APRA_Basel III Discussion Paper_06092011

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Discussion PaperImplementing Basel III capital reorms in Australia6 September 2011

www.apra.gov.au

Australian Prudential Regulation Authority



Australian Prudential Regulation Authority 2

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Glossary

AASB 9 AASB 9 Financial Instruments

AASB 138 AASB 138 Intangible Assets

AASB 139 AASB 139 Financial Instruments: Recognition and Measurement

ADI Authorised deposit-taking institution

Advanced ADIsADIs approved to use the advanced Basel II approaches to measuring risk orcapital adequacy purposes

APRA Australian Prudential Regulation Authority

APS 110 Prudential Standard APS 110 Capital Adequacy

APS 111 Prudential Standard APS 111 Capital Adequacy: Measurement of Capital

APS 116 Prudential Standard APS 116 Capital Adequacy: Market Risk

APS 120 Prudential Standard APS 120 Securitisation

APS 330 Prudential Standard APS 330 Capital Adequacy: Public Disclosure of Prudential Information

Basel II FrameworkInternational Convergence of Capital Measurement and Capital Standards: A RevisedFramework, June 2006

Basel III‘Basel III: A global regulatory framework for more resilient banks and banking systems’,December 2010

Basel Committee Basel Committee on Banking Supervision

CCB Capital conservation buer

CET1 Common Equity Tier 1

DvP Delivery-versus-payment

G-20 Group o Twenty

GDP Gross domestic product

GRCL General reserve or credit losses

ICAAP Internal capital adequacy assessment process

IFRS 13 IFRS 13 Fair Value Measurement

IRB Internal ratings-based approach to credit risk

LGD Loss given deaultPCR Prudential Capital Requirement (previously Prudential Capital Ratio)

PD Probability o deault

PPG Prudential Practice Guide

PvP Payment-versus-payment

QIS Quantitative Impact Study

RBA Reserve Bank o Australia

SPV Special purpose vehicle

Standardised ADIsADIs using the standardised Basel II approaches to measuring risk or capitaladequacy purposes




Executive summary

Regulatory adjustments to capitalAPRA proposes to adopt the Basel III regulatoryadjustments to capital that are specied as minimumrequirements, with only minor exceptions. Basel IIItakes a stricter approach than APRA in requiringdeductions to be made rom Common Equity Tier 1.APRA proposes to adopt this approach and to removethe 50:50 deduction rule in line with Basel III.At the same time, APRA proposes to revise someaspects o its existing requirements that are moreconservative than the Basel III minimum requirements.

Specically, APRA proposes to align its treatment o expected dividends and o unrealised gains and lossesrecognised on the balance sheet with Basel III. Theonly exceptions to the Basel III minimum requirementswill be that APRA will continue to require capitalisedexpenses and capitalised transaction costs to bededucted rom capital; APRA will also take a moreconservative approach in removing the doublecounting o capital in the nancial system and oninvestments in commercial institutions.

The Basel III reorms also provide national supervisors

with discretion to provide limited recognitiono certain items in calculating Common EquityTier 1. These items are deerred tax assets relatingto ‘temporary’ (timing) dierences, signicantinvestments in the common shares o non-consolidated nancial institutions, and mortgageservicing rights. APRA does not propose to apply this‘threshold treatment’ but to require that these itemsbe deducted in ull rom Common Equity Tier 1.

In December 2010, the Basel Committee on BankingSupervision (Basel Committee) released a packageo reorms to raise the level and quality o regulatorycapital in the global banking system (Basel III).This discussion paper commences APRA’s publicconsultation on these Basel III capital reorms.

APRA seeks to ensure that its prudential capitalramework is consistent with global standards. APRAthereore proposes to adopt the minimum Basel IIIrequirements or the denition and measurement o capital except in certain areas where there are strong

in-principle reasons to continue APRA’s currentpolicies. Alignment will require APRA to take a stricterapproach than at present in some areas but a lessconservative approach in others.

The Basel III reorms also allow national supervisorsto adopt a concessional treatment or certain otheritems in determining regulatory capital. APRA doesnot propose to exercise this discretion. A principalobjective o APRA’s prudential capital ramework is toensure that, or the protection o depositors and thestability o the Australian nancial system, capital must

be available to absorb losses in a gone-concern scenario(or leading up to that point). In addition, APRA’sramework seeks to ensure that there is no double-counting o capital in the Australian nancial system.The concessional treatment would not be consistentwith these objectives. APRA thereore proposes to

retain its longstanding policies in these areas.

A summary o the key proposals is provided below.

Minimum capital requirements

APRA proposes to adopt the Basel III denition o regulatory capital, under which common equity is thepredominant orm o Tier 1 capital. In addition, APRAproposes to adopt the Basel III minimum requirementsor Common Equity Tier 1, Tier 1 and Total Capital,and the stricter eligibility criteria or Tier 1 and Tier 2capital instruments.




Capital conservation buerBasel III introduces a capital conservation buerdesigned to ensure that ADIs build up capital buersoutside periods o stress that can be drawn down aslosses are incurred. The capital conservation buer isin addition to the minimum Common Equity Tier 1requirement, and capital distribution constraintswill be imposed on an authorised deposit-takinginstitution (ADI) when its capital levels all withinthe buer range. APRA is proposing to add thecapital conservation buer to the Prudential Capital

Requirement (PCR) that it determines or eachADI, which may be at or above the Basel III minima.However, APRA will have regard to the cumulativeimpact o its capital requirements when determiningthe size o the capital conservation buer to apply toeach ADI.

Countercyclical buer

Basel III also introduces a countercyclical buerdesigned to ensure that banking system capitalrequirements take account o the macro-nancial

environment in which ADIs operate. It is intendedthat the buer be imposed, through an extension o the capital conservation buer, when excess aggregatecredit growth is judged to be associated with abuild-up o system-wide risk. APRA proposes tointroduce the countercyclical buer regime in linewith the Basel III reorms.

Leverage ratio

Basel III introduces a simple, transparent, non-riskbased leverage ratio to help contain the build-upo leverage in the banking system and to saeguardagainst model risk and measurement error. APRAproposes to introduce this measure in its prudentialcapital ramework in line with the Basel III reorms.

DisclosureTo improve the transparency o regulatory capitaland market discipline, Basel III introduces newprudential disclosure requirements or the Basel IIIcapital ramework. APRA proposes to consult on thesedisclosure requirements when the Basel Committeereleases more details.

Transitional arrangements

Basel III provides generous transitional arrangements

or the new Basel III capital requirements, in respecto minimum capital ratios, deductions and capitalinstruments.

In APRA’s view, ADIs in Australia are well placed tomeet the new requirements and APRA thereoreproposes to adopt an accelerated timetable in someareas. Under APRA’s proposals:

• ADIs will be required to meet the revisedBasel III minimum capital ratios and regulatoryadjustments in ull rom 1 January 2013;

•

APRA will adopt the Basel III phase-outarrangements or capital instruments that nolonger qualiy as Additional Tier 1 capital orTier 2 capital. APRA will require outstandingnoncomplying capital instruments to be phased-out no later than their rst available call date,where one exists;

• the capital conservation buer will apply in ullrom 1 January 2016. APRA is o the view that, withthe transition allowance or capital instrumentsthat no longer qualiy as Tier 1 and Tier 2 capital,

ADIs should be able to meet the combinedCommon Equity Tier 1 minimum requirement andthe capital conservation buer by that date;

• APRA will indicate in 2015 whether anycountercyclical buer will apply rom 1 January2016 and whether any phasing-in o that buer isnecessary; and

• APRA will introduce the leverage ratio on theBasel III timetable, which envisages this ratiomigrating to a Pillar 1 requirement on1 January 2018.




