15 May 2014

Round-up of regulatory capital requirements for Australian ADIs post-Basel III

by Louise McCoach

Now that APRA's implementation of the Basel III capital reforms in Australia have largely been implemented, it is time to take stock of Australia's new capital framework.

As the prudential regulator of the Australian financial services sector, the Australian Prudential Regulatory Authority (APRA) is responsible for the implementation of the Basel Framework in Australia through its powers to formulate prudential and reporting standards.

The key prudential standards relating to regulatory capital are found in prudential standards APS 110 through APS 117 (inclusive). They are based on the capital standards set out in the Basel Framework and aim (among other things) to ensure that Australian Deposit-taking Institutions (ADIs) maintain adequate capital, on both an individual and group basis, to act as a buffer against the risks associated with their activities, including by:

  • holding minimum levels and ratios of certain types of capital;
  • establishing and maintaining internal processes to monitor and notify of any ‘significant changes’ in their capital base;
  • having a process for applying "risk weights" to each credit risk to which the Australian ADI is exposed;
  • having a process for "quantifying certain credit risk components to determine capital requirements for a given credit exposure";
  • keeping their retail banking, commercial banking and other banking businesses separate and applying different operational risk capital requirements to each area of business; and
  • keeping separate internal processes to "manage, measure and monitor" operational, market and interest rate risks.

The prudential standards relating to regulatory capital do not apply to foreign ADIs, which are expected to meet comparable capital adequacy standards in their home jurisdictions.

Basel III implementation

Since the release of the Basel III consultation package in December 2010, APRA has been actively involved in implementing a series of updates to its prudential standards to ensure consistency with the capital requirements of the Basel III framework.

In September 2012, APRA published a final set of prudential standards that gave effect to major elements of the Basel III capital reforms in Australia. Subsequently, in November 2012, APRA issued a package of final measures, including requirements for counterparty credit risk, which completed APRA’s implementation of the Basel III capital reforms for ADIs. Under these revised standards, new capital requirements took effect in Australia on an accelerated basis from 1 January 2013, subject to certain transitional arrangements.

An important component of the Basel framework is the public disclosure of regulatory information (referred to as “Pillar 3” within the framework). The Pillar 3 disclosure requirements for remuneration and capital, which were updated under Basel III, have been implemented in Australia via a revised prudential standard APS 330 which came into effect on 30 June 2013. The standard sets minimum requirements for the public disclosure of information on an ADI's risk profile, risk management, capital adequacy, capital instruments and remuneration practices so as to contribute to the transparency of financial markets and to enhance market discipline.

In addition, on 1 January 2015, prudential standard CPS 220 will come into effect. CPS 220 is a proposed cross-industry prudential standard which has been introduced to harmonise and consolidate APRA's risk management requirements for ADIs, general insurers and life companies into one prudential standard. A new CPS 510 will also come into effect on 1 January 2015 to align APRA's governance requirements relating to risk management with the enhanced requirements of CPS 220.

Capital adequacy standards

Capital adequacy requirements for Australian ADIs are set out in a number of prudential standards, most notably APS 110 and APS 111. Under APS 110, an Australian ADI is required to maintain, at all times, a minimum level of capital on both a standalone and consolidated basis.

The minimum standard requires Australian ADIs to maintain a prudential capital ratio (PCR) of at least 8 percent of its total risk-weighted assets unless APRA indicates that a higher PCR is required. In practice, APRA requires all Australian ADIs to have PCRs above the minimum requirements.

For the purposes of determining an Australian ADI’s risk-based capital ratio (and compliance with its PCR), its total risk-weighted assets is calculated as the sum of:

  • its risk-weighted on-balance sheet and off-balance sheet assets determined based either on a standardised approach using external credit ratings or on an internal ratings based approach as approved by APRA;
  • 12.5 times the sum of capital charges relating to its operational and market risks and interest rate risks on its banking books; and
  • its exposures (on a risk weighted adjusted basis) to securitisations.

Under APS 110, the capital to be maintained by an Australian ADI in order to meet its PCR may be comprised of tier 1 capital and tier 2 capital, net of all specified regulatory adjustments including deductions and amortisations. The essential characteristics that an instrument must meet to qualify as tier 1 or tier 2 capital are set out in APS 111.

New capital requirements for tier 1 and tier 2 capital took effect under APS 111 on 1 January 2013. Under transitional rules, additional tier 1 or tier 2 instruments that have been issued before 1 January 2013 and satisfy certain criteria may continue to enjoy their status as additional tier 1 or tier 2 instruments, notwithstanding that they do not satisfy the new capital requirements introduced on 1 January 2013. To the extent such transitional instruments are recognised by APRA, they will be subject to phase-out arrangements.

Tier 1 capital

Tier 1 capital comprises capital that satisfies certain essential characteristics under APS 111, including that it constitutes a permanent and unrestricted commitment of funds which ranks behind the claims of depositors and other creditors in the event of a winding-up.

