13 April 2006
Key Points:
APRA is seeking comment on these drafts by 28 April 2006.
On 7 April 2006, APRA released the long-awaited draft Prudential Standard APS 111 on the Measurement of Capital, along with the accompanying draft Guidance Notes and its formal Response to Submissions in relation to APRA's Discussion Paper in August 2005 on the adoption of IFRS covering Tier 1 Capital and Securitisation. On 30 March 2006, APRA also released its first Discussion Paper and accompanying draft Prudential Standard APS 117 and Prudential Practice Guide on interest rate risk in the banking book (non-traded interest rate risk). We summarise these prudential developments below.
APRA releases draft of proposed approach to Tier 1 capital under IFRS
Key Points
Background
On 7 April 2006, APRA released a consultation package consisting of a draft Prudential Standard APS 111, accompanying draft Guidance Notes for ADIs and its formal Response to Submissions in relation to its August 2005 Discussion Paper on the adoption of IFRS covering Tier 1 Capital and Securitisation. APS 111 implements the major proposals contained in the August 2005 Discussion Paper. These proposals included:
APRA has invited comments on draft APS 111 and the accompanying draft Guidance Notes by no later than 28 April 2006. It is expected that APS 111 will come into effect from 1 July 2006, subject to the new Tier 1 capital limits taking effect from 1 January 2008, with a two year transition period until January 2010 for institutions expecting that their Innovative Tier 1 Capital will exceed the new 15 percent limit. Similar changes to the prudential standards for general insurers will be introduced following the completion of consultation on APRA's general insurance "Stage 2" reforms dealing with capital, assets in Australia and custodian arrangements and are expected to take effect in late 2006.
The major proposals implemented by APS 111 are discussed below.
New Tier 1 capital definitions
Currently, the prudential requirements for capital for ADIs are set out in APS 110 Capital Adequacy . This prudential framework is linked to the Australian Accounting Standards. Capital instruments eligible for Tier 1 status are defined by reference to the equity test in these Standards. Following the adoption by the Australian Accounting Standards of the stricter equity test under the International Financial Reporting Standards ("IFRS"), a significant proportion of instruments which are not pure equity may no longer qualify for treatment as Tier 1 capital.
APS 111 introduces a new definition of Tier 1 capital which will replace the definition derived from the Australian Accounting Standards. Under the new definition, Tier 1 will comprise two components:
Non-Innovative Residual Tier 1 Capital
In its earlier Discussion Paper, APRA had proposed that Non-Innovative Residual Tier 1 Capital instruments would be comprised only of non-cumulative, irredeemable preference shares. APRA still adheres to its view that such shares are the only instruments of sufficient quality to qualify as Non-Innovative Residual Tier 1 Capital. It also reasserts its earlier view that such instruments should be issued directly. However, in light of submissions during the consultation period, APRA has agreed to allow such shares to contain additional features. APRA believes that these features will give institutions flexibility in issuing such instruments without compromising APRA's desire that only high quality capital is included in Residual Tier 1.
To be acceptable as Non-Innovative Residual Tier 1 Capital, preference shares:
If an ADI believes that an existing innovative instrument may qualify as a Non-Innovative instrument, it may apply to APRA to have the instrument reclassified.
APRA retains proposed New Tier 1 Capital Limits
Currently, non-cumulative, irredeemable preference shares and innovative capital instruments may not comprise more than 20 percent of Tier 1 capital. APS 111 implements the new limits proposed by APRA in its August 2005 Discussion Paper:
Institutions may apply to APRA for transitional relief where their Innovative Tier 1 Capital will exceed the proposed limit of 15 percent of net Tier 1 Capital or where their total capital will be reduced by implementing the changes contained in APS 111.
Tier 1 deductions
Currently, APRA requires Tier 1 Capital to be determined on a gross basis. This approach is inconsistent with the approach required for determining regulatory capital ratios in respect of Tier 1 Capital, which is net of intangibles (including goodwill), future income tax benefits and certain equity investments. APS 111 will bring the two approaches into line so that Tier 1 Capital will now be determined on a net basis.
