Major Balance Sheet Risks Banks Take with Respect to Capital Risks - Example

Table of Contents Table of Contents 1 COMPARISON OF TWO BANKS ACCORDING TO SOME OF THE MAJOR BALANCE SHEET RISKS THAT THEY TAKE WITH RESPECT TO CAPITAL RISKS 2 THE AUSTRALIAN PRUDENTIAL REGULATORY AUTHORITY’S (APRA) RISK MANAGEMENT FRAMEWORK 3 ANALYZING WHETHER NATIONAL AUSTRALIAN BANK (NAB) AND BANK OF QUEENSLAND HAVE ADHERED TO APRA’s RISK MANAGEMENT FRAMEWORK REQUIREMENT 3 BASIC CAPITAL RATIO FOR NAB AND BOQ 4 CAPITAL RISK RATIO OF NAB AND BOQ 5 TOTAL ASSETS TO TOTAL CAPITAL RATIO OF NAB AND BOQ 6 NAB’s AND BOQ’s RETURN ON EQUITY 7 BOQ and BEN CREDIT RATING 8 EFFECT OF THE PRODUCT TYPE AND SCOPE OF OPERATIONS TO THE CAPITAL RISK OF THE TWO BANKS 8 CONCLUSION 8 References: 9 COMPARISON OF TWO BANKS ACCORDING TO SOME OF THE MAJOR BALANCE SHEET RISKS THAT THEY TAKE WITH RESPECT TO CAPITAL RISKS NAB-BOQ For a bank, capital risk implies the probability or the likelihood that the bank’s investors will lose all or part their investments as a result of the banks operations. The people that face capital risk in the bank context would include its shareholders who actually own it and the depositors who have put their monies in the bank. In an effort to minimize capital risk therefore protecting the interests of the investors, the Australian prudential authority (APRA) has made it a requirement that all financial institutions put in place risk management frameworks. The implication of this is that the banking institutions develops measures that would help them in the identification, measurement, evaluation as well as monitoring, reporting and control of risks which are deemed to impact on their being able to effectively perform their obligations to investors, shareholders and depositors. In accordance with APRA (2014), the banks are required to plan for their appropriate bank size, complexity levels as well as the business type they engage in so as to remain effective. This paper has the main of analyzing how the two banks (NAB and BOQ) have complied with the requirements of APRA while analyzing the level of the banks’ exposure to capital risk. THE AUSTRALIAN PRUDENTIAL REGULATORY AUTHORITY’S (APRA) RISK MANAGEMENT FRAMEWORK The main responsibility that APRA has is that of ensuring enhanced quality and safety of operations by Australian banks. In this regard, APRA developed a risk management framework that contained a number of features that all financial institutions ought to observe. APRA based the framework on the Basel III capital reforms recommendations. In this regard, APRA increased tier 1 capital requirement by 2.5% to 4.5% of the financial institution’s risk weighted assets (RWA). Similarly, APRA increased the capital requirement for capital ratio (tier 1) by 2.0% to 6.0% (APRA, 2012). The increment in minimum capital requirements was aimed at enhancing investor confidence by ensuring the banks become increasingly resilient to sudden increases in capital risk than they were before implementation of the framework. ANALYZING WHETHER NATIONAL AUSTRALIAN BANK (NAB) AND BANK OF QUEENSLAND HAVE ADHERED TO APRA’s RISK MANAGEMENT FRAMEWORK REQUIREMENT The capital of banking institutions consistsof tier 1 capital and tier 2. Tier 1 capital is referred as the bank’s core capital since it mainly consist of highly relevant instruments including disclosed reserves from after tax retained earnings and shareholders paid up capital according to Sharma (2008). On the other hand, tier 2 capital is referred to as non-core capital. This is because it is mainly composed of supplementaryinstruments includingsubordinated term debts and revaluation and general reserve among other instruments according to Ledger, Wood and White (2006). It is worth noting that banks always have core capital at their disposal in their trading activities. On the other hand, the non-core capital is only available to the banks in case the bank undergoes liquidation. It is on this basis that capital ratio for banks will always be calculated based on the core capital. The proportion of the bank’s core capital and tier II capital to its risk adjusted assets is its capital adequacy ratio. Sharma states that APRA requires that banks maintain a minimum capital adequacy ratio of 8% in a bid to shield the banks from sudden increases in risk. The table below displays the minimum capital requirements for all banking institutions including the degree of compliance by NAB and BOQ. Capital APRA National Bank of Australia Bank of Queensland Common Equity Ratio 4.5% of weighted risk 8.63% 8.63% Tier 1 Capital Ratio 6.0% of weighted risk 10.81% 12.0% Tier 1: Analyzing the two banks compliance onAPRA’s capital adequacy ratio requirements NB// For NAB, the above values were retrieved from its annual report for 2014 while for BOQ; the figures were sourced from its Basel III pillar disclosures for 2014. From the above table, it is clear that the two banks (NAB & BOQ) achieved the minimum capital requirements as imposed by APRA for all Australian deposit taking financial institutions (ADIs) andeven exceeded