Recent prudential developments

By Louise McCoach and Brian Salter.

Key Points:
A brief summary of recent published articles and other items of interest in prudential regulation.

APRA considers Basel II

The quarterly edition of the Insight bulletin published this month by the Australian Prudential Regulation Authority (APRA) contains an article by Bernie Egan on the new capital adequacy standards for banks under the Basel II Framework. The article examines the background to the Framework and discusses issues relating to its implementation in Australia, including how APRA is likely to exercise its national discretion to reflect local conditions. The article also foreshadows the release by APRA of draft Prudential Standards for the implementation of "Pillar 1" of the Framework for industry consultation in the first part of 2005.

APRA discusses IFRS

The first of two discussion papers outlining APRA's proposed prudential response to the adoption of the International Financial Reporting Standards (IFRS) was released for comment on 24 February 2005. The paper deals with how APRA proposes to address the prudential implications of a number of changes to the Australian accounting standards that flow from the adoption of IFRS, including:

• fair value measurement;
• non-accrual loans and deferred acquisition costs;
• treatment of hedges;
• available for sale financial assets;
• property;
• excess of market value over net assets;
• loan loss provisioning; and
• employer sponsored defined benefit superannuation plans.

Comments on this paper must be submitted by 29 April 2005, with a proposed adoption date of 1 January 2006, subject to appropriate transitional arrangements for materially affected entities. The next discussion paper will deal with the treatment of eligible Tier 1 capital instruments and securitisation.

Standard and Poor's responds to Basel II and IRS

Standard and Poor's (S&P) has warned in its RatingsDirect online publication in February that negative ratings implications could arise for banks adopting materially lower capital adequacy standards in response to the recently released Basel II Framework. This is consistent with the view maintained by S&P in the same report that there is no excess of surplus capital in the Australian banking sector and that there is limited scope for a material decrease in capital for most institutions at current rating levels. S&P also warned that it is investigating the likely effect of IFRS on bank policies and behaviour, and the potential reaction of Australian bank stakeholders to changes to the reported equity of Australian banks under IFRS.

Basel airs concerns over outsourcing by financial services businesses

A Joint Forum comprised of the Basel Committee on Banking Supervision, the International Organisation of Securities Commissions and the International Association of International Supervisors released a paper last month under the auspices of the Bank for International Settlements. The paper, entitled "Outsourcing in Financial Services", seeks to:

• highlight the concerns of the Joint Forum in relation to the outsourcing by financial services businesses of their activities to third parties;
• develop a set of principles that give guidance to firms, and to regulators, on ways to mitigate these concerns without hindering the efficiency and effectiveness of firms.

IFRS may have consequences for the Financial Sector (Collection of Data) Act 2001

In its abovementioned discussion paper on IFRS, APRA has announced that it will be considering changes to the reporting standards determined by APRA under The Financial Sector (Collection of Data) Act 2001.

The Financial Sector (Collection of Data) Act 2001 requires certain entities to register under the Act to facilitate the collection by APRA of statistical data from these entities. Registered entities are subject to certain reporting standards (which may be varied or revoked by APRA from time to time) as determined by APRA, although APRA may grant exemptions from these reporting standards from time to time.

The Act does not empower APRA to supervise the activities of registered entities, nor does it give them any special status or guarantee their financial stability.

A company will be required to register under the Act if it satisfies any one of the following conditions:

• its sole or principal business activities in Australia are the borrowing of money and the provision of finance; or
• the sum of the values of its assets in Australia as consist of debts due to the company, which have resulted from transactions entered into in the course of the provision of finance by the company, exceeds 50% of the sum of the values of all its assets in Australia; or
• it engages in the provision of finance in the course of carrying on in Australia a business (whether or not that business is its sole or principal business) of selling goods by retail, and the sum of the value of the assets of the corporation (and its related entities) as consist of debts due to it and resulting from transactions entered into in the course of the provision of finance by that corporation exceeds $25,000,000.

These tests require a company to engage in the "provision of finance", which is defined to include the purchase of debentures or other securities issued by a corporation. In a financing context, this could include the purchase of securities issued by special purpose vehicles established for borrowings or structured finance transactions such as project financing and securitisation.

The Act sets out various exceptions to the requirement to register, including if a company is an ADI or has obtained an exemption from registration.

Each company must register within 60 days of it becoming a registrable corporation. The penalty for failing to comply with this requirement is 50 penalty units ($5,500) and continues to constitute an offence on a daily basis until rectified.

For further information, please contact Louise McCoach.