Consultation with industry and otherinterested stakeholders

APRA invites written submissions on its proposals toimplement the Basel III capital reorms in Australia.It encourages all interested stakeholders to usethis consultation opportunity to advise it o anyimplementation issues and to submit relevant cost-benet analysis inormation.

Following consideration o submissions received,APRA will issue drat prudential and reporting

standards and, where appropriate, prudential practiceguides (PPGs) or consultation in early 2012, so as toallow ADIs to prepare or the implementation o theBasel III reorms rom 1 January 2013.




1.1 OverviewIn its December 2010 document Basel III — A globalregulatory framework for more resilient banks andbanking systems, the Basel Committee released apackage o reorms to raise the level and quality o regulatory capital in the global banking system.1 Thiscomprehensive reorm package included measures:

• to raise the quality, consistency and transparencyo the capital base and harmonise other elementso capital;

• to improve the risk coverage o the Basel IIFramework2 by strengthening the capitalrequirements or counterparty credit riskexposures arising rom banks’ derivatives,repurchase and securities nancing activities;

• to promote the build-up o capital buers in goodtimes that can be drawn upon in times o stress;and

• to introduce a leverage ratio as a supplementarymeasure to the risk-based Basel II Framework tohelp contain the build-up o excessive leverage in

the banking system.

1 The December text is at: www.bis.org/bcbs/basel3.htm.2 International Convergence of Capital Measurement and Capital Standards: A

Revised Framework, Comprehensive Version (Basel II Framework) ound atwww.bis.org/publ/bcbs128.htm.

In a letter to ADIs on 17 December 20103

, APRAexpressed its ull support or the Basel III reorms andindicated its intention to consult on them in 2011 and2012. This discussion paper commences APRA’s publicconsultation on those measures relating to the quality,consistency and transparency o capital, capital buersand the leverage ratio. It does not address the Basel IIIcapital treatment o counterparty credit risk, which willbe the subject o separate consultation.4

The Basel Committee’s December 2010 documentprovides the rules text or the denition and

measurement o the minimum Basel III capitalrequirements. In the interests o internationalconsistency, APRA proposes to incorporate theserequirements into its prudential standards exceptin certain areas where there are strong in-principlereasons to continue APRA’s current approach. TheDecember 2010 document also provides a limiteddiscretion to national supervisory agencies to applya concessional treatment or certain items in themeasurement o capital. APRA does not intend toexercise this discretion (and currently excludes theseitems rom capital calculations), or reasons outlined inthis paper.

The Basel III reorms are global minimum capitalrequirements or internationally active banks.5 As withthe implementation o the Basel II Framework, however,APRA proposes to apply the capital requirements toall ADIs. In APRA’s view, the Basel III measures areprudentially sound, will improve the regulatory capitalramework or ADIs and, by ensuring that all ADIshave adequate, high quality capital, will strengthen theprotection available to depositors and the resilience o the Australian banking system as a whole.

3 www.apra.gov.au/adi/Publications/Pages/other-inormation-or-adis.aspx.

4 In June 2011, the Basel Committee announced that it had completedits review o the Basel III capital treatment or counterparty credit riskin bilateral trades. The review resulted in a minor modication o thetreatment proposed in the December 2010 document. Reer www.bis.org/publ/bcbs189.htm.

5 The application o the minimum Basel III requirements ollows theexisting scope o application set out in Part I o the Basel II Framework.

Reer paragraph 47 o the Basel III text and paragraph 9 o the Basel IIFramework.

Chapter 1 – Introduction

http://www.bis.org/bcbs/basel3.htm

http://www.bis.org/publ/bcbs128.htm

http://www.apra.gov.au/adi/Publications/Pages/other-information-for-adis.aspx









http://www.bis.org/bcbs/basel3.htm




APRA anticipates that, ollowing consideration o submissions received, it will undertake a secondconsultation in early 2012 on the detailed prudentialand reporting standards that will give eect to theBasel III capital reorms in Australia.

Continued application o the Basel II Framework

Under the Basel II Framework, APRA exercised anumber o discretions in relation to the scope o application, Pillar 1 calculations and adjustments torisk-weighted assets. APRA believes the rationale or

the exercise o those discretions is unchanged by theBasel III reorms and thereore APRA will continue toapply those discretions in the new prudential standards.Specically, the Basel III requirements will be applied atboth Level 1 and Level 2 unless APRA explicitly statesotherwise6; the capital charge or interest rate risk inthe banking book in Pillar 1 will continue to apply; andAPRA will maintain its current requirements or thedetermination o risk-weighted assets.

1.2 Structure o the paper

Chapter 2 outlines APRA’s proposals to implement therevised Basel III denition o capital, which requiresthe predominant orm o minimum Tier 1 capital tobe common equity, and the new minimum levels o regulatory capital. It also outlines APRA’s proposalsto ensure that all regulatory capital instruments arecapable o absorbing loss.

Chapter 3 outlines APRA’s proposed treatment o regulatory adjustments to capital and explains whyAPRA has chosen not to exercise its discretion toprovide a concessional treatment or certain capital

deductions.

6 Level 1 and Level 2 are dened in Prudential Standard APS 110 Capital Adequacy (APS 110).

Details o APRA’s proposals or implementation o the capital conservation buer, and the interactionbetween this buer and the PCR that APRA setsor each ADI, are set out in Chapter 4. Chapter 5provides details o the proposed leverage ratio whileChapter 6 addresses proposed revisions to disclosurerequirements or ADIs. APRA’s proposed transitionalarrangements are discussed in Chapter 7.

APRA encourages ADIs to submit cost-benetinormation as set out in Chapter 8.




The Basel III reorms introduce a denition o regulatory capital that gives greater weight tocommon equity than has applied under the Basel IIFramework. Basel III also strengthens the criteria orinclusion o other instruments in Tier 1 and Tier 2capital and takes a stricter approach to regulatorycapital adjustments than Basel II. This chapter setsout APRA’s proposals to implement these Basel IIIrequirements.

2.1 Defnition o capital

A key element o the Basel III reorms is the greaterocus on common equity, the highest qualitycomponent o capital. Under the revised Basel IIIdenition o capital, total regulatory capital consistso the sum o the ollowing elements:

• Tier 1 capital (going-concern capital), comprising:

– Common Equity Tier 1;

– Additional Tier 1; and

• Tier 2 capital (gone-concern capital)

Under Basel III, the revised elements o capital are neto the associated regulatory adjustments (discussed inChapter 3) and are subject to the ollowing new limitsand minima:

• Common Equity Tier 1 must be at least 4.5 percent o risk-weighted assets at all times;

• Tier 1 capital must be at least six per cent o risk-weighted assets at all times; and

• Total Capital (Tier 1 capital plus Tier 2 capital)must be at least eight per cent o risk-weighted

assets at all times.

Under the current Prudential Standard APS 111 Capital Adequacy: Measurement of Capital (APS 111) 7, APRAemploys a capital classication ramework derivedrom the Basel II Framework. Total regulatory capitalconsists o:

• Tier 1 capital, comprising:

– Fundamental Tier 1;

– Residual Tier 1 (comprising innovative andnon-innovative capital); and

• Tier 2 capital, comprising:

– Upper Tier 2; and

– Lower Tier 2.

Within this ramework:8

• Tier 1 capital must be at least our per cent o risk-weighted assets at all times;

• Total Capital (Tier 1 capital plus Tier 2 capital)must be at least eight per cent o risk-weightedassets at all times;

• Tier 2 capital cannot exceed Tier 1 capital; and

• Lower Tier 2 capital cannot exceed 50 per cent o Tier 1 capital.

