Capital explained

Capital is often referred to as the cornerstone of an institution’s financial strength. Indeed, minimum levels of capital make up a core component of APRA’s prudential requirements that must be met by all banks and other authorised deposit-taking institutions (ADIs) and insurance companies.

But what exactly is capital, and how does it contribute to financial strength?

Capital is an abstract concept and has different meanings in different contexts. In non-technical contexts, capital is often described as an amount of cash or assets held by a company, or an amount available to invest.

In contrast, in the regulatory context, capital is not an asset; in fact capital appears on the opposite (liability) side of the balance sheet. Like debt, capital can fund the purchase of assets (or making loans) at the company level, but is not associated with any particular asset.

At a conceptual level, capital can be viewed in two ways;

1. as the excess of assets (what the institution owns) over its liabilities (what it owes), or
2. as the amount invested by shareholders or owners of the institution, plus its accumulated retained profits.

These two approaches are mathematically, and conceptually equivalent when viewed from a balance sheet perspective.

Why then is capital so important in a regulatory context?

From a prudential regulator’s perspective, capital is a measure of the financial cushion available to an institution to absorb any unexpected losses it experiences in running its business. For a bank, such losses might include loans that default and are written off. Insurers might be hit by an unexpectedly high volume of claims in the wake of a major natural disaster.

As financial institutions are in the business of taking on risk, managing capital effectively is a very important function. Ensuring sufficient levels of capital are sustained in good times enables a financial institution to remain resilient during periods of financial adversity, and help to protect their customers in the event that it becomes insolvent (which in practice has been extremely rare in Australia, but has been more common in many other countries). 

Capital, however, is not costless. Shareholders and other investors seek a relatively high return for bearing the risk of loss. Financial institutions therefore have incentives to minimise the capital on their balance sheet. As a result, APRA - like other prudential regulators around the world - sets a minimum level of required capital for banks and insurers to ensure a high degree of safety. This required minimum is typically set as a ratio of capital to some standardised, albeit often complex, measure of risk.

Capital requirements and ratios

For banks, the level of risk is considered to be proportionate to its assets, particularly the riskiness of its assets. This is because the value of a bank’s liabilities are generally fixed (e.g. deposits), but the value of its assets can be variable.

In contrast, an insurer’s risk is proportionate to the insurance policies it has written and the nature of risks covered by the policies, which are reflected on the liability side of its balance sheet, although insurers also bear asset-side risk. So insurers have minimum capital requirements reflecting risk in the value of assets as well as the potential variability in their estimated insurance claims.

Figure 1: Comparison of capital ratios for ADIs and insurers

For banks and insurers, the amount of regulatory capital (the capital base) is calculated in a similar manner, by adding the equity capital paid in by shareholders with retained earnings and certain other instruments that are available to absorb unexpected losses. There are several different types of capital, with the core, highest quality measure known as Common Equity Tier 1 (CET1) capital.

CET1 capital is considered the highest quality capital because it does not result in any repayment or distribution obligations on the institution. As a result, it is also the riskiest for capital owners (shareholders) and therefore carries the highest cost.

APRA requires institutions to ‘deduct’ or remove from the capital base various balance sheet items that are not considered to have value in insolvency, such as intangible assets. This provides a more realistic reflection of the capital cushion that would be available in stressed conditions.

The denominator of the ratio is calculated quite differently for banks vs insurers. More specifically, for banks, a capital adequacy ratio is calculated as the amount of capital relative to its ‘risk-weighted assets’. Risk-weighted assets, in simple terms, are the loans and other assets of the bank, weighted (or multiplied by a percentage factor) for their respective level of risk of loss to the bank.

For example, government bonds or residential mortgages are risk weighted at a much lower level than an unsecured loan to a small business. Risk weights vary from 0 per cent to more than 100 per cent. The predominant risk reflected in capital ratios for banks is credit risk, or the risk of loan defaults, but other risks such as those relating to operational risks and market price movements are also captured. Australia’s capital adequacy framework for banks is based on the internationally agreed Basel framework, but APRA has made some modifications so that this framework is better tailored to Australian risks.

For insurers, the amount of capital (or the capital base) is calculated similarly to banks. The risk-based denominator is very different, however, and the calculation also differs between insurance industries to take account of the nature of risk exposure in each industry. The denominator broadly includes calculations for risk of existing claims and expected future claims, catastrophic adverse claims risk (such as from natural disasters for general insurers, and for life insurers, from pandemic or other extreme events that affect claims), allowances for expected recoveries against claims (such as from reinsurance) and the insurers’ expected expenses to administer the settlement of claims. The risk-based denominator for insurers also takes account of market and credit risks which can alter the value of assets.

Australia’s capital adequacy requirements for insurers are, in general, consistent with the international regulatory framework – the Insurance Core Principles.

Capital requirements

The minimum CET1 capital ratio for ADIs is set as the 4.5 per cent internationally agreed minimum, plus a capital buffer that provides an additional cushion. These buffers make up an additional 2-4 per cent of CET1 capital. For insurers, the prudential capital requirement is specified as a dollar amount, resulting in a minimum ratio that is effectively at least 100 per cent¹.

Banks and insurers are expected to maintain prudent buffers above these minimum amounts. They are also required to maintain forward-looking capital management plans and targets to avoid capital falling below the regulatory minimum requirements.

APRA receives quarterly financial statements which allow it to monitor the level of these ratios. Any breach of the required minimum ratios is a very significant prudential concern and would signal deficiencies in financial management or underlying financial soundness. As a result, APRA takes swift action on any potential breaches of minimum capital requirements.

To improve their capital position, institutions can either raise new capital, such as by issuing shares to investors in the market, by restricting dividends and retaining more profits in the business, or by reducing their risk profile. The latter can be done by reducing the riskiness of the business being undertaken or by shrinking its size or growth. Of course, a healthy, growing business typically seeks to improve its capital position by generating new capital from its ongoing profitability.

Conclusion

Adequate capital is critical to protect financial institutions’ depositors and policyholders. Regulators set requirements on minimum capital to ensure financial institutions can absorb unexpected losses in their business. This is a core tool of prudential regulation and also supports system-level financial stability. 

Footnotes:

¹ For more information on this topic, see our ‘Data finds: Capital resilience in Australia’s General Insurance industry’ article, March 2020.