Tier 1 capital is divided into two categories:

  • "common equity tier 1 capital", which includes an Australian ADI’s paid-up ordinary shares provided these satisfy certain criteria, retained earnings, undistributed current-year earnings, accumulated other comprehensive income and other disclosed reserves including foreign currency translation reserve and certain minority interests arising from the issue of ordinary shares to third parties by a fully consolidated subsidiary; and
  • "additional tier 1 capital", which includes instruments issued by Australian ADIs that satisfy certain criteria including that they are paid-up, perpetual, subordinated, contain no step-ups or other incentives to redeem, satisfy the requirements for loss absorption referred to below and cannot be callable by the issuer within five years.

Tier 2 capital

Tier 2 capital comprises all other components of capital that fall short of tier 1 capital but nonetheless contribute to the overall strength of the Australian ADI as a gone concern.

Tier 2 capital instruments must satisfy certain criteria set out in APS 111, including that they be paid-up, have a minimum maturity of at least five years, are subordinated to all claims except tier 1 capital, contain no step-ups or other incentives to redeem and satisfy the requirements for loss absorption referred to below.

Loss absorption requirements

Both additional tier 1 capital and tier 2 capital instruments must meet the requirements for loss-absorption set out in APS 111. Under those requirements, additional tier 1 capital and tier 2 capital instruments must include a provision that they will be written off or converted into ordinary shares of the relevant Australian ADI where a "non-viability trigger event" has occurred. A "Non-viability trigger event" will occur in respect of an Australian ADI if:

  • APRA issues a notice to the ADI that conversion or write-off is necessary because, without it, APRA considers that the ADI would become non-viable; or
  • APRA determines (and notifies the ADI) that without a public sector injection of capital, or equivalent support, the ADI would become non-viable.

Under recent revisions to APS 111, APRA's loss absorption requirements also permit mutually owned ADIs (who cannot issue ordinary shares due to their mutual structure) to issue additional tier 1 or tier 2 capital instruments that provide for conversion into mutual equity interests in the event that the non-viability provisions in these instruments are triggered.

The mutual equity interests that result from such a conversion will count towards common equity tier 1 capital provided they comply with the relevant provisions of APS 111.

Minimum Capital Requirements

The amount of tier 1 and tier 2 capital to be included in an Australian ADI’s capital base for capital adequacy purposes, net of all required deductions, is subject to the relevant Australian ADI maintaining the following minimum capital requirements:

  • a common equity tier 1 capital ratio of 4.5 percent;
  • a tier 1 capital ratio of 6.0 percent; and
  • a total capital ratio of 8.0 percent.

New capital buffers

In line with the Basel III framework, the minimum capital requirements will be supplemented by the introduction of new capital conservation and countercyclical buffers.

The capital conservation buffer will require Australian ADIs to set aside an additional amount of common equity tier 1 capital equal to 2.5 percent of an Australian ADI's total risk-weighted assets unless determined otherwise by APRA.

The countercyclical buffer will require Australian ADIs to hold additional common equity tier 1 capital of between zero and 2.5 percent (as determined by APRA) of an Australian ADI's total risk-weighted assets. APRA has chosen not to implement the transitional arrangements under Basel III for the capital conservation and countercyclical buffers. Instead, the capital conservation buffer will apply in Australia in full from 1 January 2016 and APRA will have the ability to impose the new countercyclical buffer from 1 January 2016.

Any depletion of common equity tier 1 capital below the buffer requirements will have the effect of bringing into force capital distribution constraints. These constraints will operate to prevent Australian ADIs from making distributions affecting their common equity tier 1 capital such as dividends and share buybacks. The percentage of earnings that an Australian ADI will be unable to distribute when subject to a capital distribution constraint will depend on the degree to which the capital buffer requirements have been depleted.

Also in line with the Basel III framework, APRA has announced that it will impose a domestic systemically important banks (D-SIBs) capital buffer on certain of Australia's largest banks. This announcement was followed by the release of an information paper by APRA in December 2013 outlining its D-SIBs framework, which will come into effect on 1 January 2016. The information paper provides details on the methodology used by APRA to identify D-SIBs in Australia.

APRA's assessment methodology has regard to the Basel Committee's four key indicators of systemic importance: size, interconnectedness, substitutability and complexity. Under the D-SIBs framework, the capital buffer must be met by common equity tier 1 capital and will be implemented as an extension of the capital conservation buffer.

On this basis, APRA has designated Australia's largest ADIs as D-SIBs and has set a one percent capital buffer for these ADIs. Although the Basel Committee has also proposed the introduction of an additional capital buffer for global systemically important banks (G-SIBs), no Australian banks currently qualify as G-SIBs. As such, it is unlikely that the G-SIBs capital buffer will be implemented by APRA for Australian ADIs in the near future.

 

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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.