Sinagapore Risk-Weighted Capital Requirements

Outline the key elements of the latest risk-weighted capital adequacy requirements for Australian banks and briefly explain their purpose

The 1980s and early 1990s saw barriers to entry to the financial system removed, foreign exchange controls removed and the foreign exchange market deregulated, and direct controls removed on participants' lending activities and lending rates as well as on their asset portfolios. Foreign banks have established in Australia, Australian banks have increased their overseas activities, and foreign exchange market turnover in Australia now exceeds $50 billion a day.

Prior to the adoption of the capital adequacy requirements, the Reserve Bank (ARB) recognized the need for a prudently managed bank to maintain, at least, a certain minimum capital to asset ratio. LIBRO

The Reserve Bank had set a requirement that a bank's capital should be at least 6 per cent of total balance sheet for those banks established before 1981 and 6.5 percent for those banks established after 1981. By the mid-1980s it was recognized that a simple capital ratio was inadequate because it did not distinguished between the different risks of various assets on the balance sheet and second it did not take account of the rapidly expanding volumes of off-balance-sheet business and the accompanying risk exposures.

In August 1988 the RBA introduced consolidated, risk weighted capital requirements for banks; the Banking Act 1945 was amended and the original 1988 Basel Capital Accord, developed by the Basel Committee on Banking Supervision (Basel Committee) was born to allow introduction of prudential requirements by regulation

Definition of Capital

1. Capital is the cornerstone of a bank's strength. The presence of substantial capital re-assures creditors and engenders confidence in a bank.

2. The essential characteristics of capital are that it should:

3. Represent a permanent and unrestricted commitment of funds;

4. Be freely available to absorb losses and thereby enable a bank to keep operating whilst any problems are resolved;

5. Not impose any unavoidable charge on the earnings of the bank; and rank below the claims of depositors and other creditors in the event of the winding-up of a bank.

6. Capital, for supervisory purposes, is considered in two tiers. Tier 1 (or core capital) comprises the highest quality capital elements. Tier 2 (or supplementary capital) represents other elements which do not satisfy all of the characteristics of Tier 1 capital but which contribute to the overall strength of a bank as a going concern.

7. A bank's capital base (or total capital) is the sum of its Tier 1 and Tier 2 capital less any deductions. At least 50 per cent of a bank's capital base must be Tier 1 capital.

Tier 1 Capital

8. The foundation of a bank's capital is made up of permanent shareholders' equity and disclosed reserves (created or increased by appropriation of retained earnings or other surplus). Such elements fully meet the essential characteristics of capital and represent capital resources which can best contribute resilience and flexibility to a bank experiencing financial difficulties.

9. Tier 1 capital includes issued share capital and non-cumulative irredeemable preference shares. Tier 1 capital may also include innovative capital instruments (ie capital instruments other than ordinary shares and non-cumulative irredeemable preference shares), including instruments issued through special purpose vehicles subject to the conditions in Attachment IB. Partly-paid shares (and other capital instruments) qualify for inclusion in capital only for the value of funds actually received. General reserves and retained earnings (including measured current year earnings net of expected dividends and taxation payments), although distributable in some circumstances, generally meet the attributes of Tier 1 capital. Minority interests in subsidiaries that are consistent with other named capital instruments are eligible to be counted in the Tier 1 capital of the consolidated group.

10. Non-cumulative irredeemable preference shares and innovative capital instruments included in Tier 1 capital must satisfy the conditions in Attachment IA. An instrument will not be eligible for inclusion in Tier 1 capital where it would result in the aggregate amount of innovative capital instruments and non-cumulative irredeemable preference shares exceeding 25 per cent of net Tier 1 capital (ie Tier 1 capital net of non-ordinary shares and other capital instruments).

11. With regards servicing Tier 1 capital instruments, aggregate dividend (interest) payments in any one year should not exceed the earnings of the bank during that year (ie a bank may not pay dividends from retained earnings). APRA is, however, prepared to modify this requirement, on a case by case basis, if it believes the proposed level of dividend payments can be justified by reference to other considerations, such as an assessment of the bank's on-going capital position, including commitments to raise capital, and the bank's core profitability.

Tier 2 Capital

12. There are other capital elements that impart strength to a bank's position but to a varying degree fall short of the qualities of Tier 1 capital instruments. These may be included in a bank's capital base as Tier 2 capital up to an amount equal to the bank's Tier 1 capital (net of goodwill, other intangible assets and future income tax benefits).

13. Tier 2 capital is divided into two segments, termed Upper and Lower Tier 2 capital. Upper Tier 2 capital includes elements that are essentially permanent in nature and have characteristics of both equity and debt.

14. Lower Tier 2 capital consists of elements which are not permanent. Lower Tier 2 capital may be included in Tier 2 capital to a maximum, in aggregate, of 50 per cent of Tier 1 capital (net of goodwill, other intangible assets and future income tax benefits).

Upper Tier 2 Capital

15. Upper Tier 2 capital consists of the following elements:

Asset revaluation reserves

16. APRA favours the common practice among Australian banks of revaluing assets regularly, for example by professional revaluation of premises and by marking securities to market value on a prudent basis. This approach obviates hidden or latent reserves reflecting the difference between historic cost and current value.

17. Under the Basle