The Australian Prudential Regulation Authority (APRA) recently announced what it defines as the ‘unquestionably strong’ capital benchmark for Australian retail banks. But what does this refer to, and why is it important? Essentially, the reason behind the move is to ensure a robust banking system that can withstand periods of stress, so that the critical role banks play in the economy as intermediaries between borrowers and lenders is not put at risk.

What does the benchmark measure?

The benchmark effectively measures the capital adequacy of each bank, calculated by taking the ratio of the capital base of the bank to its risk-weighted assets. The ‘capital base’ is the bank’s shareholders’ funds plus retained earnings, and the ‘risk-weighted assets’ is the value of the bank’s total assets multiplied by the relevant risk-weight, which is based broadly on the likelihood of counterparty default i.e. the greater the expectation of a borrower defaulting, the more capital needs to be held against the loan.

The common equity tier one capital (CET1) ratio announced by APRA is at least 10.5% by 1 January 2020, for all the major banks. This was welcome news, given the market expectation was that more capital would need to be held, raising the risk of new share issues, and making it more expensive for banks to do business.

How much additional capital will each bank require?

While the exact amount of additional capital each bank requires will not be known until APRA releases its discussion paper on the revised capital framework later this year, major banks should be able to achieve the new requirements via organic means, potentially with the help of discounted dividend reinvestment plans. Importantly, the risk of further new capital raisings now appears remote, unless the credit cycle or housing market deteriorates dramatically.

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