APRA proposes to replace the current componentso capital and the related ratios and limits in APS 111with the Basel III denitions, limits and minima orregulatory capital.

2.1.1 Common Equity Tier 1

Under Basel III, common equity is recognisedas the highest quality component o capital. It is

subordinated to all other elements o unding, absorbslosses as and when they occur, has ull fexibility o dividend payments and has no maturity date. It is theprimary orm o unding that helps ensure that ADIsremain nancially sound.

7 Paragraphs 6(a) and 6(b).

8 Tier 1, Tier 2 and Total capital are net o all specied deductions andamortisation as specied in APS 111.

Chapter 2 – Minimum capital requirements




The Basel III denition o Common Equity Tier 1 iscomprised o the ollowing elements:

• common shares;

• share premium;

• retained earnings;

• accumulated other comprehensive income;

• other disclosed reserves;

• minority interests (subject to certain criteriaoutlined in Appendix 5); and

• regulatory adjustments applied in the calculationo Common Equity Tier 1.

APRA proposes to adopt the Basel III denition o Common Equity Tier 1 to replace the concept o ‘Fundamental Tier 1’ in APS 111 paragraph 18(a). Therequirements or Fundamental Tier 1 already refectmost o the Basel III requirements or Common EquityTier 1. The proposed APRA denition o CommonEquity Tier 1 will refect other additional Basel IIIrequirements, such as more detailed criteria or theclassication o common shares.

Appendix 1 sets out the proposed criteria orclassication as common shares or regulatory capitalpurposes.

In calculating Common Equity Tier 1, Basel III takesa less conservative approach than APRA to thetreatment o two particular items:

• expected dividends; and

• unrealised gains and losses.

Consistent with its objective o introducing the

Basel III minimum capital requirements except wherethere are strong in-principle reasons not to do so,APRA is proposing to bring its treatment o these twoitems into line with Basel III.

Expected dividendsBasel III provides or dividends to be removed romCommon Equity Tier 1 ‘in accordance with applicableaccounting standards’. In practice, this means thatdividends are to be deducted when declared, whichis usually ater balance date. APS 111 adopts a moreconservative approach, which requires expectedcurrent year dividends (net o an allowance ordividend reinvestment) to be deducted rom retainedearnings when determining Tier 1 capital. SinceBasel III introduces higher minimum common equity

requirements and a capital buer that automaticallyrestricts dividend payments when capital levelshave been diminished, APRA proposes to adopt theBasel III treatment o dividends. That is, dividends willbe deducted rom retained earnings only ater theyhave been declared.

Unrealised gains and losses

Basel III allows all unrealised gains and lossesrecognised on the balance sheet to be included in thedetermination o Common Equity Tier 1. In contrast,

APRA’s current treatment o unrealised gains andlosses (excluding loans) allows:

• 100 per cent o liquid ‘held or trading’ unrealisedgains and losses to be included in FundamentalTier 1; and

• 45 per cent o unrealised pre-tax gains and lossesin specied reserves to be included in Upper Tier2 capital, subject to meeting specic eligibilitycriteria.

APRA proposes to amend its current approach to alignwith Basel III. That is, APRA proposes to ollow theBasel III approach to allow unrealised gains and lossesto be included in determining Common Equity Tier 1.9

9 The items previously included in APS 111 paragraphs 24 (h) and (i) willno longer be recognised in Tier 2 capital.




The reliability and robustness o air values are crucialor capital adequacy purposes. APRA proposes thatAPS 111 will retain its requirements relating to therecognition o air values. Moreover, to ensure thatthere is adequate transparency about the proportiono regulatory capital that comprises unrealised gainsand losses, ADIs will be subject to additional reportingrequirements, which will help APRA to monitor theimpact o AASB 9 Financial Instruments (AASB 9) (whenit comes into eect)10 and the use o air values.Appendix 2 provides urther details on these reportingrequirements, which will be additional to thoserequired under IFRS 13 Fair Value Measurement (IFRS13)disclosures.11

The Basel Committee is continuing to review thetreatment o unrealised gains and losses, taking intoaccount the evolution o the accounting ramework.APRA may amend its proposals should the outcomeo this review lead to changes in the treatment o air value adjustments in the calculation o CommonEquity Tier 1.

Criteria or common shares or mutually owned ADIs

The criteria or classication as common shares inCommon Equity Tier 1 is intended to apply to all ADIs,including mutually owned ADIs, taking into accounttheir specic constitutional and legal structure.Basel III provides some scope or instruments otherthan ‘common shares’ to be recognised as part o Common Equity Tier 1. The Basel III rules text statesthat ‘the application o the criteria should preserve thequality o the instruments by requiring that they aredeemed ully equivalent to common shares in terms o their capital quality as regards loss absorption and do

not possess eatures which could cause the conditiono the bank to be weakened as a going concern duringperiods o market stress.’

10 AASB 9 is scheduled to come into eect or annual reporting periodsbeginning on or ater 1 January 2015.

11 IFRS 13 is eective or annual reporting periods beginning on or ater1 January 2013.

There are a number o mutually owned ADIs thathave issued instruments currently qualiying as Tier1 capital. APRA invites submissions rom these ADIsas to whether the eatures o the instruments willcomply with the criteria or Common Equity Tier 1(or Additional Tier 1 criteria, set out in section 2.1.2below). APRA also invites submissions more generallyon how new capital instruments issued by mutuallyowned ADIs could be deemed to be the equivalent o common shares (or Additional Tier 1 capital) in termso their capital quality and loss absorption.

2.1.2 Additional Tier 1 Capital

The Basel III denition o Additional Tier 1 capital

comprises the ollowing elements:

• instruments issued by an ADI that meet thecriteria or inclusion in Additional Tier 1 capitaland are not included in Common Equity Tier 1.Appendix 3 provides the criteria or inclusion inAdditional Tier 1 capital;

• share premium/stock surplus resulting rom theissue o instruments included in Additional Tier 1capital;12

• instruments issued by consolidated subsidiaries o the ADI and held by third parties that meet thecriteria or inclusion in Additional Tier 1 capitaland are not included in Common Equity Tier 1(subject to criteria outlined in Appendix 5); and

• regulatory adjustments applied in the calculationo Additional Tier 1 capital.

12 Share premium that is not eligible or inclusion in Common EquityTier 1 will only be permitted to be included in Additional Tier 1 capital

i the shares giving rise to the share premium are permitted to beincluded in Additional Tier 1.




APRA supports the principle that non-common equityelements included in Tier 1 capital must be able toabsorb losses while the ADI remains a going concern.To be considered loss absorbent on a going-concernbasis, all instruments included in Additional Tier 1 willneed to be subordinated, have ully discretionary non-cumulative dividends or coupons and have neither amaturity date nor an incentive to redeem.

APRA proposes that an instrument issued by an ADImust meet the Basel III minimum set o criteria to beincluded in Additional Tier 1 capital, as provided in

Appendix 3. Signicant changes rom the currentAPS 111 requirements are the ollowing:

• the provisions currently in APS 111 Attachment Aallowing hybrid instruments in innovative Tier 1capital will be removed;

• ‘innovative’ eatures such as step-ups or otherincentives to redeem, which over time haveeroded the quality o Tier 1, will not be allowed;

• although Additional Tier 1 capital instrumentsmay be callable by the ADI ater a minimum o

ve years rom the date o issue, the ADI must notcreate an expectation that a call will be exercised.Additionally, any call must not be exercised unlessthe ADI replaces the called instrument withcapital o the same or higher quality or the ADIdemonstrates to APRA that its capital positionwill be well above its PCR ater a call option isexercised;

• Additional Tier 1 capital instruments must meetthe non-viability requirements (see also section2.2); and

• Additional Tier 1 capital instruments classiedas liabilities or accounting purposes must haveprincipal loss absorption through a conversionor write-down mechanism that allocates lossesto holders. APRA proposes that write-down orconversion be triggered when the issuing ADI’sconsolidated (i.e. Level 2) Common Equity Tier1 ratio is at or below 5.125 per cent.13 This is thelowest level at or below which any distributionson Tier 1 instruments under the capitalconservation buer regime are prohibited in theBasel III reorms.

