Implementing Basel III in Australia - APRA holds the line - Fund Management/ REITs - Finance and Banking

On Friday 30 March 2012, the Australian Prudential Regulation Authority (APRA) released for public consultation a set of 5 draft prudential standards to give effect to the Basel III capital reforms in Australia. APRA concurrently released a paper outlining its responses to the main issues raised in submissions received on its proposed framework for implementing the Basel III capital reforms in Australia (see September 2011 discussion paper, Implementing Basel III capital reforms in Australia).

APRA has concurrently released a letter to authorised deposit-taking institutions (ADIs) outlining further interim arrangements for capital instruments issued before the new prudential standards come into effect on 1 January 2013.

Notwithstanding that industry participants raised a number of issues in their submissions on the Basel III framework for Australia, APRA has indicated that it is unwilling to deviate substantially from the position that it proposed in its September 2011 discussion paper.

Key responses

APRA's response paper addresses various issues raised by industry participants during the consultation process, including with respect to minimum capital requirements, the definition of capital, regulatory adjustments to capital, prudential disclosures and transitional arrangements. This article focuses on APRA's responses to key submissions on the minimum capital requirements and the specific criteria that must be satisfied by regulatory capital instruments.

Timing

APRA has not moved from its accelerated implementation of the Basel III capital requirements, which ADIs will be required to meet in full from 1 January 2013. Some submissions argued that these reforms should be phased in over a two year period in accordance with the Basel Committee's timetable to ensure that ADIs are in the same position as their overseas counterparts. However, APRA noted that since ADIs in Australia already meet the minimum Common Equity Tier 1 ratio under Basel III, it does not believe that phase-in arrangements are necessary.

Mutually owned ADIs and the minimum capital requirements under Basel III

A key issue raised by mutually owned ADIs (mutual ADIs) was a concern that they will find it difficult to satisfy the minimum capital requirements under Basel III. As mutual ADIs are unable to issue ordinary shares, they have a limited ability to raise Common Equity Tier 1 Capital, other than through retained earnings.

In its response paper, APRA recognised that certain aspects of the Basel III reforms are problematic for mutual ADIs and intends to consult separately with them with respect to these issues. However, APRA is unlikely to support any solution that involves a departure from its policy of applying a common set of prudential requirements across all ADIs, as opposed to creating a two-tier capital regime to cater for the specific requirements of mutual ADIs.

Importantly, APRA stated that any solution would need to embrace the principle that instruments issued by a mutual ADI would only be recognised as common equity if their loss absorption features are fully equivalent to common shares and they do not possess features which, in times of stress, could cause the financial condition of the mutual ADI to weaken as a going concern.

Mutually owned ADIs and instruments qualifying as common equity

Mutual ADIs are also concerned with the implementation of the Basel III prohibition that prevents instruments from qualifying as common equity if they impose a contractual cap on distributions. In their submissions, mutual ADIs pointed out that this prohibition was inconsistent with ASIC's regulatory guidelines which require dividends on investor shares issued by a mutual ADI to reference an external benchmark or a fixed percentage of the company's annual profit after tax. However, APRA clarified that it does not believe that ASIC's regulatory guidelines are necessarily inconsistent with the Basel III prohibition provided that:

there is no linkage between dividend payments and the price paid at issuance;
the dividend amount is a maximum amount and does not operate as a de facto minimum;
the ADI retains full discretion to reduce or waive distributions; and
there are no other features which could weaken an ADI as a going concern during periods of stress.

Bail-in provisions

Under the Basel III reforms, all regulatory capital instruments must be capable of absorbing loss. To achieve this objective, APRA will require all Additional Tier 1 and Tier 2 instruments to contain a provision which requires them to be converted to common equity or written-off upon the occurrence of a trigger event. A trigger event will occur where APRA determines that, without conversion or write-off (and in the absence of a public sector injection of funds), an ADI would become non-viable.

APRA previously proposed a full write-off as the default provision unless it approved the conversion mechanism on a case-by-case basis. However, in response to submissions indicating a preference for conversion over write-off, APRA will now permit an ADI to elect to convert instruments into common equity upon the occurrence of the non-viability trigger. However, all capital instruments with a conversion mechanism must, as a backstop, also provide for a write-off mechanism in the event that conversion is unable to be effected immediately or does not result in an increase in Common Equity Tier 1.

Unfortunately, APRA did not take the opportunity to clarify at what point it would determine that an ADI is non-viable, which means that considerable uncertainty in relation to this issue remains (for further details, see Basel introduces tough capital rules affecting hybrid securities).

In addition, while not in the Basel III rules, APRA proposes to retain its proposed maximum conversion ratio to enable an ADI to quantify from the outset the maximum dilution effect of converting its capital instruments. However, in recognition that the 50% maximum conversion ratio that it had originally proposed is potentially onerous, APRA has indicated that it is considering lowering the maximum conversion ratio to 20%.

Interim arrangements

Subject to APRA's approval, any capital instrument issued in compliance with the draft APS 111 may be fully recognised in the relevant category of capital until its first call date. If APRA determines that an instrument complies with the final APS 111, it will continue to be recognised in the relevant category of capital. These interim arrangements are additional to the arrangements set out in APRA's letters to ADIs of 17 September 2010 and 27 May 2011 (see One step closer to Basel III - APRA's interim arrangements for Additional Tier 1 Capital instruments for further details).

APRA has invited written submissions on the response paper and draft prudential standards by 31 May 2012. In addition, APRA has indicated that it intends to release its proposed approach to counterparty credit risk and Pillar 3 disclosures under Basel III once the reforms relating to these issues have been finalised by the Basel Committee. APRA has also indicated that later in 2012, APRA will consult on reporting standards and consequential amendments to other prudential standards required to implement the Basel III capital reforms.

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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 bulletin. Persons listed may not be admitted in all states and territories.

Implementing Basel III in Australia - APRA holds the line

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