RDP 2022-03: Macrofinancial Stress Testing on Australian Banks 4. Capital and Asset Growth

Having determined the amount of profit banks make, both before and after provisions for credit losses, the model then calculates the effect those profits have on capital and loan growth. This is done by using decision rules to determine how much profit banks retain and how much is paid out as dividends, as well as the amount of assets that are created from retained earnings (i.e. internal funding). These decision rules are set out in Section 4.1. Section 4.2 then discusses how risk weights are determined, allowing the model to determine end-period capital ratios.

4.1 Retained profits, dividends and asset growth

The profits banks make in the current period can either be retained or distributed as dividends. When profits are retained they can be either used to invest in new assets or to lift capital adequacy. These decisions are modelled using rules that are influenced by two factors: whether a bank made a profit or loss in the period; and the level of their CET1 ratio relative to certain pre-defined thresholds for investments and dividends, which take into account the prudential regulatory requirements. In particular:

1. If a bank makes a profit in the period, and their capital ratio is at or above a pre-defined threshold allowing unconstrained dividend payments, then it pays a dividend consistent with its historical payout ratio.^[22] The residual profits are then reinvested in new assets. The quantum of new assets created is determined as a multiple of these retained earnings, given a high enough CET1 ratio, where the multiple is set based on starting period CET1 ratios; this implies that banks are targeting a constant capital ratio over time. The distribution of these new assets across various loan portfolios (housing loans, business loans, credit card loans, etc) is also assumed to be consistent with banks' current portfolio allocation.^[23]
2. If a bank makes a profit in the period, but its CET1 ratio is below the threshold for unconstrained dividend payments, then it pays a constrained dividend.^[24] A bank under stress – that is, with a capital ratio above 4.5 per cent but within its capital conservation buffer (CCB) – will set its dividend payout ratio consistent with the restrictions APRA imposes in the Prudential Standard APS 110.^[25] Banks under this threshold for reinvestment restrict their asset growth by default; assets for banks in this situation are grown by just the amount of retained earnings without the usual leverage. Unlike in Brassil et al (2022), we do not explicitly model credit demand or lending spreads (which could be used to imply demand for a given quantum of credit growth), given our different aims to Brassil et al and the simple nature of our macroeconomic block. Accordingly, the implicit assumption in our model is that loan demand softens due to the macroeconomic shock that also lowers bank capital ratios, but that the volume of loans demanded does not actually shrink. However, it is possible to alter this default setting in order to model the effect on banks if they grow assets at a pre-specified rate (as done in Section 5.4).
3. If a bank makes a loss, then it pays no dividend, regardless of the level of its CET1 ratio. Banks continue to replenish asset losses. The decision to require banks in this situation to still roll over (healthy) loans is not because we assume that credit demand will be exactly unchanged, but rather because we want to avoid modelling outcomes in which banks maintain capital adequacy by contracting credit supply and, in turn, amplifying the shock to the macroeconomy.

The revised level of capital that is calculated from this three-state decision rule then forms the numerator for the end-of-period capital ratio. The revised level of assets is a key input into the calculation of the risk-weighted assets (the denominator). To determine the value of risk-weighted assets we also need to update risk densities (that is, the average risk weight across each bank's portfolio).

4.2 Risk densities

Changes in risk weights can have substantial effects on bank capital ratios. For example, early during the COVID-19 pandemic major banks estimated that ‘risk-weight migration’ – changes in average risk weights – could subtract between 80 to 180 basis points from their CET1 capital ratios. The model formulates risk-weighted assets by modelling the growth in average loan risk weight for each bank separately from changes in the volume of loans on the balance sheet.^[26] For risk-weight modelling, banks are separated into two categories – standardised banks and IRB banks – with different methods used to calculate risk weights for each group.

Standardised banks calculate their risk weights for prudential purposes using risk weight schedules provided by APRA's APS 112. For these banks, it is not expected that there will be a material increase in risk weights as APRA has clarified that such banks are not expected to revalue mortgage properties when they become aware of a material change in the value of properties in an area or region.^[27] This, along with the fact that there is limited scope for growth in risk weights on lending other than residential mortgages, means that standardised banks are unlikely to experience much in the way of risk-weight migration from a deterioration in economic conditions. For this reason, the model's default is to hold average loan risk weights for these banks constant at their starting levels.

IRB banks are allowed to use internal estimates of PDs and LGDs to determine risk weights for various assets they hold on their balance sheets. Our model approximates this approach by using the endogenously estimated PDs and LGDs for each asset class (as discussed above) to calculate the growth in average risk density across the balance sheet. These PDs and LGDs are converted to a weighted average PD and LGD across all asset classes. To better match how we understand banks' internal models to work, and the procyclicality in them, we smooth PDs and LGDs through the cycle by calculating a weighted average of initial PDs and LGDs provided by banks and the estimated PDs and LGDs from the model. The weights used to do this are calibrated to ensure the resulting growth in risk weights roughly matches estimates from APRA industry stress tests, which we believe are likely to be more accurate.

The average risk weight for the whole portfolio is then calculated using the regulatory-determined formula, which can be represented by the following simplification:^[28]

where the correlation factor R is set at 0.15 for all asset classes.

Footnotes

The model captures ‘net’ dividend payouts, after dividend reinvestment plans, without distinguishing between retained profits and reinvested dividends. This means historical payout ratios in the model are lower than those reported by banks. [22]

The model also assumes that banks adjust their Additional Tier 1 and Tier 2 capital by the same amount as their CET1 capital, so that the composition of their balance sheet does not change. This implicitly assumes that banks issue new capital instruments in proportion to their reinvested profit. [23]

The thresholds are based on the capital framework as currently legislated, but will be updated when the revised capital framework and thresholds take effect in 2023. [24]

These require that banks retain at least 40 per cent of their earnings when their capital ratio is within the top quartile of the CCB (which is 2½ per cent of risk-weighted assets, plus 1 per cent for D-SIB banks), rising by 60 per cent for the 3rd quartile, 80 per cent for the 2nd quartile and 100 per cent for the 1st quartile. When calculating the relevant restriction, we abstract from bank-specific prudential capital requirements (‘Pillar II charges’) for simplicity. [25]

These risk-weight calculations are done under the currently prevailing capital framework, which will change in 2023. [26]

For more information, please see APRA's ‘Banking COVID-19 frequently asked questions’ (available at <https://www.apra.gov.au/banking-covid-19-frequently-asked-questions>). [27]

This formula is a simplification because the formula and correlation factors will change slightly depending on which asset class is being considered. What is shown here applies to mortgages, the largest asset class. Banks typically also need to set the correlation factor higher than 0.15 on mortgages to comply with APRA requirements for portfolio-wide risk weights; 0.15 represents the minimum required value for individual mortgages. [28]