51% 14.51% 0% BEN 7.95% 4.62% 3.33% The comparative return on equity for the two banks for the last two years has been depicted in the table above. It has revealed that Westpac had a higher return on equity in comparison to Bendigo and Adelaide bank. However, it can be seen that BEN’s ROE significantly increased in 2013 by 3.33% while that of Westpac remained constant. This is an indication that Westpac presents a lower capital risk to its shareholders in comparison to BEN. Westpac and BEN credit rating A bank’s credit rating could affect its cost of capital and hence its capital risk. The Westpac bank has been rated at AA- in 2013 according to standard & poor’s. On the other hand, BEN was rated at A-. This implies that Westpac has a better credit rating and hence has increased borrowing ability as investors would be more confident on its ability to repay the money and interest. However, it should be noted that both the banks have relatively good ratings which imply improved ability to attract investments and hence funds. Effect of the product type and scope of operations to the capital risk of the two banks Bendigo and Adelaide bank has a smaller scope of business operations in comparison to Westpac. BEN has its operations solely in Australia while Westpac has its operations in Australia, New Zealand and the pacific region. It should also be noted that Westpac bank offers a wide range of financial services and products in comparison to BEN. To some extent, this explains the differences in capital risk between the two banks. According to Liang and Rhoades (1991), banks that have a wide range of products being offered across diverse geographical regions have higher probabilities of lowering their capital risk since economic problems in one region may be offset by better economic conditions in other regions. This explains Westpac’s lower capital risk in comparison to BEN. Conclusion From the analysis, it has been revealed that both Westpac and BEN banks have adequately met the minimum capital requirements as set forth by APRA and have even exceeded these regulatory requirements. This is an indication of their relatively excellent performance in their bid to protect the interest of investors through minimization of capital risk. It should however be noted that Westpac has a higher capital adequacy ratio and hence higher safeguards against capital risk in comparison to BEN. The banks have been noted to greatly differ in other financial ratios such as the basic capital ratio and the capital risk ratio which is a further indication that Westpac has stronger safeguards against capital risk which on the other hand indicates a higher capital risk for BEN. Similar observations have been made in the banks’ total assets capital ratio where Westpac has been noted to be better equipped in terms of capital risk control. In a similar manner, Westpac was noted to have higher returns on equity ratio than BEN implying that the shareholders of BEN face a greater capital risk in comparison to those of Westpac. Although Westpac credit rating was downgraded to AA- from AA in 2012, it is still better compared to that of BEN which is A-. However, it should be noted that both banks have very strong credit ratings. The higher credit rating of Westpac however denotes increased ability to raise funds in comparison to BEN. In terms of products and services, Westpac has been noted to be more diversified both in terms of product offerings and geography. This is a non-financial measure of risk which indicates that Westpac faces lower capital risk than BEN. Based on the analysis therefore, it is no doubt that Westpac is exposed to lower levels of capital risk in comparison to BEN. This is because it has stronger ratios than BEN in all aspects. Furthermore, Westpac has been noted to be more diversified in comparison to BEN which is an indication of lower capital risk. In conclusion, both banks are noted to have made great strides in guarding themselves against capital risk to an extent of exceeding APRA’s regulatory requirements on capital risk. References: APRA 2012. APRA releases final Basel three reform package, Retrieved on 28th August 2014, from; http://www.apra.gov.au/mediareleases/pages/12_23.aspx APRA 2013. Prudential standards CPS 220 risk management. Retrieved on 28th August 2014, from; http://www.apra.gov.au/CrossIndustry/Consultations/Documents/Level-3-Draft-Pruden ial-Standard-CPS-220-Risk-Management-(May-2013).pdf Grier, W. A. (2007). Credit analysis of financial institutions (2nd ed.). London, UK: Euromony Institutional Investor PLC. Harker, P. T., Zenios, S. A. (2000). Performance of financial institutions: Efficiency, innovation, regulation. Cambridge, UK: Cambridge University Press. Khan, M.Y., Jain, P. K. (2008). Management accounting: Text, problems and cases. New, Delhi: Tata McGraw- Hill. Ledgerwood, J. (1999). Microfinance handbook: An institutional and financial perspective. Washington D. C.: The World Bank. Ledgerwood, J., White, V. (2006). Transforming microfinance institutions: Providing full financial services to the poor. Washington, D.C.: World Bank. Liang, N. J., and Rhoades, S.A. (1991). Asset diversification, firm risk, and risk-based capital requirements in banking. Review of Industrial Organization (6), 49-59. Sharma, M. (2008). Management of Financial Institutions: With emphasis on bank and risk management. New Delhi: Prentice Hall. Shroek, G. (2002). Risk management and value creation in financial institutions. New Jersey: John Wiley & Sons. Thomas, L. B. (2006). Money, banking, and financial markets. Mason, OH: South-Western. Bendigo and Adelaide Bank. 2013. Annual report, Retrieved on 28th August2014, from; http://www.bendigoadelaide.com.au/public/shareholders/pdf/aps_330/2013-12-31- APS330.pdf Westpac. 2013. Annual report, Retrieved on 28th August 2014, from; file:///C:/Users/Nicholas/Desktop/2013_WBC_Annual_Report-2.pdf Bendigo and Adelaide Bank. 2014. APS 330- Public disclosure of prudential information, Retrieved on 28th August 2014, from; http://www.bendigoadelaide.com.au/public/shareholders/announcements/aps_330.as p Westpac. 2014. Pillar 3 report. Retrieved on 28th August 2014, from; http://www.westpac.com.au/docs/pdf/aw/ic/Pillar_3_Report_Sep_2013_FINAL.pdf Read More