APRA proposes that stapled securities may be eligibleor inclusion as Additional Tier 1 capital where theymeet the relevant criteria or such capital, includingthe loss absorption provisions (set out in section 2.2).

Payments on Additional Tier 1 instruments will beconsidered a distribution o earnings under theproposed capital conservation buer regime (seeChapter 4). This will improve their loss absorbency ona going-concern basis by increasing the likelihood thatdividends and coupons will be reduced or cancelled

in times o stress as a result o the restrictions ondistributions that apply through the application o thecapital conservation buer requirements.

13 Where an ADI is a stand-alone entity and is not part o the Level 2

group, the applicable benchmark will be the Level 1 Common EquityTier 1 ratio.




2.1.3 Tier 2 capitalThe Basel III denition o Tier 2 capital comprises theollowing elements:

• instruments issued by an ADI that meet thecriteria or inclusion in Tier 2 capital and are notincluded in Tier 1 capital. Appendix 4 providesthe criteria or inclusion in Tier 2 capital;

• share premium/stock surplus resulting rom theissue o instruments included in Tier 2 capital;14

• instruments issued by consolidated subsidiaries o

the ADI and held by third parties that meet thecriteria or inclusion in Tier 2 capital and are notincluded in Tier 1 capital (subject to the criteriaoutlined in Appendix 5);

• certain loan loss provisions (see below); and

• regulatory adjustments applied in the calculationo Tier 2 capital.

The objective o Tier 2 capital is to provide lossabsorption on a gone-concern basis. APRA supportsthis objective and proposes to simpliy the Tier 2

ramework in APS 111 in line with the Basel III criteria.The current categories o ‘Upper’ and ‘Lower’ Tier2 will be removed and one set o criteria or eligibleinstruments is proposed (reer to Appendix 4).

Tier 2 capital instruments will need to meet theminimum criteria o being subordinated to depositorsand general creditors and having an original maturity o at least ve years. Recognition in regulatory capital willbe amortised on a straight-line basis during the nalve years to maturity. An ADI will not be allowed toexercise a call (ater ve years) unless the instrument

is replaced with capital o the same or better qualityor the ADI demonstrates to APRA that its capitalposition will be well above its PCR ater the call optionis exercised. APS 111 will be revised to refect theseminimum Basel III criteria.

14 Share premium that is not eligible or inclusion in Tier 1 will only be

permitted to be included in Tier 2 i the shares giving rise to the sharepremium are permitted to be included in Tier 2 capital.

General reserve or credit losses (GRCL) or ADIsusing the standardised approach to credit risk

For ADIs using the standardised approach to creditrisk, Basel III allows general provisions/general loanloss reserves in Tier 2 capital. APS 111 currentlyprovides that a general reserve or credit losses heldagainst uture, but presently unidentied, losses thatis reely available to meet losses that subsequentlymaterialise qualies or inclusion in Tier 2. Provisionsascribed to identied deterioration o particular assetsor known liabilities, whether individual or grouped,

are to be excluded. Under Basel III, the amount o any loan loss reserve eligible or inclusion in Tier 2is limited to a maximum o 1.25 percentage pointso credit risk-weighted assets calculated under thestandardised approach. APS 111 paragraph 24(g)(i)currently limits the GRCL to 1.25 percentage pointso total risk-weighted on- and o-balance sheet assets.APRA proposes to amend APS 111 to base the eligiblelimit or the GRCL on credit risk-weighted assets, inline with Basel III.

Excess o total eligible provisions under the advanced

internal ratings-based (IRB) approach to credit risk

Under Basel III, ADIs using the advanced IRB approachto credit risk may recognise the dierence betweenthe amount o any loan loss reserve and expectedlosses (i.e. any provisions in excess o expected losses)in Tier 2 capital, up to a maximum o 0.6 per cent o credit risk-weighted assets. At national discretion, alimit lower than 0.6 per cent may be applied. APS 111paragraph 24(g)(ii) already implements the Basel IIIrequirement and APRA does not propose exercising itsdiscretion to lower the 0.6 per cent limit.




2.1.4 Criteria or inclusion in consolidatedcapital – minority interest and other capitalissued by consolidated subsidiaries held by thirdparties

Under Basel III, minority interest arising rom theissue o common shares by an ADI’s subsidiary may beincluded in the ADI’s consolidated Common EquityTier 1 only i:

• the issuing subsidiary is itsel an ADI (or overseasequivalent); and

• the issue meets the Basel III criteria or commonshares (set out in Appendix 1).

Further, the amount that can be included is reducedby the surplus Common Equity Tier 1 o the subsidiaryattributable to the minority shareholders, calculated asset out in Appendix 5.

The Basel III requirement is more restrictivethan APRA’s current requirement, which allowsrecognition in Fundamental Tier 1 capital at Level 2o the ull amount o minority interests arising romconsolidation o common equity capital issued tothird parties by subsidiaries consolidated in theLevel 2 group.

Basel III also allows Additional Tier 1 and Tier 2capital instruments issued to third-party investors byconsolidated subsidiaries to be included in the Tier 1and Tier 2 capital o the consolidated banking group(Level 2). This is on the basis that the instrumentsmeet the criteria or classication as regulatorycapital (set out in Appendices 3 and 4, respectively).The amount that can be included is reduced by thesurplus capital o the subsidiary attributable to third-party investors in the Additional Tier 1 and Tier 2instruments. Appendix 5 sets out how the amountthat can be recognised is calculated.

APRA currently allows an ADI to include in ull allother eligible Tier 1 and Tier 2 capital instrumentsissued by consolidated subsidiaries in the ADI’s Level2 capital i all the criteria or inclusion have been met,unless APRA specically requires them to be excluded.APRA may exclude a capital instrument i it assessesthat the instrument does not, in substance, representa genuine contribution to the nancial strength o theADI. This might be, or instance, where the instrumenthas been unded (directly or indirectly) or guaranteedby another member o the Level 2 group.

APRA proposes to adopt the Basel III approach tolimit the recognition o minority interests associatedwith common shares and Additional Tier 1 and Tier2 capital instruments o consolidated subsidiariesheld by third parties. The allowable amount would becalculated in accordance with the approach set out inAppendix 5.

2.1.5 Criteria or inclusion in consolidatedcapital – capital issues involving use o specialpurpose vehicles (SPVs)

Under Basel III, capital instruments issued to thirdparties out o SPVs cannot be included in CommonEquity Tier 1. This is consistent with APRA’s currentrequirements or Fundamental Tier 1 capital.

Basel III permits recognition o Additional Tier 1and Tier 2 capital instruments issued to third partiesthrough an SPV subject to the conditions that:

• the instruments (between the ADI and the SPVand between the SPV and investors) ully meetthe relevant entry criteria or the level o capital;

• the only asset o the SPV is its investment in thecapital o the ADI; and

• issue proceeds are readily accessible to anoperating entity or the holding company withinthe consolidated group.

