APRA releases Discussion Paper on the adoption of IFRS and its approach to Tier 1 Capital

By Brian Salter and Matthew Parsons.

Key Points:
APRA has proposed to de-couple the definition of Tier 1 capital instruments and securitised assets from the relevant accounting treatment under IFRS. APRA has proposed new criteria for Tier 1 capital for ADIs and general insurers. APRA has also released draft prudential standards and discussion papers to implement Basel II.

APRA today released its second Discussion Paper in relation to the introduction of International Financial Reporting Standards ("IFRS") in Australia. The introduction of IFRS in Australia will, among other things, result in a reclassification for accounting purposes of debt and equity instruments, and more stringent rules for securitised assets to be removed from the balance sheet. In this Discussion Paper, APRA addresses these issues, and outlines how it proposes to treat Tier 1 capital and Securitisations. APRA has invited comments on the Discussion Paper, to be submitted no later than 28 October 2005.

Tier 1 Capital

APRA proposes to de-couple the definition of capital instruments eligible for Tier 1 capital from Australian Accounting Standards. However, it proposes a number of refinements in its approach to assessing Tier 1 capital.

First, it will introduce new limits for the types of instruments that may be classified as Tier 1 capital:

• "Fundamental Tier 1" will comprise ordinary shares, retained earnings, general reserves and net current year's earnings. Fundamental Tier 1 must constitute at least 75% of net Tier 1 capital.
• "Residual Tier 1" will comprise all other Tier 1 capital, including "pure" preference shares (that is, non-cumulative and irredeemable) and "Innovative Tier 1" instruments. Residual Tier 1 must not exceed 25% of net Tier 1 capital.
• "Innovative Tier 1", which is a sub-category of Residual Tier 1, comprises innovative Tier 1 capital instruments, for example instruments with an incentive for the issuer to call, such as a step-up provision or an option to convert to ordinary shares, instruments issued indirectly through a special purpose vehicle, and instruments not representing a "share". Innovative Tier 1 capital must not exceed 15% of net Tier 1 capital.

Previously, APRA had a single combined limit of 20% for "pure" preference shares and innovative instruments. Also, this was calculated on gross Tier 1 capital, but the proposal is to calculate the limit on Tier 1 capital net of Tier 1 deductions such as intangible assets.

Second, it will permit Innovative Tier 1 capital instruments to be issued directly by ADIs and general insurers. Previously, such instruments were required to be issued by special purpose vehicles.

Third, it will remove the current mandatory conversion requirement for directly-issued Tier 1 and Tier 2 capital instruments. APRA intends to rely on the subordination requirements and additional loss absorption criteria that is proposes to include in the prudential standards.

APRA proposes to introduced amended prudential standards and guidance notes to implement these measures which would come into force from 1 July 2006. The revised limits on Residual and Innovative Tier 1 Capital would become effective from 1 January 2008 or, if an ADI would be materially affected by the revised limits, from 1 January 2010.

Securitisation

APRA proposes to de-couple the assessment of securitised assets of ADIs for capital adequacy purposes from the accounting treatment of the assets. This change would also be effective from 1 July 2006.

APRA also proposes to:

• review it current "clean sale" requirements for securitised assets and its "separation requirements for special purpose vehicles, as currently set out in APS 120;
• exclude securitised assets from consolidated reporting to APRA, and require separate reporting for selected securitisation information; and
• consider the application of securitisation principles for ADIs to assess securitisations within the general insurance industry, but a prudential standard will not be prepared until industry standard becomes more established.

Other Basel II Developments

APRA has also recently released the second and third instalments in its series of discussion papers and draft prudential standards regarding the implementation of the Basel II Capital Framework which is set to come into force in Australia on 1 January 2008.

The discussion papers set out the internal ratings-based approach for the calculation of regulatory capital for credit risk and the standardised approach for the calculation of regulatory capital for operational risk. APRA believes that the majority of ADIs will use the standardised approach for calculating both types of risk.

The first paper accompanies draft standard APS 113 and outlines the internal ratings-based approach to credit risk. The standardised approach to credit risk was set out in a discussion paper which was released earlier this year. The internal ratings-based approach requires that an ADI's credit exposures are to be divided into defined IRB asset classes. The credit risk regulatory capital charge for these asset classes will be calculated by the ADI subject to its own credit risk components which will be supervised by APRA.

The second paper outlines the standardised approach to operational risk which will be contained in draft standard APS 114. The draft standard provides that an ADI's activities will be divided into two categories - 'retail/commercial banking' and 'all other activity'. The operational risk capital requirement of the 'retail/commercial banking' will be determined as a proportion of loans and advances relating to those activities whereas the latter category will be determined as a proportion of net income not related to retail and commercial banking.

All ADIs will be required to implement comprehensive risk management frameworks for both operational and credit risk. The requirements of these frameworks will be contained in a prudential standard that will be available in 2006.

The assistance of Maya Greenberg is gratefully acknowledged.