Australia: Implementation Of Basel II: APRA Releases A Raft Of Draft Prudential Standards

Last Updated: 18 October 2007
Article by Brian Salter and Jamie Taylor

On 2 July 2007, APRA released two updated draft Prudential Standards: Prudential Standard APS 110 Capital Adequacy and Prudential Standard APS 111 Capital Adequacy: Measurement of Capital, and an accompanying Discussion Paper.

Submissions in respect of these new draft Prudential Standards were due by 30 July 2007. APRA proposes to issue final drafts of APS 110 and APS 111 in late 2007 and it is expected that these drafts will come into effect from 1 January 2008.

The key changes contained in the new draft APS 110 and APS 111 are set out below.

Level 1 and Level 2 changes

In the new draft APS 110, APRA's definition of Level 1 for capital adequacy purposes has been extended to also include, in addition to an ADI, certain APRA approved subsidiaries of that ADI – the new draft APS 110 refers to the ADI and these subsidiaries together as an Extended Licensed Entity ("ELE").

In the new draft APS 110, Level 2 will include, in addition to a consolidated banking group, any immediate locally incorporated non-operating holding company of an ADI.

Quality of capital

The new draft APS 111 contains certain new or amended provisions relating to the quality of regulatory capital, including:

  • Substance over form: where a component of capital, when looked at in conjunction with other related transactions that affect its economic substance, could be reasonably considered not to meet the requirements of the Prudential Standard for a particular category of capital, the component will not be eligible to be included as part of that category of capital at Level 1 or Level 2;
  • Guarantees: any capital instrument guaranteed by a Level 2 group member, where such a guarantee may prevent the instrument satisfying the required features of eligible capital on a group basis, will not be eligible as Level 2 capital;
  • Category of capital must be preserved: where a capital instrument, when measured at a Level 2 basis, qualifies to a higher category of capital than when measured at a Level 1 basis, that capital instrument must be reclassified at the lower category when measured at Level 2;
  • Future events: measurement of a capital instrument cannot have regard to a future event until it has irrevocably occurred;
  • Exclusion from capital base: APRA may require an ADI to exclude from its capital base any component of capital where APRA has reasonable grounds to believe that such a component does not represent a genuine contribution to the financial strength of the ADI or the consolidated banking group, as appropriate; and
  • Adjustment to Level 2 capital ratio: APRA may require an ADI to adjust its Level 2 risk-based capital ratio where capital to fully support risk across the consolidated banking group is not readily available.

Deductions from capital base

In the new draft, APRA has adopted the Basel II 50/50 approach - all deductions must be made 50 percent from Tier 1 capital and 50 percent from Tier 2 capital ("50/50 Basis"). Where an ADI has insufficient Tier 2 capital to cover the required deductions, the excess deductions must be made from Tier 1 capital.

The new draft APS 111 includes the following deductions:

  • minority investments (more than 20 percent but less than 50 percent of voting shares) in insurance companies and other financial entities (other than ADIs and overseas equivalents); and
  • investments in subsidiaries (other than ADIs, insurers and overseas equivalents) at Level 1 that do not form part of an ELE.

Undercapitalised subsidiaries

Under the new draft APS 111 APRA may require, if necessary, an ADI to deduct from its Level 2 capital any identified capital shortfall in non-consolidated subsidiaries.

Limits on equity investments

Under the new draft APS 111:

  • all equity investments (including holdings of units in trusts) at Level 1 and Level 2, in excess of prescribed limits must be deducted, to the extent of that excess, on a 50/50 Basis;
  • the prescribed limits for equity investments are to be based on the capital base at both Level 1 and Level 2;
  • the limit for individual equity investments in non-subsidiary entities is reduced to 0.15 per cent of the capital base; and
  • equity holdings acquired through underwriting of new equity issues are not required to be deducted until 90 days after the date of issue.

The new draft APS 111 also clarifies that equity legally held in the name of the ADI or other group members on behalf of third parties may be ignored for the purposes of determining the amount of equity investments.

General Reserve for Credit Losses

APRA expects that ADIs will make provisions, in the form of capital, for certain expected losses (known as the General Reserve for Credit Losses).

The methodology for determining how much of the General Reserve for Credit Losses can be included in capital under the new draft APS 111 differs depending on whether an ADI adopts the standardised or IRB approach.

Interest on Lower Tier 2 capital instruments

The new draft APS 111 clarifies the circumstances in which dividends or interest payments on Lower Tier 2 instruments may be paid. Under the new draft APS 111, an issuer of a Lower Tier 2 instrument may not make a dividend or interest payment on such an instrument when that issuer is insolvent or will become insolvent immediately after that payment. Where, however, such a dividend or interest payment is deferred because of solvency concerns, the deferred payments may accrue interest.

Claims in liquidation

Under the new draft APS 111, instruments will not be precluded from qualifying for Upper or Lower Tier 2 capital by virtue of the fact that they allow a holder to claim against an issuer in liquidation for previously deferred dividend and interest payments that remain unpaid.

Dividend stoppers

So called "dividend stoppers" are often used to preserve the ranking of capital instruments by stopping payment of dividends or interest on a junior instrument when dividends or interest have not paid on a senior instrument. Under the new draft APS 111, dividend stoppers may be included in both Tier 1 and Upper Tier 2 capital instruments.