These conditions are essentially included in APRA’scurrent requirements, set out in Attachment C o APS 111. However, some amendments will be requiredto Attachment C to align APRA’s requirements withthose o Basel III in relation to, or instance, the newentry criteria or each level o capital.




2.2 Loss absorbency o regulatorycapital at the point o non-viability

During the global nancial crisis, a number o distressed international banks were rescued bythe injection o public sector unds in the orm o common equity and other orms o Tier 1 capital.This had the eect o supporting not only depositorsbut also investors in regulatory capital instruments.Consequently, Tier 2 capital instruments (mainlysubordinated debt), and in some cases AdditionalTier 1 instruments, did not absorb losses incurred by

banks that would have ailed had the public sector notprovided support.

In response to this outcome, the Basel III reormsrequire that all regulatory capital instruments (i.e. allAdditional Tier 1 and Tier 2 instruments) must becapable o bearing loss. In particular, a public sectorinjection o capital needed to avoid the ailure o anADI should not protect investors in regulatory capitalinstruments rom incurring the loss that they wouldhave suered had the public sector not chosen tointervene. To achieve this objective, the criteria or

inclusion in regulatory capital have been enhanced toensure that all regulatory capital instruments issued byADIs are capable o absorbing losses in the event thatan ADI is unable to support itsel in the market place.

2.2.1 Application

APRA proposes that the Basel III non-viabilityrequirements outlined below will be required to beincluded in the terms o all Additional Tier 1 andTier 2 instruments (with additional requirements orADIs operating as part o wider consolidated groups

– see section 2.2.3). APRA proposes that theserequirements must be incorporated in the contractualterms and conditions o each instrument eligible asregulatory capital rom 1 January 2013. (Section 7.2.3outlines the treatment o instruments that do notmeet the eligibility criteria or regulatory capital ater1 January 2013).

2.2.2 Non-viability requirements

Write-o as deault provision

Basel III requires that the terms and conditions o all Additional Tier 1 and Tier 2 instruments issuedby ADIs provide or such instruments to be eitherwritten-o or converted into common equity uponthe occurrence o a trigger event. APRA proposesthat all Additional Tier 1 and Tier 2 instruments mustcontain a deault provision that the instrument willbe ully written-o upon the occurrence o a trigger

event. As an alternative, but only with APRA approvalat the time o issue, ADIs may instead elect to includea provision providing or conversion o the instrumentinto common equity upon the occurrence o a triggerevent. Conversion cannot be into unlisted equity.

Trigger event

APRA is proposing to adopt the Basel III denitiono a trigger event. That is, a capital instrument willbe written o or converted into listed equity at theearlier o:

• a decision that a write-o (or, where applicable,conversion), without which the ADI wouldbecome non-viable, is necessary, as determinedby APRA; and

• the decision to make a public sector injection o capital, or equivalent support, without which theinstitution would have become non-viable, asdetermined by APRA.




ConversionUnder APRA’s current requirements, capitalinstruments converting into ordinary shares mustinclude a maximum conversion ratio, which is setbased on 50 per cent o the ordinary share price at thetime o issue. The Basel III proposals do not provideor an explicit conversion limit; however, APRAremains o the view that a limit is necessary to enablean ADI to readily quantiy the maximum dilution andto ensure that it has prior shareholder approval or anyuture issue o the required number o shares. APRA

proposes to replace the current maximum conversionratio based on 50 per cent o the ordinary share priceat the time o issue with one based on 20 per cent o the ordinary share price at the time o issue. Whereinstruments are to convert to common equity, APRAproposes that ADIs will be required to maintain allprior authorisations necessary to immediately issuethe relevant number o shares to eect conversion,as specied in the instrument’s terms and conditions,should the trigger event occur.

2.2.3 Group treatment

APRA proposes that, where an issuing ADI is asubsidiary o a wider banking group regulated byAPRA and the ADI or its parent wishes the instrumentto be included in the capital o the consolidated Level2 group, the terms and conditions must speciy awrite-o or conversion event that can be triggered byAPRA. This additional trigger event is the decision tomake a public sector injection o capital, or equivalentsupport, in the APRA-regulated ADI or its parent,without which the ADI or its parent would havebecome nonviable, as determined by APRA.

Furthermore:

• i the instrument converts into common shares,conversion must be into the common shares o alisted parent institution; and

• any supervisor o the subsidiary must not be ableto impede APRA’s right to trigger conversion orwrite-o o the instrument.

Where the APRA-regulated ADI is a subsidiary o another institution that is not regulated by APRA, i theinstrument is to be recognised as capital under APRA’sprudential requirements it must, in addition to theconversion trigger event required above, provide that:

• any supervisor o the parent entity cannot impedeAPRA’s right to require write-o or conversion inrelation to the APRA-regulated institution; and

• any right o write-o or conversion by the parentsupervisor must generate Common Equity Tier 1in the Australian institution and must not lead tothe issuance o unlisted equity by the Australianinstitution.




Under Basel III, a number o regulatory adjustmentsare applied to regulatory capital — in most cases,to Common Equity Tier 1. Basel III also providesdiscretion to apply a ‘threshold treatment’ to givelimited recognition to certain items in CommonEquity Tier 1. In addition, Basel III applies a risk-weightat 1250 per cent to certain exposures that werepreviously 50:50 deductions rom Tier 1 and Tier 2under the Basel II Framework.

3.1 Adjustments to Common Equity

Tier 1Basel III requires the ollowing to be deducted in ullrom Common Equity Tier 1:

• goodwill and other intangibles;15

• deerred tax assets other than deerred tax assetsthat arise rom ‘temporary’ (timing) dierences;

• cash fow hedge reserve;

• shortall o the stock o provisions to expectedlosses;16

• gain on sale related to securitisation transactions;• cumulative gains and losses due to changes in

own credit risk on air valued nancial liabilities;

• dened benet pension und assets;

• investments in own shares (treasury stock); and

• reciprocal cross holdings in the capital o banking,nancial and insurance entities.

APRA’s current approach in APS 111 requires thededuction o many o the items listed above. However,

some amendments to APS 111 will be required toalign APRA’s requirements ully with Basel III. Theseamendments are outlined below.

15 The deduction o mortgage servicing rights is subject to the threshold

treatment.16 For ADIs approved to use advanced IRB approaches to credit risk.

3.1.1 Deductions already included in APS 111APRA proposes to adopt the Basel III principle thatregulatory deductions should be made rom CommonEquity Tier 1. The rationale is that, i an element o thebalance sheet is o insucient quality to be includedin the calculation o regulatory capital, then it is notappropriate or it to be included in Common EquityTier 1. APRA proposes that the ollowing deductionscurrently required rom Tier 1 capital under APS 111 willbe required to be made rom Common Equity Tier 1:

• goodwill and other intangibles;

• deerred tax assets;17

• cash fow hedge reserve;

• shortall o the stock o provisions to expectedlosses (or advanced ADIs);

• gain on sale related to securitisation transactions;

• cumulative gains and losses due to changes inown credit risk on air valued nancial liabilities;

• dened benet pension und surpluses; and

• all holdings o the capital o banking, nancial andinsurance entities.

APRA’s denition o ‘intangibles’ includes capitalisedexpenses and capitalised transactions costs (seeAPS 111 Attachment D, paragraphs 9 and 10). APRA isnot proposing to change this denition.

