Trends in Australian Bank Capital

LETTER OF TRANSMITTAL

This reportЎ¦s topic is Trends in Australian Bank Capital. The content is as following:

1. The explanation of why Ў§Regulators usually want more equity capital whereas shareholders usually favour less equity capitalЎЁ

2. The differences between bank equity capital and bank regulatory capital

3. A discussion of the functions of bank capital and the role of the risk-return trade-off

4. The differences between tier 1 and tier 2 capital

5. The components of tier 1 and tier 2 capital and the cost and risk implications of them

6. Details of the trends in the four major Australian banks for the last five years.

1.

In Hogan et al (2004) Page 249 states that Ў§from the shareholdersЎ¦ point of view, the appropriate amount of capital is an amount that is small enough to produce at least an adequate return on capital and yet is large enough to absorb risk.ЎЁ However, bank regulators have the responsibility of protecting depositorsЎ¦ funds and the safety of the financial system, which requires Ў§banks with higher credit risk to hold higher minimum capital.ЎЁ

The following table shows the capital ratios for the four major Australian banks over the last five years:

2004 2003 2002 2001 2000

Westpac Banking Corporation Tier 1 6.9 7.2 6.5 6.3 6.6

Tier 2

Total 9.7 10.5 9.6 9.9 9.6

Commonwealth Bank of Australia Tier 1 7.43 6.96 6.78 6.51 7.49

Tier 2 3.93 4.21 4.28 4.18 4.75

Total 10.25 9.73 9.8 9.16 9.75

ANZ Banking Group Limited Tier 1 6.9 7.7 7.9 7.5 7.4

Tier 2 4.0 4.0 2.8 3.2 3.4

Total 10.4 11.1 9.5 10.3 10.2

National Australia Bank Limited Tier 1 7.3 7.7 7.6 7.5 6.6

Tier 2

Total 10.6 9.6 10.0 10.2 9.3

Sources: http://www.anz.com; http://www.commbank.com.au; http://www.westpac.com.au; http://www.nabgroup.com

The Australian Prudential Regulation Authority (Ў§APRAЎЁ) has set minimum regulatory capital requirements for banks that are consistent with the Basel Accord. These requirements define what is acceptable as capital and provide for standard methods of measuring the risks incurred by the Bank. APRA has set minimum ratios that compare the regulatory capital with risk weighted on and off balance sheet assets. The minimum risk-weighted capital ratio is 8%. The following formula is used to calculate the risk-weighted capital ratio:

Risk-weighted capital ratio = Qualifying capital .

Total risk-weighted assets

The numerator of the ratio is qualifying capital, which includes Tier 1 capital such as paid-up ordinary shares and retained profits, and Tier 2 capital such as term subordinated debt after making required deductions for items such as goodwill and equity holdings in other banks.

Equity capital is a permanent commitment of funds which earns the residual income of the firm after all interest and other costs have been paid. In Orgler/ Wolkowitz Bank Capital 1976, bank equity capital represents Ў§all claims on the bankЎ¦s profits, and in the Report of Condition it is divided into several accounts that include preferred stock, common stock, surplus, undivided profits, and reserves for contingencies and other capital reservesЎЁ. Whereas regulatory bank capital is bank funding which qualifies as bank regulatory capital under the regulatorЎ¦s rules. The regulatory capital is divided into two parts which will be mentioned later in this report.

Functions of bank capital:

ЎP Absorbing Losses

Capital is not held as a reserve against all losses under all circumstances. Extensive difficulties in the general economy may well result in individual bank losses, but banks are not expected to insulate themselves against