Capital adequacy – looking past the headline ratios

Comparing capital adequacy ratios is full of traps for the unwary. I recently flagged a speech by Wayne Byres (Chairman of APRA) that indicated APRA will be releasing a package of capital adequacy changes that will be more aligned with the international minimum standards and result in higher reported capital ratios.

While waiting for this package to be released, I thought it might be useful to revisit the mechanics of the S&P Risk Adjusted Capital (RAC) ratio which is another lens under which Australian bank capital strength is viewed. In particular I want to highlight the way in which the S&P RAC ratio is influenced by S&P’s assessment of the economic risks facing banks in the countries in which the banks operate.

The simplest way to see how this works is to look at an example from 2019 when S&P announced an upgrade of the hybrid (Tier 1 and Tier 2) issues of the Australian major banks. The senior debt ratings were left unchanged but the hybrid issues were all upgraded by 1 notch. Basel III compliant Tier 2 ratings were raised to “BBB+” (from “BBB”) and Tier 1 were raised to “BBB-” (from “BB+”).

S&P explained that the upgrade was driven by a revision in S&P’s assessment of the economic risks facing the Australian banks; in particular the “orderly decline in house prices following a period of rapid growth”. As a consequence of the revised assessment of the economic risk environment,

  • S&P now apply lower risk weights in their capital analysis,
  • This in turn resulted in stronger risk-adjusted capital ratios which now exceed the 10% threshold where S&P deem capital to be “strong” as opposed to “adequate”,
  • Which resulted in the Stand-Alone Credit Profile (SACP) of the Australian majors improving by one-notch and hence the upgrades of the hybrids.

Looking past the happy news for the holders of major bank hybrid issues, what was interesting was how much impact the revised assessment of the economic outlook has on the S&P risk weights. The S&P assessment of the economic outlook is codified in the BICRA score (short for the Banking Industry Country Risk Assessment) which assigns a numeric value from 1 (lowest risk) to 10 (highest risk). This BICRA score in turn determines the risk weights used in the S&P Risk Adjusted Capital ratio.

As a result of S&P revising its BICRA score for Australia from 4 to 3, the risk weights are materially lower with a commensurate benefit to the S&P assessment of capital adequacy (see some selected risk weights in the table below):

BICRA
Residential MortgagesBankCorporate, IPCRE, Business LendingCredit Cards
3302375105
4373387118
% Change
18.9%30.3%13.8%11.0%

The changes were fairly material across the board but the impact on residential mortgages (close to 20% reduction in the risk weight) is particulate noteworthy given the fact that this class of lending dominates the balance sheets of the Australian majors. It is also important to remember that, what the S&P process gives, it can also takeaway. This substantial improvement in the RAC ratio could very quickly reverse if S&P revised its economic outlook score or industry rating.

The other aspect of this process that is worth noting is the way in which the risk weights are anchored to S&P defined downturn scenarios and an 8% capital ratio. In the wake of the Royal Commission into Australian Banking, there has been a lot of focus on the idea of large banks being “Unquestionably Strong”. APRA subsequently determined that a 10.5% CET1 benchmark for capital strength was sufficient for a bank to be deemed to meet this test.

In that context, the S&P assessment that an 8-10% RAC ratio is “adequate” sounds a bit underwhelming. However, my understanding is the S&P risk weights are calibrated to an “A” or “substantial” stress scenario which is defined by the following Key Economic Indicators (KEI)

  • GDP decline of up to 6%
  • Unemployment of up to 15%
  • Stock market decline of ups to 60%

The loss rates expected in response to this level of stress are translated into equivalent risk weights using a 8% RAC ratio. The capital required by an 8% RAC ratio may only be “adequate” in S&P terms, but starts to look a lot more robust when you understand the severity of the scenario driving the risk weights that drive that requirement.

Summing up

I am not suggesting that there is anything fundamentally wrong with the S&P process, my purpose is simply to offer some observations regarding how the ratios in the capital adequacy assessment should be interpreted:

  1. Firstly to recognise that the process is by design anchored to an 8% capital ratio and risk weights that are calibrated to a very severe (“Substantial” is the term S&P uses) stress scenario, and
  2. Secondly, that the process is very sensitive to the BICRA score

This is not an area in which I will claim deep expertise so it is entirely possible that I am missing something. There are people who understand the S&P rating process far better than I do and I am very happy to stand corrected if I have mis-understood or mis-represented anything above.

Tony – From the Outside

Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk.

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