17 Including or timing dierences, as discussed in section 3.2.1.

Chapter 3 – Regulatory adjustments to capital




3.1.2 Dierences between Basel III deductionsand APS 111

For some other items, the adjustments to regulatorycapital in APS 111 are dierent in certain elementsrom Basel III. For the reasons set out below, APRAproposes to maintain the dierence in approach withrespect to certain elements o:

• investments in own shares (treasury stock); and

• investments in the capital o banking, nancialand insurance institutions that are outside the

scope o regulatory consolidation.

Investments in own shares

Basel III requires an ADI to deduct investments inits own common shares, Additional Tier 1 and Tier2 capital rom the corresponding tier o capital, toavoid the double-counting o the ADI’s own capital.It also requires deduction o any instruments that anADI could be contractually obliged to purchase. Thededuction applies to investments in the banking andtrading book. Gross long positions may be deducted

net o short positions in the same underlying exposureonly i the short positions involve no counterparty risk.Further, Basel III requires deduction o exposures toown shares through holdings o index securities. APRAinvites submissions on the practical consequences o alookthrough approach to index securities.

APS 111 currently requires ADIs to deduct (rom theappropriate tier o capital) all holdings o their owncapital instruments, unless exempted by APRA. Hence,APRA’s approach is broadly in line with Basel III.However, it diers in two particular respects. Firstly,APS 111 also requires deduction rom capital o any unused trading limit in own capital instrumentsagreed with APRA. Secondly, or holdings o capitalinstruments by other group members, APS 111 allowsinclusion in capital o two types o holding: thoseunded by third-party investors (such as lie insurancepolicyholders) and those included in employee share-based remuneration schemes. APRA is o the view thatthese holdings are in eect third-party investmentsand do not confict with the Basel III objective o avoiding the double-counting o capital. APRA doesnot thereore propose to remove these exemptions.

Investments in the capital o banking, fnancial andinsurance institutions that are outside the scope o regulatory consolidation

Under Basel III, investments in banking, nancial andinsurance institutions that are outside the scope o

regulatory consolidation (non-consolidated nancialinstitutions) include:

• direct, indirect and synthetic holdings o capitalinstruments. ADIs should look through holdingso index securities to determine their underlyingholdings o capital;

• holdings in both the banking book and tradingbook; and

• underwriting positions held or more than veworking days.




I the capital instrument does not meet the criteriaor regulatory capital o the ADI, the capital is to beconsidered common shares or deduction purposes. Inthe case o index securities, national authorities maypermit ADIs to use a conservative estimate i ADIsnd it operationally burdensome to look through andmonitor their exact exposures to the capital o othernancial institutions.

The Basel III treatment o these investments dependson their size and their nature. In particular, Basel IIIdistinguishes between investments on the basis o

signicance. ‘Signicant investments’ are dened asinvestments that are more than 10 per cent o theissued common share capital o the non-consolidatednancial institution.

Under Basel III, signifcant investments in non-consolidated nancial institutions that are notcommon shares must be ully deducted rom capital,using a ‘corresponding deduction approach’. Thismeans that the deduction is applied to the same tiero capital or which the capital would qualiy i it wereissued by the ADI itsel. Where deduction is required

rom a particular tier o capital but the ADI does nothave enough o that tier to satisy the requirement,the shortall will be deducted rom the next higher tiero capital.

Signicant investments in the common shares o non-consolidated nancial institutions are subject to thethreshold treatment described in section 3.2 below.

Under Basel III, insignifcant investments in non-consolidated nancial institutions that in aggregateexceed 10 per cent o the ADI’s common equity mustbe deducted rom capital, using the corresponding

deduction approach. Amounts below 10 per cent, whichare not deducted, will continue to be risk-weighted inaccordance with the prudential requirements or creditrisk (or investments in the banking book) or marketrisk (or trading book investments).

APRA’s current requirements do not make the Basel IIIdistinction between signicant and insignicantinvestments in non-consolidated nancial institutionsbut at Level 1 and Level 2, they do require deduction(50 per cent rom Tier 1 and 50 per cent rom Tier 2capital)18 or:

• all investments in other ADIs’ capital instruments,unless held or trading purposes;19

• investments in capital instruments o non-consolidated subsidiaries whether regulated orunregulated;

• signicant minority investments (being between20 and 50 per cent o voting shares) in othernancial institutions, including insurers;20 and

• investments in capital instruments o non-consolidated nancial institutions, includingequity holdings under 20 per cent, in respect o the excess o any individual investment above0.15 per cent o the ADI’s capital base (at Level 2)or the excess o the aggregate o individualinvestments (including equity held in commercial

enterprises) below 0.15 per cent o the ADI’scapital base that is above ve per cent o theADI’s capital base, beore deductions.

Individual investments below those limits are risk-weighted at 300 per cent (i listed) or 400 per cent(i unlisted).

18 As provided under the Basel II Framework.19 Unless the subsidiary acts as a holding company or pass-through o

exposures and other capital investments in subsidiary ADIs or equivalentoverseas deposit-taking institutions. Holdings by a subsidiary holdingcompany in subsidiaries not eligible or consolidation must be deductednet o the value o the holding company’s investment in any consolidatedsubsidiary ADI or equivalent overseas deposit-taking institution.

20 For investments o more than 50 per cent, intangibles, post-acquisitionprots and reserves are deducted rom Tier 1 while net tangible assets

are deducted 50:50 rom Tier 1 and Tier 2 capital. For investments ininsurers, value o business in orce (VBIF) must be deduced rom Tier 1.




The rationale or APRA’s longstanding requirementto deduct investments in non-consolidated nancialinstitutions is to avoid the double-counting o capitalin the nancial system and to address the heightenedsystemic risk posed by such cross-holdings.21 Capitalcannot be used more than once, and APRA’sdeductions rule ensures that when capital absorbsa loss at one nancial institution, this does notimmediately result in a loss o regulatory capital in anADI that has invested that capital. Accordingly, APRAdoes not support allowing any such investments incapital calculations, whether signicant or otherwise.

APRA thereore proposes to continue to requireull deduction o investments in non-consolidatednancial institutions but to replace the current 50:50deduction rom Tier 1 and Tier 2 with the Basel IIIcorresponding deduction approach described above.22 This deduction would include:

• all investments in non-consolidated nancialinstitutions (as dened in Basel III) in the bankingbook;

• the net long position (as dened in Basel III)23

o all investments in non-consolidated nancialinstitutions in the trading book; and

• underwriting positions held or more than veworking days.

Consistent with the principle o avoiding double-counting and to simpliy capital calculations, APRAproposes to remove the exemptions, described above,currently provided or small individual investments.

21 The Basel Committee’s Consultative Document Strengthening theresilience of the banking sector, December 2009, paragraph 101 supportsthis rationale, noting that deduction will ‘increase the resilience o the banking sector to nancial shocks and reduce system risk andprocyclicality’.

22 For Additional Tier 1 instruments held in the banking book, this will bea stricter approach than under Basel III but is a less strict approach orTier 2 instruments.

23 The net long position is dened as the gross long position net o shortpositions in the same underlying exposure where the maturity o theshort position either matches the maturity o the long position or has a

residual maturity o at least one year. Reer paragraph 80 o the Basel IIItext.

ADIs are invited to make submissions as to whetherrequiring ADIs to look through holdings o indexsecurities to determine their holdings o investmentsin non-consolidated nancial institutions would beoperationally burdensome.

Basel III provides national supervisors with thediscretion to exclude temporarily investments madein the context o resolving or providing nancialassistance to reorganise a distressed nancialinstitution. APRA intends to exercise this discretion inappropriate circumstances.

At Level 1, where other ADIs or APRA-regulatedinstitutions, or their equivalent overseas institutions,are wholly owned or eectively controlled (directlyor indirectly) by the ADI and have been consolidatedwith the ADI at Level 2 or capital adequacy purposes,equity exposures and capital instruments held insuch subsidiaries are risk-weighted at 400 per cent inAPS 111. APRA proposes to retain this requirement.

