30 May 2011

One step closer to Basel III - APRA's interim arrangements for Additional Tier 1 Capital instruments

APRA has now released interim arrangements that set out modified eligibility requirements for Additional Tier 1 Capital instruments under Basel III, following its earlier clarification on APS 111 – Capital Adequacy. These interim arrangements, released on Friday 27 May, are intended to assist banks that wish to issue new Tier 1 capital instruments before APRA finalises new prudential standards to give full effect to Basel III.

As these arrangements are only interim measures, APRA is also currently preparing a discussion paper on how it intends to incorporate the Basel III eligibility requirements into its finalised prudential standards. APRA indicated that this paper will be released in the coming months, with the aim of issuing final prudential standards in mid-2012.

What is Additional Tier 1 Capital?

Broadly speaking, Tier I capital is capital that is available to absorb a bank's losses on a "going-concern" basis, or capital that can be depleted without placing the bank into insolvency, administration or liquidation. The purest form of capital is known as Common Equity Tier 1 capital under Basel III (or Fundamental Tier 1 capital under APS 111) and includes common shares and retained earnings.

In addition, there are certain other capital instruments which can be counted towards Tier 1 capital even though they are not Common Equity Tier 1 capital. Such capital instruments must satisfy certain eligibility requirements and are known as Additional Tier 1 capital under Basel III (or Residual Tier 1 capital under APS 111).

The current APS 111 sub-divides Residual tier 1 capital into two categories, namely Innovative and Non-Innovative Residual Tier 1 capital. However, under Basel III this distinction will be abolished and all Additional Tier 1 capital will be required to satisfy the same, but more stringent, eligibility criteria. In anticipation of this change, APRA's interim arrangements introduce a single eligibility criteria for Additional Tier 1 capital – effectively abolishing the current (and less stringent) Innovative Tier 1 capital category.

Additional Tier 1 capital – what has changed

In its 27 May announcement, APRA confirmed that it would, on an interim basis, accept newly issued Tier 1 capital instruments as being eligible for transitional treatment as Additional Tier 1 capital on the basis they satisfy both the current eligibility requirements in APS 111 and the new interim criteria set out in the 27 May announcement.

The key differences between the new interim arrangements and APS 111 with respect to Additional Tier 1 capital are as follows:

No step-ups or other incentives to redeem: there is now a prohibition on the inclusion of step-ups and other provisions which act as incentives for the issuer to redeem.

In this regard, APRA has previously indicated that where the timing for a change of pricing of an instrument (eg. interest changes from a fixed to a floating-rate basis) coincides with an issuer call option, this is likely to be construed by APRA as an incentive to redeem and will therefore be prohibited.

Additional restrictions on issuer calls: under APRA's interim arrangements, eligible Additional Tier 1 capital instruments cannot be called within five years of issuance other than as a result of a tax or regulatory event. They also cannot be called by the issuer unless they are replaced concurrently or beforehand with capital of the same or better quality, or the issuer can satisfy APRA that its capital position is well above minimum capital requirements, so that issuing replacement capital is unnecessary.

Conversion into share capital: Under Basel III, Additional Tier 1 capital instruments that are classified as liabilities for accounting purposes must have principal loss absorption mechanisms either through (i) conversion into shares at a pre-specified trigger point or (ii) a write-down mechanism which allocates loss to the instrument at a pre-specified trigger point.

APRA has adopted this requirement in its interim arrangements by requiring all Additional Tier 1 capital instruments recognised as liabilities under Australian Accounting Standards to include a provision under which they convert to shares if the Common Equity Tier 1 ratio of the issuing ADI's consolidated banking group falls below 5.125%. The pre-specified trigger point designated by APRA is above the minimum Common Equity Tier 1 ratio set under Basel III (being 4.5%).

Interestingly, the inclusion of this requirement seems to be a vote of confidence by APRA for contingent debt instruments (or CoCo bonds) which are convertible bonds which convert to equity at a pre-determined capital ratio. CoCo bonds have recently captured the attention of banking supervisors in a number of jurisdictions, due to their potential to allow banks to successfully restore their capital ratios without the need for government intervention.

Blanket prohibition on stapled securities: APRA has indicated that stapled securities will no longer qualify as Tier 1 capital on the basis that they do not meet the conversion/ write-down features set out in the Basel III criteria.

Instruments cannot hinder recapitalisation: under the interim arrangements an Additional Tier 1 capital instrument cannot contain provisions which hinder recapitalisation of the issuer (such as provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified time frame).

Cannot be issued by SPV: an Additional Tier 1 capital instrument cannot be issued directly or indirectly through a special purpose vehicle and cannot be secured nor covered or otherwise supported by any guarantee, put option or other facility which enhances the seniority of the investors vis-à-vis all other creditors of the issuer.

Dividend pushers and dividend stoppers: Under Basel III, "dividend pushers" (which require an issuer to make a dividend/coupon payment in relation to an instrument if a payment is made on another, typically more junior, instrument) are prohibited. Consistent with this, APRA has indicated that instruments with dividend pushers will not be recognised as Additional Tier 1 capital under the interim arrangements. However, it has indicated that it is willing to allow Additional Tier 1 capital instruments to contain "dividend stopper" clauses (which prevent payment of dividend/coupon on ordinary shares or more junior instruments), provided the dividend stop is confined to the immediate distribution period.

Effect of interim arrangements

APRA has indicated that once the final prudential standards have been released ADIs may then apply to have any Tier 1 capital instruments issued under the interim arrangements treated as a permanent addition to their Tier 1 capital. However, it is uncertain how instruments that are issued under the interim arrangements will be assessed against the final prudential standards released by APRA. This uncertainty may lead to ADIs further deferring issuance of Tier 1 instruments on the basis of the interim arrangements if they cannot be sure that they will be fully recognised when Basel III comes into force on 1 January 2013.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.