Cross-default

The new draft APS 111 explicitly prohibits all cross-default clauses.

Events of default

With the exception of the cross-default provisions discussed above, the current APS 111 does not prescribe the forms of event of default which are or are not acceptable in a capital instrument. The new draft APS 111 has clarified the APRA's stance in relation to events of default by prescribing that, for Tier 1 and Upper Tier 2 capital instruments, the only acceptable event of default is the winding up of the issuer.

Transition arrangements

The new draft APS 111 (or a revised version thereof) is expected to come into force from 1 January 2008. Any new instrument issued before and after 1 January 2008 which does not comply with the proposed changes set out above will not be eligible for inclusion in an ADI's capital base.

APRA is proposing transition arrangements for instruments currently in existence. Such instruments, where they do not comply with the new draft APS 111, may be recognised as eligible capital until such time as they are redeemed, repaid or converted.

Securitisation: APS 120

On 11 July 2007 APRA released its response to the submissions that it had received to its November 2006 draft of APS 120, along with a "final draft" of the new APS 120.

Submissions to APRA in relation to the final draft Prudential Standard are due by 10 August 2007.

In summary, some of the changes APRA has made in the revised draft are positive and address a number of the comments made in submissions to APRA on the November 2006 draft. Highlights include:

  • the introduction of a self-assessment regime for ADIs involved in securitisation;
  • the removal of the proposed requirement that an SPV must have its own separate personnel and a narrowing of the scope of the "originating ADI" concept;
  • changes made to the application of a maximum capital charge in relation to securitised pools;
  • a clarification of the requirements in relation to the replacement of ADIs providing facilities or services to an SPV;
  • a clarification of the treatment of cash collateral facilities;
  • the removal of the requirement for certain legal opinions to be obtained in connection with a securitisation; and
  • the simplification of the investor disclosure requirements for ADIs.

A number of new provisions have been inserted or provisions from the November 2006 draft retained which, if introduced without amendment, will present real challenges to ADIs involved in securitisation. Examples of these provisions include:

  • the limited transitional arrangements proposed by APRA;
  • the treatment of warehouse facilities;
  • the still expansive definition "originating ADI";
  • the new restrictions on threshold rate provisions;
  • the tightening of restrictions on clean-up calls; and
  • the prohibition on the subordination of servicing and management fees.

Our more thorough analysis of the new APS 120 is available here.

Standardised approach to credit and operational risk: APS 112 and APS 114

On 31 July 2007, APRA released two revised draft Prudential Standards: Prudential Standard APS 112 Capital Adequacy: Standardised Approach to Credit Risk and Prudential Standard APS 114 Capital Adequacy: Standardised Approach to Operational Risk, as well as an accompanying Response to Submissions.

While APRA will accept submissions in respect of the revised draft APS 112 and APS 114 made before 3 September 2007, it is intended that these Prudential Standards are "final drafts" which will come into force from 1 January 2008.

The key changes contained in the revised drafts APS 112 and APS 114 are set out below.

APS 112

The first draft APS 112 applied a risk-weighting of 100 percent to all loans secured by mortgages where those loans are past due for more than 90 days and/or impaired, regardless of whether or not those loans were the subject of lenders mortgage insurance.

Under the revised draft APS 112, APRA will allow such past due and/or impaired loans to retain their original risk weighting so long as the total of such loans insured by a single insurer does not exceed the ADI’s large exposures limit (as defined in APS 221).

APS 114

The first draft APS 114 required ADIs using the standardised approach to determine their operational risk exposure charge applicable to loans and advances for retail and commercial banking activities by aggregating the value of loans and advances across retail and commercial banking and multiplying that aggregate value by a factor (beta). The first draft APS 114 proposed a beta of 15 percent.

The revised draft APS 114 requires that ADIs calculate their operational risk exposure charge by dividing their business into three separate categories and applying a separate beta to loans and advances associated with each:

  • a beta of 12 percent will apply to retail banking
  • a beta of 15 percent will apply to commercial banking; and
  • a beta of 18 percent will apply to all other activity areas of business.

Market risk: APS 116

On 2 August 2007, APRA released a draft of Prudential Standard APS 116 Capital Adequacy: Market Risk, and an accompanying Discussion Paper. APRA intends that APS 116 will replace the existing Prudential Standard APS 113 Capital Adequacy: Market Risk. Submissions in respect of the draft APS 116 must be made before 5 September 2007.

The draft APS 116 imposes the following obligations on ADIs:

  • capital must be held against market risks – specifically against risks associated with positions allocated to the trading book and all foreign exchange and commodity risks
  • positions in financial instruments must be allocated to the trading book if those positions are held with "trading intent" or to hedge other trading book items
  • a framework for valuation of trading book positions must be maintained; and
  • approval must be sought from APRA where an ADI wishes to use its own risk measurement model (rather than APRA's standard model) for determining the amount of capital it must hold against market risk.

Also, under the draft APS 116, "lower-rated" government securities will no longer qualify for zero risk-weighting and the maximum charge for all lower-rated securities has been increased from 8 percent to 12 percent.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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