3.2 Threshold deductions

Basel III allows limited recognition o three assetitems when calculating Common Equity Tier 1.These items are:

• deerred tax assets relating to ‘temporary’(timing) dierences;

• signicant investments in the common shares o non-consolidated nancial institutions; and

• mortgage servicing rights.

Supervisors have the discretion to allow recognitiono each o these items up to 10 per cent o the ADI’s

common equity, and up to a total o 15 per cent orthe three items in aggregate. Amounts above theselimits must be deducted rom Common Equity Tier 1;amounts not deducted are to be risk-weighted at250 per cent.

APRA does not propose to exercise this discretion.




3.2.1 Deerred tax assets or temporarydierences

Basel III applies a split treatment or deerred taxassets. Deerred tax assets that rely on the utureprotability o the ADI to be realised are to bededucted in the calculation o Common Equity Tier 1(see section 3.1 above). Deerred tax assets may benetted with associated deerred tax liabilities only i the deerred tax assets and liabilities relate to taxeslevied by the same taxation authority and osetting ispermitted by the relevant taxation authority. However,

deerred tax assets relating to temporary dierencesare eligible or the concessional treatment outlinedabove. Such assets arise rom the dierences betweenthe carrying amount o an asset and its tax base.For example, an ADI may recognise provisions orpotential losses on loans in determining tax amountsand net prots in its published nancial statementsbut the taxation authority may not recognise suchprovisions until sometime in the uture; this deerredtax asset represents the ‘early recognition’ o potentialloan losses.

Under longstanding policy, APRA requires all deerredtax assets (net o deerred tax liabilities) to bededucted rom capital. The deduction is rom Tier 1capital, except or deerred tax assets associatedwith collective provisions eligible or inclusion in theGeneral Reserve or Credit Losses, which are in eectdeducted rom Tier 2 capital. In Australia, deerredtax assets, whatever their origin, rely on the utureprotability o the ADI to be realised and are notavailable to absorb losses on a gone-concern basis.

APRA is aware that, in some jurisdictions, deerred

tax assets do not rely on the uture protability o the banking institution and are, in eect, treated likereceivables rom the local taxation authority. Thisis not the case in Australia. APRA is also o the viewthat prudential capital requirements should be keptseparate rom a jurisdiction’s tax regime.

Hence, APRA retains its view that deerred tax assetscannot be included in the calculation o regulatorycapital and it does not intend to allow limitedrecognition o deerred tax assets or temporarydierences. APRA proposes to require all deerredtax assets (net o deerred tax liabilities), includingthose arising rom temporary dierences, to be ullydeducted rom Common Equity Tier 1.

3.2.2 Signifcant investments in the commonshares o non-consolidated fnancial entities

Basel III requires signicant investments in thecommon shares o non-consolidated nancialinstitutions to be ully deducted rom an ADI’scapital i these investments exceed 10 per cento the ADI’s common equity. However, amountsbelow this threshold may receive recognition whencalculating Common Equity Tier 1, with a risk-weighto 250 per cent.

As noted in section 3.1 above, APRA’s longstandingpolicy requires all investments in the capital o non-consolidated nancial institutions (except or an

exemption or small investments) to be deductedrom an ADI’s capital so as to avoid double-countingin the nancial system. APRA sees no prudential basisor distinguishing between investments in commonequity and investments in other capital instruments,whether signicant or insignicant. Accordingly, itdoes not propose to exercise its discretion in thisarea. APRA proposes that all signicant investments innon-consolidated nancial institutions, whether in theorm o common equity or other capital instruments,be deducted rom capital, using the correspondingdeduction approach described above.




3.2.3 Mortgage servicing rightsMortgage servicing rights are servicing contracts ona portolio o mortgage loan receivables. They arecontractual agreements, typically between the originallender and a third party specialising in the variousunctions o servicing mortgages, including collectiono mortgage payments and payment o taxes andinsurance premiums. They can potentially be on-sold to other parties. Investor interest in mortgageservicing rights is typically driven by the opportunityto earn a spread/margin.

Mortgage servicing rights are not common in Australia. AASB 138 Intangible Assets (AASB 138) deems themto be intangible assets and, accordingly, APRA wouldrequire these assets to be deducted rom Tier 1 capitalat both Levels 1 and 2. APRA remains o the view thatthis is the most appropriate treatment and proposes torequire any mortgage servicing rights to be deductedrom Common Equity Tier 1, consistent with thetreatment o other intangible items under Basel III.

3.3 Other deductions rom capital

To simpliy the calculation o capital, Basel III changesthe treatment o the ollowing items, which werepreviously deducted 50:50 rom Tier 1 and Tier 2capital and now will be risk-weighted at 1250 per cent:

• certain securitisation exposures;

• non-payment/delivery on non-delivery-versus-payment (DvP) and non-payment-versus-payment (PvP) transactions;

• certain equity exposures under the probability o deault (PD)/loss given deault (LGD) approach;and

• signicant investments in commercial entities.

APRA proposes to adopt the Basel III approachand apply a 1250 per cent risk-weight to thosesecuritisation exposures currently deducted 50:50 inPrudential Standard APS 120 Securitisation (APS 120).24 APRA will also apply a 1250 per cent risk-weight tonon-DvP and non-PvP transactions.

APRA did not adopt the PD/LGD approach or equityexposures and does not propose any changes to itscurrent treatment o such exposures.

APRA does not, however, propose applying a 1250per cent risk-weight to signicant investments in

commercial institutions. Currently, APRA appliesa 50:50 deduction or investments in commercialinstitutions in excess o:

• 0.15 per cent o the ADI’s Level 2 capital basebeore deductions (at both Tier 1 and Tier 2) oran individual investment; and

• ve per cent o the ADI’s Level 2 capital basebeore deductions (at both Tier 1 and Tier 2) inaggregate.

Individual investments below these limits are risk-

weighted at 300 per cent (i listed) or 400 percent (i unlisted).

APRA’s longstanding position is that the ownershipo equity or the holding o other investments incommercial institutions is not a normal part o banking business. Where an ADI undertakes suchactivity it is APRA’s view that the activity should beunded by shareholders, not depositors or othercreditors. Consistent with its longstanding positionand the proposed treatment o investments in nonconsolidated nancial institutions, APRA proposes to

require ADIs to deduct rom Common Equity Tier 1:

• all investments in commercial institutions held inthe banking book; and

24 Most exposures in APS 120 are deducted 50:50; exceptions requiringdeduction rom Tier 1 capital include unpaid gains on sale, unds lentto establish reserve accounts, overpayments or assets and capitalised

expenses. APRA proposes that these items will be deducted romCommon Equity Tier 1 rather than rom Tier 1.




• underwriting positions in commercial institutionsheld or more than ve working days.

APRA proposes that investments held in the tradingbook continue to be treated in accordance withthe relevant market risk prudential requirements o Prudential Standard APS 116 Capital Adequacy: MarketRisk (APS 116).

In addition to the items listed above, APRA currentlyrequires the ollowing items, which are not treated as50:50 deductions under the Basel II Framework, to bededucted 50:50 under APS 111:

• any guarantee, or credit derivative coveringcredit exposures at Level 2, that provides or amateriality threshold below which no paymentwill be made in the event o a loss; and

• any non-repayable loans advanced by anADI under APRA’s certied industry supportarrangements.

In light o the changes made under Basel III to existing50:50 deductions to simpliy capital calculations, APRAproposes to deduct these remaining items in ull rom

Common Equity Tier 1.




