15 May 2014

Australia's implementation of the Basel III capital framework - how divergent is it?

by Louise McCoach

Australia's overall compliance assessment with the Basel III capital framework is technically qualified.

In March 2014, Australia's capital framework was assessed under the Basel Committee's Regulatory Compliance Assessment Programme (RCAP) to be overall compliant with the Basel Capital framework, notwithstanding that it diverges from the Basel capital standards in two areas: the definition of capital and the internal ratings-based (IRB) approach to credit risk.

Even though these areas of divergence were assessed as material by the RCAP team, they are quite technical in nature and have not affected Australia's overall compliance assessment. In light of this it is not clear whether the areas of divergence will be corrected in the future. It is possible that they could remain as permanent departures which reflect regulatory settings or interpretations that are appropriate for Australia's domestic capital framework.

The key areas of divergence are summarised below.

Implementation of the definition of capital

Australia's implementation of the definition of capital was assessed by the RCAP Team as materially different in two areas:

  • APRA's treatment of an authorised deposit-taking institution's (ADI's) direct or indirect investments in its own capital; and
  • the loss absorption requirements for regulatory capital.

Deductibility of own capital instruments

Basel III requires a bank to calculate regulatory capital net of deductions for certain investments in its own capital instruments, whether held directly or indirectly. In implementing this requirement, APRA treats certain indirect holdings by an ADI as not caught by the Basel framework definition of “indirect holdings”, namely, “exposures that will result in a loss to the bank substantially equivalent to any loss in the direct holding”.

In particular, APRA will allow indirect holdings held through vehicles subject to consolidation within an ADI’s financial statements to be included in the calculation of regulatory capital provided the following conditions are met:

  • the ADI (or relevant vehicle) did not fund acquisition of the capital instruments (ie. they must be funded by third parties such as life insurance policyholders or other third-party investors);
  • the associated risks and rewards are borne primarily by third parties; and
  • the ADI can demonstrate to APRA, if required, that decisions to acquire or sell such capital instruments are made independently and in the interests of the relevant third parties.

The RCAP team concluded that the above conditions for counting investments in own-capital instruments towards regulatory capital were capable of being interpreted fairly widely, which could ultimately lead to a materially significant increase in reported regulatory capital. Although recognising this, APRA has indicated that it does not consider this outcome to be inappropriate. This is because the risks and rewards of the holding are borne by third parties which, in APRA’s view, does not conflict with the Basel framework definition of “indirect holdings”.

Loss absorption requirements

The second area of departure relates to APRA's prudential standard APS 111, which sets out the essential loss absorption characteristics that an instrument must meet in order to qualify as tier 1 or tier 2 capital. The RCAP team ultimately assessed that the Basel III loss absorption requirements relating to the non-viability trigger have not been fully implemented by APS 111. This finding was based on the fact that under the Basel III loss absorption requirements, the non-viability trigger must be specified as the earlier of:

  • a decision that a write-off, without which the bank would become non-viable, is necessary, as determined by the relevant authority; and
  • the decision to make a public sector injection of capital, or equivalent support without which the bank would have become non-viable, as determined by the relevant authority.

Further, the issuance of any new shares as a result of the trigger event must occur prior to any public sector injection of capital. This is to ensure that all capital providers suffer a loss prior to taxpayers in the event of a government capital injection.

In contrast, the second limb of the non-viability trigger is formulated slightly differently under APS 111 as a determination by APRA that "without a public sector injection of capital, or equivalent support, the ADI would become non-viable".

The key difference between the second limb requirements of APS 111 and the Basel capital framework is that the latter assumes that a decision to make a public sector injection of capital has already been made. In contrast the APS 111 formulation leaves open the possibility that a public sector injection of capital will not be made.

In its formal response to the assessment, APRA stated that this departure reflects a deliberate decision on APRA's part to avoid creating a moral hazard by using language suggesting that such support may be forthcoming for any ADI (public sector support for a banking institution being virtually unprecedented in Australia). Consistent with this, APS 111 does not go on to expressly require the issuance of any new shares as a result of the trigger event to occur prior to any public sector injection of capital.

As a result of these departures, the Basel Committee has determined that APRA’s choice of trigger does not guarantee that new shares issued following a trigger event will be issued prior to any public sector injection of capital. Instead, it relies on APRA’s ability to trigger conversion prior to government capital support, which the RCAP team has assessed as a material departure.

The IRB approach to credit risk

Australia's implementation of the IRB approach to measuring credit risk was assessed as materially different from the approach under the Basel capital framework in two areas.

The first area relates to the Basel capital framework requirement that, under the IRB approach, residential mortgage loans will be eligible for retail treatment, regardless of exposure size, so long as (subject to certain limited exceptions) the credit is extended to an individual who is the owner-occupier of the property.

Under APRA’s implementation, mortgage loans will be eligible for retail treatment under the IRB approach regardless of the occupancy status of the property. Although APRA observed that there has been no material difference in the performance of owner-occupied versus non-owner-occupied residential mortgages in recent history, the RCAP team noted some uncertainty in relation to the performance of residential mortgage loans during a significant economic downturn and, accordingly, saw the potential risk for capital understatement as a result of APRA’s treatment as material.

In its formal response to the assessment, APRA noted that the relevant paragraph in the Basel capital framework requiring owner-occupancy status for retail eligibility is ambiguous and a large number of other Basel Committee member jurisdictions have implemented the relevant paragraph in the same manner as APRA.

The second area where Australia's implementation of the IRB approach differs from the Basel III requirements relates to its non-application of the 1.06 scaling factor, as prescribed for risk-weighted asset amounts calculated under the IRB approach, to the specialised lending asset class. Based on sample ADI data, the RCAP team determined that Australia's failure to apply the 1.06 scaling factor to this asset class potentially resulted in a significant understatement of capital, which has led to a material departure assessment in respect of this failure.

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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.