FIN3109 Lecture Notes - Lecture 4: Common Stock, Procyclical And Countercyclical, Call Option
FIN3109 – Module 4
- Prudential Supervision
oThe Australian Prudential Regulation Authority (APRA)
Prudential regulator of financial institutions since 1998
oPrudential Regulation
Requirements that limit the risk-taking of banks and other Financial Institutions in
order to protect depositor’s funds, the finds of other creditors, and to maintain
financial system stability.
- Moral Hazard
oBank managers may take too much risk with depositors’ funds if the government guarantees
the finds or if they believe they are so important the government will always bail them out in
a crisis
- APRA’s Approach to Prudential Supervision
oAPRA aims to encourage responsible behaviour by financial institutions and ensure that
managers are responsible for their decisions
oThe prudential framework consists of:
Prudential Statements that aim to ensure ADIs effectively manage their risks
The capital adequacy requirements (CAR) including minimum prudential capital
ratios (PCRs)
- Prudential Standards
oThe role of the standards is to reduce the likelihood of illiquidity or insolvency
- The Capital Adequacy Requirement (CAR)
oCAR’s role is to ensure an ADI has sufficient equity capital to sustain its solvency should it
incur losses
Used internationally 0 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 in operation in 2008
New revisions, termed Basel 3 were introduced in 2013 and the staged roll-out is
continuing
- Basel 1 and Basel 2
oCAR =
oCapital: Provides a cushion to absorb losses
oRisk Adjustment: Different assets have different risk exposures and more capital should be
required where the risk is greater
oQualified Capital: Tier 1 (high quality) and Tier 2 (lower quality) capital
- Total Risk-weighted Assets
o1988: Banks estimated only credit risk: On-balance sheet + off balance sheet
o1996 Amendment: Banks also measure market risk
Interest rate risk + exchange rate risk + equity price risk + commodity price risk
o2008 Basel 2: Banks also estimate Operational Risk
- Basel 2 Amendments
oStandard CAR was unchanged: CAR =
oKey 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
find more resources at oneclass.com
find more resources at oneclass.com
- Tier 3 Capital
oConsisted 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
- Measuring Operational Risk
o
oWhere,
The capital charge under the Standardised Approach
Annual gross income in a given year, as defined above in the Basic Indicator
Approach, for each of the eight business lines
A fixed percentage, set by the Committee, relating the level of required capital to
the level of the gross income for each of the eight business lines.
oOperational Risk: Based on gross income earned by each business line weighted by a factor
- Basel 3
oBasel 3 is a response to the Global Financial Crisis
oImplementation began on January 1 2013
oThe target date for full implementation after all transition periods is 2019
- Basel 3 changes include:
oTier 1 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.
oMinimum PCRs
Common Equity Tier 1 Capital (CET1)
Comprising ordinary shares and retained earnings, which are the main
component of Tier 1 capital, must be at least 4.5% of the 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
oConservation 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)
oGlobally, the buffer will be phased in from 2016 to 2019.
oHowever, the APRA has decided that it will be fully implemented in Australia from January 1
2016.
oCountercyclical Buffer:
In addition to the conservation buffer, from 1 January 2016, APRA may, by notice in
writing to all ADIs, require them to hold additional Common Equity Tier 1 Capital, of
between 0 and 2.5% of total risk-weighted assets, as a countercyclical capital buffer.
Hence, there will be a capital buffer (CB) comprising the conservation buffer plus
any countercyclical buffer.
CB = Conservation Buffer + Countercyclical Buffer
oIt is not mandatory that banks meet the capital buffer (CB) fully, but they will face
restrictions if they do no. E.g. Restrictions on dividend issues, staff bonuses etc.
oAssuming 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%)
oHowever, our 4 largest banks will need to hold a benchmark of level 8% because they have
been designated ‘systemically important banks’
oAPRA has announced that stronger capital benchmarks, to ensure Australian banks are
‘unquestionably strong’ will be implemented as of January 2020.
find more resources at oneclass.com
find more resources at oneclass.com
oLeverage Ratio: A supplementary (or back-stop) ratio to measure to further limit risk.
The trial minimum leverage ratio is:
Leverage Ratio:
oLiquidity Coverage Ratio (LCR) introduced on January 1 2015. Larger banks must maintain an
adequate level of unencumbered, high-quality liquid assets that can be converted into cash
to meet its liquidity needs for a 30 calendar day time horizon under a significantly sever
liquidity stress scenario specified by supervisors.
LCR:
oCommitted 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 written as
LCR =
oNet Stable Funding Ratio: As of 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.
NSFR:
- Financial System Enquiry
oIn addition to increasing mortgage risk weights for major banks, the Financial System
Enquiry made a number of recommendations regarding banking regulation and the
government endorsed these in October 2015.
oAmong these is the development of a template for reporting ADI capital ratios that is
transparent against the minimum Basel capital framework
oAlso included is the continuation of the financial claims scheme that covers depositors to a
maximum of $250000 per account holder per ADI. It will continue to be funded in an ex-
poste manner rather than through a bank deposit tax.
oThat 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
oBanking systems have always experienced crises.
oThe 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
oThe RBA examines key indicators of financial performance:
Profitability of Australian Banks
A direct indicator of viability
Losses by and ADI can trigger runs on deposits in that similar institutions
Asset Quality of Australian Banks
Look at the proportion of impaired assets and losses on loan defaults
Capital Holdings of Australian Banks
The amount of a bank’s capital relative to its size indicates its ability to
withstand losses
Liquidity of Australian Banks
Does and ADI hold adequate liquid assets?
The Share Market’s Assessment of Australian Banks
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
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 financial institutions in order to protect depositor"s funds, the finds of other creditors, and to maintain financial system stability. Moral hazard: bank managers may take too much risk with depositors" funds if the government guarantees the finds 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: Prudential statements that aim to ensure adis effectively manage their risks. The capital adequacy requirements (car) including minimum prudential capital ratios (pcrs) Prudential standards: the role of the standards is to reduce the likelihood of illiquidity or insolvency.
