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APRAs Risk Management Framework - Case Study Example

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The paper "APRA’s Risk Management Framework" is a perfect example of a finance and accounting case study. For banks, the capital risk is about the likelihood or probability of the bank’s investors losing all or part of their capital invested into the bank due to the way the bank carries out its operations. Thus the main bank stakeholders exposed to capital risk are the shareholders that own the bank as well as the depositors…
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Table of Contents Introduction 2 APRA’s Risk management framework 2 Whether NAB and BENDIGO & ADELAIDE BANK have adhered to the risk management framework requirements issued by APPRA 3 Comparison of the Banks basic capital ratio 4 Bendigo & Adelaide Bank and NAB Capital Risk Ratio 5 The banks’ total assets to total capital ratio 6 Return on equity for the banks 6 The two banks credit ratings 7 How the product types offered by the two banks and their scope of operation affect their credit risk 7 Similarities and differences between the two banks capital risks 8 Conclusion 9 COMPARISON OF TWO BANKS (NAB and BENDIGO & ADELAIDE BANK) INTERMS OF THE MAJOR BALANCE SHEET RISKS THEY TAKE WITH SPECIFIC EMPHASIS ON CAPITAL RISK Introduction For banks, capital risk is about the likelihood or probability of the bank’s investors losing all or part of their capital invested into the bank due to the way the bank carries out its operations. Thus the main bank stakeholders exposed to capital risk are the shareholders that own the bank as well as the depositors since the bank has their deposits. In this regard, the Australian Prudential Regulatory Authority (APRA) has put in measures aimed at minimizing capital risk and thus protect investor’s interests by requiring banks and other financial institutions to enforce risk management strategies or frameworks (APRA, 2017). Thus, banks develop measures that facilitate them in identifying, measuring, evaluating and monitoring, reporting and controlling risks likely to hinder their ability to effectively fulfil their obligations to the depositors, investors and shareholders. In this regard, APRA requires banks to plan for their appropriate bank size, their level of complexity and their business type so as to be effective. This report is aimed at analyzing how the above banks fair as far as APRA requirements for capital risk mitigation are concerned. APRA’s Risk management framework In Australia, APRA is charged with the responsibility of enforcement of enhanced quality and safety of banks operations in Australia. In fulfilment of this mandate, APRA has put in place a risk management framework with various features that are supposed to be observed by all banks in Australia. This framework is based on the recommendations of Basel III reforms. This has seen APRA increase tier 1 capital requirements by almost double from 2.5% to 4.5% of the bank’s risk weighted assets (RWA) while also increasing the tier 1 capital ratio requirement by 2% to 6%. These increases are aimed at aiding the banks become more resilient to sudden increases in capital risk especially after the global recession and thus increase investor confidence on the safety of their investments or deposits (APRA, 2017). Whether NAB and BENDIGO & ADELAIDE BANK have adhered to the risk management framework requirements issued by APPRA Banks have two types of capital namely Tier 1 capital and tier 2 capital with tier 1 capital being the bank’s core capital mainly consisting of highly relevant instruments such as the shareholders paid up capital as well as reserves from retained earnings while on the other hand, Tier 2 capital is the banks’ non-core capital that is mainly composed of such supplementary instruments as revaluation and general reserves and subordinated term debts among other instruments. The bank’s core capital is always at their disposal in their normal operations while the non-core capital is only available in case of liquidation (nab.com, 2017). As such, the banks’ capital risk and hence capital ratios are calculated on the basis of core capital with the proportion of the bank’s core capital and tier II capital to the banks risk adjusted assets being referred to as the banks’ capital adequacy ratio. In this regard, banks are required by APRA to maintain a minimum capital adequacy ratio of 8% so as to shield themselves from sudden increases in capital risk. The table below compares the two banks performance in terms of capital adequacy in 2016. Capital APRA NAB Bendigo & Adelaide bank Common Equity Ratio 4.5% of weighted risk 9.77% 7.97% Tier 1 Capital Ratio 6.0% of weighted risk 12.19% 10.17% Total capital 8% 14.14% 12.20% Fig. 1: Analysis of the banks compliance in capital adequacy ratio requirements by APRA From the above comparison, it can be observed that the two banks have met APRA’s minimum capital requirements imposed on all Australian deposit taking financial institutions and greatly exceeded them. NAB attained a common equity ratio of 9.77 which is above APRA’s minimum requirement of 4.5%. Bendigo & Adelaide Bank has also achieved the requirement by attaining a common equity ratio of 8.09% this indicates that the two banks have been prudent in ensuring they comply with