them. From the table, it can be seen that NAB attained a common equity ratio of 8.63 which was way above the APRA’s 4.5% minimum requirement. The same achievement was attained by BOQ which also attained a common equity ratio of 8.63%. This is an indication that the two banks have been successful in ensuringcompliance with the laid down standards by APRA regarding capital which have the objective of reducingthe banks’ exposure to the resultant capital risk. Their having had a higher minimum capital is a clear indication that they would still be able to operate efficiently and effectively even where there are conditions of sudden increases of risk that may arise from negative events happening. As far as the total adequacy ratio is concerned, it should be observed that NAB had a total adequacy ratio of 12.16% while BOQ had a total adequacy ratio of 12.0%. This is an implication that NAB has a better propensity to manage capital risk when compared to BOQ. BASIC CAPITAL RATIO FOR NAB AND BOQ Measuring of the degree of capital risk can also be done use of the market approach whichwould be helpful in putting the banks’ capital risk at adequate levels in addition to the requirements of APRA’s regulatory framework. This approach is known as the basic capital ratio and it utilizes the relationship between the common equity of the bank and its total assets. Using the approach, one can measure the bank’s capital risk since a higher basic capital ratio would denote that the bank has put in place higher level of safeguards against risk as postulated by Khan and Jain (2008). For the case of NAB and BOQ, their basic capital ratios for the year 2014 have been calculated below. Note that the figures used were obtained from the banks 2014 annual reports and are in terms of million dollars. Basic capital ratio = Equity /Total Assets NAB =$47,908/$883,301 =5.42% BOQ =$3,304.5/$46,904.6 =7.05% From the above calculations, there is an indication that BOQ has a higher basic capital ratio of 7.05% in comparison to that of 5.42% achieved by NAB. This means that BOQ is exposed to lower degree of capital risk when compared to NAB. As such, this may imply thatstakeholder’sinterests are better protected inBOQ if there was to be sudden increase in risk thoughthis differs from what was observed above about APRA’s requirements. CAPITAL RISK RATIO OF NAB AND BOQ Another method of measuring capital risk is that of comparing capital to total assets when assessing the bank’s capital adequacy. It is worth noting that shareholders would need the banks tohold enough amount of capital so thatthey can guard against possibleloss that may arise from default risk. This is the fact that holding adequate capital amounts carries with it cost for the bank not withstanding and thus the relevance of identifying the risk that the banks absorb because of holding capital in their operations as stated by Shroek (2002). In this case, capital would be determined after liabilities have been subtracted from its total assets. It should be noted that the level of capital risk the bank holds has both merits and demerits. First, a higher capital ratio would imply that investors get lower rates of return which threaten their profit goals. Secondly, the higher capital ratio would mean reduced insolvency risk for the bank. Based on the above facts therefore, the bank could opt to reduce its capital ratio which would increase its leverage to total assets and which would result in increased level of returns to its shareholders. Although returns will increase however, the bank will expose itself to increased solvency risk which calls for the bank to come up with its optima ratio that satisfies both the shareholders need for increased returns and the needs of the bank for ensuring it is not exposed to the risk of insolvency as put forward by Thomas (2006).We calculate the capital risk ratio for the banks as shown below; Capital Risk Ratio = Total Capital/Total Assets = (Total assets-Total Liabilities)/Total assets Basic capital ratio = Equity /Total Assets NAB =$47,908/$883,301 =5.42% BOQ =$3,304.5/$46,904.6 =7.05% Note that the figures used were obtained from the banks 2014 annual reports and are in terms of million dollars. The above calculations have revealed that BOQ has a higher capital risk in comparison to NAB. This is an indication of better protection against insolvency although the banks shareholders would have to expect lower returns. On the other hand, NAB’s shareholders would expect higher returns but the bank would be exposed to greater solvency risks. TOTAL ASSETS TO TOTAL CAPITAL RATIO OF NAB AND BOQ This is also called the TAC multiplier and it assesses capital risk through the use of the relationship between the total assets and total capital of the banks. The ratio is vital in the determination of the level ofleverage of the banks of their total assets rates of return. This ratio limits the amount of debt that the bank could issue thus capping itslong-term growth. An increased TAC multiplier implies higher capital risk for the bank while a lower TAV multiplier is an indication