Loss absorption criteria
Currently, there is some doubt over whether Tier 1 and Tier 2 capital instruments would be available to absorb losses in wind-up situations and on an on going basis. Under APS 111, APRA intends to reduce this doubt by introducing additional loss absorption criteria. The proposed criteria include provisions strengthening subordination criteria and limitations on payments of dividends or interest. Specifically, the accompanying draft Guidance Notes require that documentation used in issuing Tier 1 or Tier 2 instruments explicitly stipulates that payments of dividends or interest is at the discretion of the issuer and that the failure to make a payment does not constitute an event of default.
APRA releases final draft of proposed changes to assessment of securitised assets
Key Points
Currently, the assessment of securitised assets for capital adequacy purposes is linked with the treatment of these assets under the Australian Accounting Standards. Following the adoption of IFRS by the Australian Accounting Standards, APRA proposes to de-couple the capital adequacy assessment of securitised assets from their accounting treatment. APRA also proposes to amend reporting obligations to exclude assets that have passed the "clean sale" test. These proposals will be effected by amendments to the existing Prudential Standards and Guidance Notes.
APRA has invited comments on the above proposals by no later than 28 April 2006. It is expected that the amendments will take effect from 1 July 2006.
APRA is considering other proposals unrelated to IFRS which are also likely to have an impact on the prudential requirements for securitisation. These will be discussed in a separate paper to be released by APRA later in 2006.
APRA releases discussion paper and accompanying draft prudential standard on interest rate risk in the banking book
Key Points
As part of its ongoing work to implement Basel II, APRA, on 30 March 2006, released a Discussion Paper and accompanying Draft Prudential Standard APS 117 and Prudential Practice Guide on interest rate risk in the banking book (non-traded interest rate risk). APRA has invited comments on the Discussion Paper and Draft Prudential Standard, to be submitted no later than 30 June 2006.
Content of APS 117
Draft Prudential Standard APS 117 relates primarily to how non-traded interest rate risk must be managed and measured. APRA defines non-traded interest rate risk as "the risk of loss in earnings or in the economic value of the banking book of an ADI as a consequence of movements in interest rates." APS 117 requires that ADIs have in place a framework to "measure, manage and monitor non-traded interest rate risk that is commensurate with the nature, scale and complexity of the ADI's operations". Further, APS 117 stipulates that ADIs must hold adequate regulatory capital against non-traded interest rate risk.
APS 117 does not apply to all ADIs; it only applies to those ADIs which employ an Internal Ratings-based ("IRB") approach to credit risk or an Advanced Measurement Approach ("AMA") to operational risk. Consequently, the proposed requirements included in APS 117 will not apply to ADIs which employ the standardised Basel II approach to credit risk and operational risk.
Where an ADI is subject to APS 117 and seeks to quantify non-traded interest rate risk regulatory capital requirements using an IRB model, approval from APRA will be required. In order for such approval to be granted under APS 117, the IRB model in question must be demonstrably capable of determining the regulatory capital requirement within a 99 per cent confidence level.
Further, APS 117 requires that any ADI using an IRB model for determining non-traded interest rate risk regulatory capital requirement must provide quarterly reports to APRA in respect of the output of that model.
On the horizon
While ADIs employing standardised Basel II approaches may have been spared the additional requirements contained in APS 117, they are not totally in the clear. APRA intends to release, sometime later this year, some "general requirements for the management of non-traded interest rate risk" in relation to ADIs not covered by APS 117. Such requirements are likely to include the production of a standard quarterly report which will be monitored by APRA. Any ADIs identified through this quarterly reporting mechanism as "outliers" may be subject to requirements to maintain a minimum capital ratio.
APS 117 is still in draft form and APRA is currently accepting submissions in relation to it. It is expected that the standard will be finalised in 2007 and will come into force by 1 January 2008.
For further information, please contact Louise McCoach.
