Shares in Westpac Banking Corp (ASX: WBC), Australia's second largest bank, have leaped 1.7% higher today following the group's quarterly capital and asset update.
News of new capital requirements has been all over financial mastheads lately, as the big banks seek to raise billions and billions of dollars from new and existing shareholders.
Are you confused by bank capital requirements?
As part of the ongoing regulation of Australia's major banks in the wake of the Global Financial Crisis, through APS330 Public Disclosure, APRA requires each of the 'Big Four' banks to disclose information about their risk management practices.
One way APRA monitors the banks and enhances their financial integrity is by setting capital buffers in place, should a financial or credit crisis take a hold on the local market.
These 'buffers' have slowly been implemented since the GFC. However, many of the disclosure documents used to monitor the banks would still look like a foreign language to those unfamiliar with bank statements.
Indeed, it'd take a diligent and shrewd investor or analyst to cross-check every line item in the banks' annual reports.
However, the basic capital buffer strategy employed up until today is that each of the domestic systemically important banks, or D-SIBs for short, are required to maintain a common equity tier-1 (CET1) capital ratio of at least 8%.
Like any ratio, the CET1 ratio is made up of two parts.
The first of which is the numerator: Common Equity Capital.
Below, I've attached a screenshot of Westpac's recent capital position.
Click to enlarge. Source: Westpac 2015 Interim Report.
As can be seen, CET1 is made up of equity from various sources. APRA defines common equity as components of capital which:
- Provide a permanent and unrestricted sources of funds
- Are freely available to absorb losses
- Do not impose any unavoidable servicing charge against profits; and
- Rank behind the claims of depositors and other creditors in the event of a winding up of the bank
Big bank shareholders can read more about this wonderful stuff, here.
The second part of the capital adequacy ratio imposed by APRA is, of course, the denominator: Risk-Weighted Assets, or RWA for short.
RWA is – obviously — the risk part of the equation. It's a measure which sets out the "inherent potential for default calculated on rules comparable with global peers", according to Westpac's capital update released today.
There are many depths to which we could dive to on this subject, and there are many different types of risks the bank must take into consideration…
Westpac's RWA. Source: Westpac 2015 3Q Pillar 3 Report, 17 August 2015.
As can be seen above, Westpac's total risk has grown over the past three quarters. And between 31 March and 30 June this year (i.e. the third quarter), the bank's credit risk increased modestly – largely a result of growth in the bank's loan portfolio.
However, risk in 'non-credit' (particularly 'interest rate risk in the banking book') rose more aggressively.
Again, we could go into great depth to analyse these figures, but we won't. However, it is worth noting that there are two ways to calculate the RWA for any Australian bank:
- The standardised approach. Used by every bank except the big four (including Westpac) and Macquarie Group Ltd (ASX: MQG).
- The internal ratings-based (IRB) approach is used by the five biggest banks. This approach allows them to set their own risk weightings for loans, interest rate exposures, and so on.
What's the difference?
As you can imagine, having two different risk-weighting models for different firms creates an uneven playing field.
But if you thought allowing the biggest banks to set their own risk models was smart, here's what the recent Murray Financial System Inquiry had to say…
Source: Murray Financial Inquiry, 2014.
I think you'll agree, that last sentence is particularly concerning.
Bringing it full circle
Recently, we've seen APRA increase the risk-weighting for investor housing loans – rightly so in my opinion.
And following the Murray Inquiry's call for a capital buffer which would make the Big Four "unquestionably strong by being in the top quartile of internationally active banks", APRA recently announced that it supported the inquiry's view on bank capital.
It suggested, "that the major banks would need to increase their capital adequacy ratios by at least 200 basis points, relative to their position in June 2014, to be comfortably positioned in the top quartile of their international peers over the medium- to long-term, as recommended by the FSI."
As a result of APRA's announcements, each of the big banks have scrambled to issue more shares, debt or hybrid notes to investors. Although not apparent right now, this will dampen their growth potential and profitability over the medium term.
Some commentators have suggested APRA's 'line in the sand' for bank capital lies around 10%, up from the current 8%.
What does this mean for Westpac and the Big Four banks?
BEFORE the regulator's decision to increase investor-lending risk weights meaningfully, Westpac's current CET1 ratio is 9%.
Motley Fool Analyst, Mike King, recently showed however that Westpac is heavily exposed to investor lending.
Make of that what you will.
Foolish takeaway
Westpac isn't the only big bank facing the prospect of higher capital requirements. Indeed, Commonwealth Bank of Australia (ASX: CBA), Australia and New Zealand Banking Group (ASX: ANZ) and National Australia Bank Ltd (ASX: NAB) are each in the boat with Westpac, and have work to do on their capital positions.
Until the dust settles, I'd advise Foolish investors to watch on from the sidelines.
A better dividend stock than the big banks