of lower capital risk for the bank in accordance to Thomas (2006). The TAC multiplier for the banks has been calculated below; NAB =$883,301/$47,908= 18.43 Times BOQ =46,904.6/$3,304.5= 14.19 Times The above calculations have indicated that BOQ has greater TAC Multiplier compared to NAB. In this regard, BOQ is considered to have greater capacity to issue more debt securities incomparison withNAB which is considered to face greater solvency risk. NAB’s AND BOQ’s RETURN ON EQUITY Return on equity is another method of assessing capital risks for financial institutions. This stems from the fact that shareholders are exposed to the risk arising from the moneys they invest as capital and they thus have an interest on the bank’s profitability since this indicates the return on their equity or investment. The greater the return on equity the bank has, the lower the level of risk that the shareholders will be exposed to. On the other hand, lower return o equity indicates that shareholders are exposed to higher risk according to Ledgerwood (1999). The return on equity for the two banks has been calculated as shown below; Bank 2013 2014 BOQ $185.8/2,817.8=6.59% $260/3,340.5= 7.78% NAB $6,322/46,376=13.63% $5,298/47,908= 11.06% The above results are analyzed in the table below; ROE 2014 2013 % CHANGE BOQ 7.78% 6.59% +1.19% NAB 11.06% 13.63% -2.57% The comparative return on equity for NAB and BOQ banks for the years 2013 and 2014 have been analyzed in the table above. The table shows that NAB had higher return on equity over the two years when compared to BOQ. It is however worth noting that NAB’s return on equity declined while that of BOQ increased. This is an indication that NAB’s capital risk to its shareholders is lower in comparison to BOQ. BOQ and BEN CREDIT RATING The cost of capital of a bank and hence its capital could be affected by its credit rating. The NAB was rated at Aa2 by Moody’s, AA- by standard and poor’s and AA- by Fitch ratings with a stable outlook. On the other hand, BOQ has been rated Baa1 by Moody’s, BBB+ by Standard and poor’s and BBB+ by Fitch with a stable outlook. The implication is that NAB has a better credit rating and is hence able to increase its borrowing since investors will place more confidence on its ability to repay both the principle and interest whenever they follow due in comparison to BOQ. It is however worth noting that the two banks ratings are relatively good and hence they are able to attract funds from investors. EFFECT OF THE PRODUCT TYPE AND SCOPE OF OPERATIONS TO THE CAPITAL RISK OF THE TWO BANKS BOQ has a smaller scope of operations when compared to NAB given that BOQ is more of a regional bank with a smaller branch network while the NAB is more national with a bigger branch network. NAB also offers more financial services compared to BOQ. To a great extent, this serves to explain the differences in the banks’ capital risks. Liang and Rhoades (1991) states that banks with wider scope of operations across differing geographical regions will probably have lower capital risks owing to the fact those economic problems in one region could be offset by improved economic regions in other regions. This explains why NAB has a lower capital risk. CONCLUSION The above analysis has revealed that both NAB and BOQ banks have met the minimum capital requirement s by APRA and have even exceeded them. This shows that their performances are relatively excellent as far as protecting the interests of investors by minimizing capital risk are concerned. From the analysis, it can be concluded that NAB has a higher capital ratio meaning greater safeguards against capital risk when compared to BOQ. The banks differ to a great extent as far as other rations are concerned as has been observed above. The ratios however also indicate that NAB is better placed against capital risks when compared to BOQ. The same can be said of the banks TAC multiplier where NAB has been observed as better equipped in controlling capital risk than BOQ. NAB also has better credit rating according to major rating firms as has been seen above in comparison with BOQ. However, both banks have relatively good credit ratings though NAB can be able to access more funding owing to its better credit rating when compared to BOQ. In addition, NAB also has a greater scope of operation both in terms of regional presence and services when compared to BOQ which also may mean diversification of risk and hence indicating that NAB is exposed to lower capital risk when compared to BOQ. Arising from the above analysis, it is clear that NAB has lower credit risk exposure when compared to BOQ. This is seen from the stronger ratios that NAB has in comparison to those of BOQ. However, both banks have adequately met the requirements of APRA and even exceeded them and hence can be said to have adequately guarded themselves against capital risk. References: APRA 2012. APRA releases final Basel three reform package, Retrieved on 31st March, 2015, 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). 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