Why Are There Capital Requirements on Banks? Explain the Main Sources of Bank Capital and the Pattern of the Risk-Adjusted Assets of Australian Banks, Using the Data Presented in Tables 1 and 2 in Gorajek and Turner (September 2010)

Overview

The Australian Prudential Regulation Authority (APRA) oversees Australia’s financial institutions and supplies a set of rules and requirements that must be followed. The rules set out by APRA are an application of the international capital standards developed by the Basel Committee on Banking Supervision (BCBS) – Basel II. The first statement introduced in 1985 included a capital adequacy requirement (CAR). This requirement was that financial institutions must hold an adequate amount of capital, which in the case of Australia’s ADIs is a minimum of 8% of their risk-adjusted assets (Hunt and Terry, 2008: pg. 102).

Essay

A bank’s capital can be described as a cushion that absorbs losses (Hunt and Terry, 2008: pg. 103). Its purpose is to sustain a bank’s solvency when it is making losses and effectively ensure the bank has sufficient time to return back to profitability (Hunt and Terry, 2008: pg 103). National regulators, including APRA, specify a minimum amount of capital (8%) that banks must invest and the form that capital should take.

The incentive for prudential supervision arose from ‘concerns about bank instability following the deregulation of the financial system’ in the early 1970s (Hunt and Terry, 2008: pg. 102). Then came the introduction of CAR based on the Basel Accord (now updated to Basel II) from BCBS in 1985. The reason behind this was to reduce the chance that a regulatory body would have to act in order to protect ADIs from insolvency (Hunt and Terry, 2008: pg 102). Capital requirements aim to ensure that ADIs effectively manage and minimise their risks so that insolvency becomes less likely. This is highlighted by one of APRA’s supervisory objectives which is to ‘better align capital requirements of financial institutions to the risks being borne’ (Hunt and Terry, 2008: pg. 100). In terms of capital adequacy, ADIs are most affected by credit risk, market risk and operating risk. Credit risk is the most significant as most of...