Bank Capital Requirements for Borrowers

Key takeaways

• Capital is not cash reserves - it is the equity funding portion of the balance sheet.
• Requirements are expressed as a ratio to risk-weighted assets, not to total assets.
• APRA set "unquestionably strong" benchmarks following the Financial System Inquiry.
• Capital-hungry lending is priced higher, which is why investor and high-LVR loans cost more.

What is bank capital, actually?

A common misconception is that capital is money set aside in a vault. It is not. Capital describes how the bank is funded: the portion coming from shareholders rather than from depositors and lenders.

That distinction matters because equity absorbs losses first. If loans go bad, shareholders lose value before depositors lose anything. The more equity in the funding mix, the larger the loss the bank can survive.

Common Equity Tier 1 is the highest-quality form - ordinary shares and retained earnings - and it is the measure APRA and analysts watch most closely.

How does capital reach your loan?

Through the cost of equity. Shareholders require a substantially higher return than depositors, so equity is the most expensive money on the balance sheet. A loan that requires more capital must earn a wider margin to deliver the same return.

Step five is the one borrowers feel most sharply and understand least. When a lender "comes out of the market" for a segment, it is often a capital allocation decision rather than a view about those borrowers.

What does "unquestionably strong" mean?

The 2014 Financial System Inquiry recommended that Australian banks maintain capital ratios that would be unquestionably strong by international comparison, so that they retain access to funding markets during a crisis. APRA implemented benchmarks to that effect and subsequently revised the capital framework to be more transparent and comparable.

The rationale is systemic rather than institutional: a banking system that stops functioning in a downturn amplifies the downturn. Higher capital is insurance the whole economy buys, paid for through slightly higher lending margins.

For a borrower, the trade-off is worth naming honestly. Stronger capital means marginally more expensive credit in normal times and a materially better chance that credit remains available in bad ones.

Frequently asked questions

What is CET1?

Common Equity Tier 1 capital - the highest-quality capital, consisting mainly of ordinary shares and retained earnings. It is measured as a ratio to risk-weighted assets and is the primary capital measure APRA and analysts watch.

Does more bank capital make my loan more expensive?

Marginally, yes. Equity costs more than deposits, so higher capital requirements raise the blended funding cost. The trade-off is a banking system far more likely to keep lending through a downturn.

Why do investment loans require more capital?

Because they attract higher risk weights under APRA's prudential standards, reflecting historically higher loss experience. More risk-weighted assets means more required capital, which is priced into the rate.

Is bank capital the same as a cash reserve?

No. Capital describes the equity share of how the bank is funded, not a pool of set-aside cash. Liquidity requirements are a separate regime dealing with whether the bank holds enough easily sold assets.

Related reading

• Expected Loss vs Unexpected Loss
• Where Banks Actually Get the Money They Lend You
• Covered Bonds and Bank Liquidity

Sources

• Prudential Standard APS 110 Capital Adequacy — APRA
• Financial System Inquiry final report — Commonwealth of Australia