Bank regulators impose minimum capital adequacy standards on commercial banks. I

Question

Bank regulators impose minimum capital adequacy standards on commercial banks. In Australia, which entity is the key regulator for capital adequacy of commercial banks? Briefly explain the main functions of capital. What is the minimum capital requirement under the Basel III capital accord? Identify and define the different types of acceptable capital under the Basel II and Basel III capital accords. Remember that Basel II continues to function, with Basel III acting to strengthen its main pillars.

Explanation / Answer

In Australia, entity which is responsible for maintaining capital adequacy is Australian Prudential Regulation Authority (APRA).

Main functions of capital for a bank is to absorb losses happening due to various types of risks prevelant within the bank viz. operational, credit, market, liquidity, business etc. To overcome these losses at the time of crisis, BASEL accord has recommended certain provisions to be maintained in the form of capital requirements. Under Basel III capital accord minimum capital requirement is divided for Tier 1 and Tier 2 capital.

Tier 1 capital under BASEL III is mainly comprises of shareholder's equity and retained earnings. Tier 1 capital is capability of bank to absorb losses without ceasing business operations. Minimum ratio of Tier 1 capital to RWA (Total Risk Weighted Assets) is 10.5%.

Tier 2 capital under BASEL III comprises of revaluation reserves, subordinated debts, general loss reserves and undisclosed reserves. It is seen as a supplementary capital in addition to Tier 1 capital. As per BASEL III accord minimum Total Capital ratio to risk weighted assets (RWA) is 12.5%. Since Tier 1 capital contributes 10.5% so Tier 2 capital requirement is balance 2%.

Therefore, Tier 1 capital requirement is 10.5% and Tier 2 capital requirement is 2% of total RWA.

BASEL II was less strict than BASEL III. Under BASEL II Tier 1 capital was comprising shareholder's equity, disclosed reserves, retained earnings etc. Tier 2 capital comprises of other bank reserves, hybrid instruments medium and long term subordinated loans. There was also Tier 3 capital under BASEL II which comprised of short term subordinated loans. This Tier 3 capital is not valid anymore in BASEL III.

In summary we can say that capital requirements under BASEL III has become more conservative than BASEL II. Only good quality of capital under BASEL III qualifies as Tier 1. Reserves like disclosed reserves does not qualify anymore as Tier 1 capital under BASEL III.

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