CET1 ratio: If you invest in ASX bank stocks, here’s why it is an important metric to know

In this article we look at the Common Equity Tier 1 (CET1) ratio – what it is and why it is important. And we’ll look at the Big 4 Banks‘ ratios.

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So what is the CET1 ratio?

A Common Equity Tier 1 (CET1) ratio is a measure of financial health and capital adequacy for banks. It is calculated by dividing the bank’s CET1 capital—which includes common equity, retained earnings and certain additional elements—by its total risk-weighted assets. This ratio is considered important because it provides an indication of how well capitalised a bank is in relation to its overall risk exposure.

The value of a bank’s liabilities (i.e. deposits) are fixed, but the value of its assets can be variable. So, the ratio provides a sort of cushion to absorb any unexpected losses that might occur, such as loans that default for whatever reason.

Banks must report the CET1 ratio regularly and maintain it at levels designated by law. So what are the big 4 banks’ ratios? CBA has a CET1 ratio of 12.3%, Westpac has 12.4%, NAB has 12.15% and ANZ has 13.3%. As you can see, ANZ has the highest, with the other Big 4 being neck and neck.

What are the minimum levels in Australia?

In Australia, the minimum ratio for banks is 4.5% plus a capital buffer that provides an additional cushion (that’s 2-4% of CET1 capital). But banks are expected to maintain buffers above and beyond that level and can expect retaliation from APRA when this is not the case.

APRA is the Australian Prudential Regulation Authority, the government body responsible for ensuring the financial soundness of banks, credit unions, building societies, insurance companies and other institutions in Australia. It works with these entities to ensure they are meeting their obligations under the law (including checking they meet CET1 ratio requirements) and providing fair outcomes for customers.

We also note that insurers have to maintain CET1 ratios too given their operating model is similar, although the regulations for insurers is best left to another article.

The collapse of Xinja and its aftermath showed how important CET1 is

Some investors may remember neobank Xinja and its collapse in late 2020, barely 18 months after an unrestricted banking license. It was burning cash too fast with no lending product generating interest to offset interest paid on deposits. The final straw was the falling over of a $430m deal with a Dubai-based investment group.

Earlier this month, former CEO of Xinja Eric Wilson and non-executive director Craig Swanger were disqualified from being ‘accountable persons’ of an ADI (Authorised Deposit-taking Institution) for 8 and 10 years respectively. And why?

Because between May and August 2020, Xinja claimed to have entered into 3 agreements with investors purporting to raise CET1 capital. But this was undermined because Xinja entered into side agreements with those investors containing additional terms.

‘An accurate understanding of banks’ capital adequacy framework is essential for APRA to protect depositors by ensuring banks have the financial resilience to withstand a crisis,’ declared APRA’s deputy chair Margeret Cole.

‘It is vital that accountable entities and accountable persons are open and cooperative with APRA so that it may effectively discharge its responsibilities for overseeing the safety and soundness of Australia’s financial system’.

Do you see the point that is being made here? CET1 capital provides such a buffer to banks that it calls into account the very foundation of their existence. We should note that Swanger told the AFR that he did not agree with APRA’s findings and reluctantly agreed to settle the matter based on professional medical advice, after health problems in late 2022.

What about the US?

Let’s look at the minimum CET1 ratio regulations in the United States, a banking market that investors would have paid attention to given the close links between the Australian and American financial system, not to mention the Silicon Valley Bank dramas that occurred in 2023.

The current minimum CET1 ratio for all large and internationally active banking organisations supervised by the Federal Reserve is 7%, though certain banks may be subject to higher requirements as determined by their individual supervisors. As in Australia, CET1 ratios are closely monitored by banking regulators to ensure that they aren’t breaching them.

But as the regional bank collapses of 2023 illustrated, high ratios may not be enough to protect a bank from an extreme case like a bank run – where all depositors rush for their cash. Such an event is unlikely to result in a bank collapsing in Australia because of the federal government’s deposit guarantee of $250,000 per person – so investors shouldn’t worry about that happening here.

Why should investors pay attention to the CET1 ratio?

Investors should pay close attention to a bank’s CET1 ratio because it is a key measure of its financial health. This ratio is an important indicator of the bank’s ability to absorb losses in times of economic stress and meet regulatory requirements. The higher the ratio, the stronger the bank’s capital position and ability to withstand potential losses. Additionally, high levels of capital adequacy can bolster investor confidence, resulting in more favourable terms when accessing capital markets.

To make a long story short, analysing a bank’s CET1 ratio can provide investors with tangible information about its strength and stability in challenging times. But don’t take our word for it, take APRA’s.