Banking explained - Part 2

Here's Part 1.

Did you know that banks generally earn only about 1% on every dollar of assets on their books? Yet they also regularly produce returns on equity of greater than 20%. How do they do it?

The answer is pretty straightforward - they use the power of leverage. For every dollar of real capital (shareholders' funds) on a bank's books, it can hold more than $20 in assets.

Scary stuff

That means that if just five percent of assets on the balance sheet were written off, shareholders' equity would be reduced to zero. It's pretty scary stuff and explains why banks tend to trade on lower PERs than other industrial stocks.

It's also one of the reasons that Australia's financial services regulator, the Australian Prudential Regulation Authority (APRA), sets out stringent guidelines to make sure banks maintain plenty of capital.

Now, APRA may not enjoy the best reputation after its handling of the HIH disaster but it appears to have a better grip on the banks.

The regulator works from an international agreement known as the Basel capital accord, named after the quiet town in Switzerland (where else?) where it was forged.

The accord relies on a few key terms such as Tier 1 capital, Tier 2 capital and Risk Adjusted (or weighted) Assets (RAA), each of which we'll explain with the help of Westpac's 2002 accounts. So, these are the basic capital adequacy ratios:

Tier 1 capital is basically the net assets of the bank, less any intangibles such as goodwill. In 2002, Westpac had net assets of $10.5bn and intangibles of $2.1bn. This roughly equals the bank's Tier 1 capital of $8.3bn.

Tier 2 capital is a bit of a misnomer as it's not really capital at all. The main component is usually special forms of debt that rank behind other creditors in the event of a liquidation. It is still debt, though, rather than equity capital.

Another major component of Tier 2 capital is the general provision for doubtful debts, which we discussed last issue. This amount reduces the assets of a bank, but for regulatory purposes is allowed to be added back on as Tier 2 capital. Quite generous really.

Total capital

In Westpac's case, total Tier 2 capital was $4.8bn comprising debt of $4.0bn and a general provision for doubtful debts of $0.8bn. When Tier 1 and Tier 2 capital are combined and a few extra deductions made, this forms a figure known as total capital. Westpac's 2002 total capital was $12.1bn.

The final part of the equation is RAA. APRA accepts that some assets are more risky than others, and provides a risk weighting of 0,20,50 or 100% to each one. APRA then focuses on the amount of capital compared to RAA. But let's explore that important RAA number first.

The 50% and 100% risk categories are the most important. The 50% weighting is for residential home loans. APRA understands that very few housing loans become bad debts and therefore reduces the weighting of these assets.

The 100% weighting applies to almost every other loan. That means APRA thinks a loan to BHP Billiton is just as risky as one to David Dodgy on his credit card. It sounds silly, and it is. That's why the regulators of the world are currently rewriting the rules to create a better system.

Here's a hypothetical example. Bank X has $1,500 in assets comprising home loans of $1,000, personal loans of $100, corporate loans of $300 and credit card debts of $100. For risk-weighting purposes, the housing loans are weighted at 50%, meaning the total RAA for this category is $500.

Risk-weighting

Notwithstanding the different risks of the other types of loans they are all grouped into the 100% risk-weighting category. Therefore, the $500 in loans translates into $500 in RAA. The total RAA is $1,000.

Now APRA requires banks to maintain Tier 1 capital and total capital of 4% and 8% respectively as a percentage of RAA. That means our hypothetical bank would need to hold Tier 1 capital of at least $40 and total capital of at least $80. Now back to the real world.

After Westpac's assets are risk-weighted, RAA comes in at $129bn. Therefore, Westpac has a Tier 1 ratio of 6.5% ($8.3bn divided by $129bn) and a total capital ratio of 9.4%, easily exceeding the minimum levels APRA requires.

But the banks don't just serve one master when it comes to maintaining capital reserves. They also must appease ratings agencies which tend to view things a little differently than the regulators. And that will be the topic of Part 3.