APRA regulation framework on capital effectively reducing their exposure to capital risk (bendigoadelaide.com.au, 2017). Their efficient and effective operation even in conditions of increased risk arising from occurrence of negative events is shown in the two bank’s relatively high total capital adequacy ratios with NAB achieving 14.14% while Bendigo & Adelaide Bank achieved 12.20%. Thus, although both the companies have complied with APRA’s requirement with respect to capital adequacy, NAB has performed better. Comparison of the Banks basic capital ratio The degree of capital risk can also be assessed using the market approach that is vital in putting the banks’ capital risk at adequate levels in addition to the regulatory framework by APRA. The approach is called basic capital ratio and it makes use of the bank’s common equity relationship to its total assets (Grier, 2007). The ratio is useful in measuring the banks’ capital risk since a bank with a higher basic capital ratio will have put in place a higher level of safeguards against risk. The basic capital ratio for the two banks have been computed below. Basic capital ratio = Equity/Total Assets NAB = $48,522/814,335 = 5.96% Bendigo & Adelaide Bank = $4,573.9/71,008.4 = 6.44% Arising from the calculations, Bendigo & Adelaide Bank seems to have higher basic capital ratio of 6.44% compared to NAB’s 5.96%. As such, Bendigo & Adelaide bank is exposed to lower levels of capital risk when the two banks are compared on this basis implying that shareholder interests are better taken care of in the bank and the bank would be better placed to respond to sudden increase in risk despite the above difference. Bendigo & Adelaide Bank and NAB Capital Risk Ratio Capital risk can also be measured by assessing the bank’s total assets to its capital in assessing its capital adequacy. Though shareholders require banks to hold enough capital to guard against possible losses arising from default risk, holding adequate capital amounts also carry with it cost to the bank and hence the need to assess the banks absorb by holding adequate capital. For instance, holding high capital levels would mean lower rates of returns for investors thus threatening their profit goals though it also means reduced insolvency risk for the bank (Harker and Zenios, 2000). The bank’s capital risk is calculated as shown below; Capital risk ratio = (Total assets-Total liabilities)/Total assets = Total capital/ Total assets NAB = $48,522/814,335 = 5.96% Bendigo & Adelaide Bank = $4,573.9/71,008.4 = 6.44% The above calculations show that Bendigo & Adelaide Bank has a higher capital risk when compared to NAB. This indicates that though the bank is better protected against insolvency, the shareholders would expect lower returns. NAB on the other hand would give its shareholders more returns though the bank is exposed to higher solvency risks. The banks’ total assets to total capital ratio Also called the TAC multiplier, the ratio assesses capital risk by using the relationship between the bank’s total assets and total capital. This is important in determining the level of leverage of the bank’s total assets rate of return. The ratio limits the amount of debt the bank would issue thus capping its long-term growth (Khan and Jain, 2008). The higher the multiplier, the higher the capital risk. This has been calculated as shown below; NAB = $814,335/48,552 = 16.77 times Bendigo & Adelaide Bank = $71,008.4/4,573.9 =15.52 times From the calculations, it is clear that NAB has greater TAC multiplier with comparison to Bendigo and Adelaide bank. This means that NAB has a greater capacity to issue more debt securities when compared with Bendigo & Adelaide bank which faces more solvency risk. Return on equity for the banks This is another method of assessing financial institutions capital risk given that shareholders are exposed to the risk that arise from money invested as capital and hence they have an interest in the bank’s profitability as this is the return on their investment. Thus, banks with higher returns have less exposure to capital risk and vice versa. ROE 2015 2016 % Change NAB =5940/55,217 = 10.76% =519/48,552 =1.07% -90.06% Bendigo & Adelaide Bank =340.5/4,579.1 =7.44% =303.1/4,573.9 =6.63% -10.89% From the analysis above, Bendigo & Adelaide Bank has greater return on equity over the two years which are more stable compared to NAB. Both the banks experienced a decline in returns on equity although that of NAB was greater. This indicates that NAB has greater risk exposure to its shareholders compared to Bendigo & Adelaide Bank (Sharma, 2008). The two banks credit ratings The banks’ capital risk could also be assessed from the credit ratings point of view. NAB has been rated Aa2 by Moody’s, AA- by Fitch and AA- by Standard & Poor’s. On the other hand, Bendigo and Adelaide Bank has been rated A- with a negative outlook by Standard & Poor’s, A- with a stable outlook by Fitch Ratings and A2 with a stable outlook by Moody’s. It is thus clear that NAB has a better credit rating which implies its ability to easily access funding from investors who would have more confidence in the bank’s ability to meet its financial obligations when compared to Bendigo & Adelaide Bank (relbanks.com, 2017). However, it could be said that the two banks have relatively good ratings which has a good bearing on their credit risk. How the product types offered by the two banks and their scope of operation affect their credit risk Bendigo and Adelaide bank has an Australia wide scope of operations where it provides thousands of people with fantastic customer services and a full range of banking services every day. On the other hand, NAB has a much wider scope. NAB is more of an international bank with a bigger operation scope in terms of branches while offering a wider range of financial services. The scope of these banks operations also give an indication of their capital risks. Since NAB has a wider scope of operations across differing geographical regions, it is likely to experience lower capital risk than Bendigo Adelaide Bank whose scope of operations is smaller (Ledgerwood and White, 2006). This is because economic problems in one region could be offset by improved economic conditions in the other. In this regard therefore, NAB has lower capital risk as far as its scope of operations is concerned. Similarities and differences between the two banks capital risks Arising from the analysis above, there are a number of similarities between the two banks capital risks. The two banks have met APRA requirements on capital adequacy. In addition, the bank shave relatively good credit ratings by various rating agencies. The two banks also have their liquidity coverage ratios and their net finding ratios above 100%. This is an indication of relatively strong position as far as capital risk is concerned meaning that both investors in both banks are relatively shielded from capital risk. However, there also exists differences between the two banks level of risks as indicated by the various ratios calculated. These differences lead to the conclusion that NAB is more efficient against capital risk when compared to Bendigo and Adelaide Bank. These differences arise mainly because of the banks scope of operations meaning that the bank with a bigger scope of operations has spread its risks across many areas thus exposing it to less capital risk. The differences also arise from the bank’s level of capital vis-à-vis its debts. NAB having a greater capital proportion is thus better placed to deal with capital risk while its better credit rating gives it better access to funding thus reducing the threat on capital. This is why the two banks have differing levels of capital risk. Conclusion Based on the above analysis, both Bendigo and Adelaide Bank as well as NAB have met the minimum capital requirements as set out by APRA’s prudent management framework while exceeding them in some instances. Thus, their performance is relatively excellent when it comes to protecting the interests of investors through minimization of capital risk. However, the analysis indicates that NAB had a higher capital ratio and this is an indication of greater protection against capital risk in comparison to Bendigo & Adelaide Bank as was also indicated by the other ratios analyzed. Although both banks have relatively good credit ratings, NAB is rated better and hence it could have better access to funding when compared with Bendigo & Adelaide Bank. The greater scope of operations that NAB has both in terms of regional spread and the services offered means diversification of capital risk which could be an indication that NAB has a lower exposure to capital risk in comparison to Bendigo & Adelaide bank. As such, this analysis indicates that NAB has a lower credit risk in comparison to Bendigo & Adelaide Bank which has been indicated by the strength of its ratios, while having met APRA’s requirements hence more adequately guarding the investors against capital risk in comparison to Bendigo & Adelaide Bank. References: APRA, 2017, Authorized deposit-taking institutions (ADIs) prudential framework, Retrieved on 29th April 2017, from; http://www.apra.gov.au/adi/PrudentialFramework/Pages/adi-prudential-framework.aspx APRA 2017, Prudential standards for ADIs, Retrieved on 29th April 2017, from; http://www.apra.gov.au/adi/PrudentialFramework/Pages/prudential-standards-and- guidance-notes-for-adis.aspx relbanks.com, 2017, Best Australian banks, retrieved on 29th April 2017, from; http://www.relbanks.com/best-banks/australia nab.com, 2017, 2016 Pillar 3 report, Retrieved on 29th April 2016, from; https://www.nab.com.au/content/dam/nabrwd/About- Us/shareholder%20centre/documents/2016- full-year-pillar-3-report.pdf bendigoadelaide.com.au, 2017, Basel III Pillar disclosures: Prudential standard APS 330, Retrieved on 29th April 2017, from; http://www.bendigoadelaide.com.au/public/shareholders/pdf/aps_330/2016-12-31- APS33.pdf Grier, W, 2007, Credit analysis of financial institutions (2nd ed.). London, UK: Euromony Institutional Investor PLC. Harker, P&, Zenios, S2000, Performance of financial institutions: Efficiency, Innovation, regulation. Cambridge, UK: Cambridge University Press. Khan, M&, Jain, P2008, Management accounting: Text, problems and cases. New, Delhi: Tata McGraw- Hill. Ledgerwood, J&, White, V2006, Transforming microfinance institutions: Providing full financial services to the poor. Washington, D.C.: World Bank. Sharma, M2008, Management of Financial Institutions: With emphasis on bank and risk Management. New Delhi: Prentice Hall. National Australian Bank annual report, 2016 Bendigo & Adelaide Ban Read More
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