The Basel III regulatory capital ramework introducestwo capital buers aimed at addressing procyclicalityand raising the resilience o the banking system.These are:

• a capital conservation buer; and

• a countercyclical buer.

The objectives are to build capital buers inindividual ADIs and in the banking system that canbe used in times o stress and to achieve the broadermacroprudential goal o protecting the banking

system rom periods o excess credit growth.

4.1 Capital conservation buer

Basel III introduces a capital conservation buer o 2.5 per cent, comprised o Common Equity Tier 1,above the regulatory minimum capital requirement.This buer is intended to promote the conservationo capital and the build-up o adequate buers abovethe minimum that can be used to absorb losses duringperiods o nancial and economic stress.

The capital conservation buer regime imposesconstraints on an ADI when its Common Equity Tier 1level alls within the capital conservation buer range.The constraints limit distributions such as dividendsand bonuses, and the level o constraint increases thecloser an ADI’s Common Equity Tier 1 level is to therequired minimum. The minimum Basel III distributionconstraints, based on a 2.5 per cent capital conservationbuer, are shown in the ollowing table. An ADI wouldbe required to conserve 80 per cent o its earnings inthe subsequent nancial year i its holdings o CommonEquity Tier 1 capital were only between 0.625 per cent

and 1.25 per cent above its minimum Common EquityTier 1, Tier 1 and Total Capital requirements. That is, itcould not make payouts o more than 20 per cent o its earnings in terms o dividends, share buybacks anddiscretionary bonus payments.

Table 4.1 – Individual ADI minimum capital conservationrequirements (or a buer o 2.5 per cent)

Capital conservationbuer range(percentage)

Minimum capitalconservation ratios(expressed as apercentage o earnings)

0 to 0.625 100

> 0.625 to 1.250 80

> 1.250 to 1.875 60

> 1.875 to 2.500 40

2.500 0

APRA proposes to introduce a capital conservationbuer, comprised o Common Equity Tier 1, o up to2.5 per cent. The buer will apply in addition to theminimum Common Equity Tier 1, Additional Tier 1and Total Capital ratio requirements and will need tobe met with Common Equity Tier 1, over and aboveany Common Equity Tier 1 needed to meet theminimum capital requirements.

Other key aspects o APRA’s proposed capitalconservation buer requirements, in line withBasel III, are:

(a) Elements subject to the restriction ondistributions: Items proposed to beconsidered as distributions include dividendsand share buybacks, discretionary paymentson Additional Tier 1 capital instrumentsand discretionary bonus payments to sta.Payments that do not result in a depletiono Common Equity Tier 1, which may or

example include certain scrip dividends andproceeds o any dividend reinvestment, arenot considered distributions.

(b) Defnition o earnings: Earnings are denedas distributable prots calculated prior tothe deduction o elements subject to therestriction on distributions. Earnings arecalculated ater the tax that would have beenreported had none o the distributable itemsbeen paid. As such, any tax impact o makingsuch distributions is reversed out.

Chapter 4 – Capital buers




(c) Solo or consolidated application: Theramework is proposed to be applied at theconsolidated level, i.e. restrictions wouldbe imposed on distributions out o theconsolidated group (Level 2). APRA alsoproposes to have discretion, in line withthe Basel III requirements, to apply thedistribution constraints at Level 1 to conserveresources in specic parts o the group.

(d) Additional supervisory discretion: Althoughthe buer is capable o being drawn down

when needed, ADIs would not be expectedto operate in the buer range in normaltimes. APRA thereore proposes that an ADIoperating within the buer range be requiredto enter into a capital remediation planwithin a timerame determined by APRA.In any case, the Internal Capital AdequacyAssessment Process (ICAAP) o ADIs willrequire their capital management plans todemonstrate how they will rebuild buersover an appropriate timerame.25

Notwithstanding these requirements, APRA alsoproposes to continue the approach to dividend andinterest payments on Tier 1 instruments in APS 111paragraph 30. That is, unless otherwise approved byAPRA, the aggregate amount o dividend or interestpayments cannot exceed, at Level 1 and Level 2, anADI’s ater-tax earnings.

25 APS 110, paragraph 6(b).

4.2 Relationship o the buerto APRA’s Prudential CapitalRequirements

Under the Basel II Framework, the supervisory reviewprocess (known as Pillar 2) is intended to ensure thatADIs have adequate capital to support all the risks intheir business and to encourage ADIs to develop anduse better risk management techniques in monitoringand managing their risks. Based on this process, APRAsets a PCR or Tier 1 and Total Capital or each ADI,which must be met at all times.26 The PCR is set at alevel proportional to each ADI’s overall risk prole.

This approach will not change under the proposedBasel III reorms. However, given the ocus o Basel IIIon Common Equity Tier 1 as the highest qualitycomponent o capital, APRA believes that it isappropriate to set a PCR primarily by reerence toCommon Equity Tier 1. PCRs would also be set orTier I and Total Capital.

APRA proposes to apply the capital conservationbuer above the PCR or Common Equity Tier 1

determined or each ADI.27

However, where APRAapplies a PCR or Common Equity Tier 1 above 4.5per cent, APRA will have regard to the cumulativeimpact o the PCR and the capital conservation buer,and may choose to set the capital conservation buerat a level below 2.5 per cent. In such a case, thebuer would be divided into our equal ranges orthe application o the minimum capital conservationranges. In no case, however, would the sum o thePCR or Common Equity Tier 1 plus the capitalconservation buer be less than seven per cent.

26 Reer APRA’s Discussion Paper ‘Implementation o the Basel II CapitalFramework: 10 Supervisory Review Process’, 12 September 2007, atwww.apra.gov.au/adi/Documents/Discussion-paper-Supervisory-Review-Process.pd .

27 For the purposes o this discussion paper, the discussion will ocus on

a Common Equity Tier 1 PCR only. APRA proposes to also apply theprinciples outlined in this section to a Tier 1 PCR and Total Capital PCR.

http://www.apra.gov.au/adi/Documents/Discussion-paper-Supervisory-Review-Process.pdf







The diagrams in Figures 4.1 and 4.2 illustrate twodierent scenarios or the PCR and the capitalconservation buer:

• a PCR or Common Equity Tier 1 (CET1) o 4.5per cent and a capital conservation buer (CCB)o 2.5 per cent (Figure 4.1); and

• a PCR or Common Equity Tier 1 (CET1) o 5.5per cent and a capital conservation buer (CCB)o 2.0 per cent (Figure 4.2).

APRA notes that, in view o the signicant increasesin minimum capital requirements under Basel III, theexisting PCRs determined or each ADI will need tobe reviewed and recalibrated. This will occur oncethe minimum capital requirements are nalised. ADIswill be inormed o changes to their PCRs beore thecommencement o the Basel III capital regime. APRA’scurrent policy o prohibiting the disclosure o PCRswill continue.

Figure 4.1 – Application o the PCR and capital conservation buer: Scenario 1

9.0

8.0

7.0

6.0

5.0

4.0

3.0

2.0

1.0

0

Distributions restriction range

PCRCET1

CET1

CET1 0% capital conservation 100% capital conservation

C a p i t a

l r a t i o

( p e r c e n

t )

Basel III capital requirement: PCRCET1 4.5 per cent + CCB 2.5 per cent




APRA proposes to introduce the Basel IIIcountercyclical buer in its prudential capital regime.Broadly speaking, the application o the buer wouldhave the ollowing main elements:

• APRA will continuously review the need or thecountercyclical buer, in consultation with theReserve Bank o Australia (RBA);

• in addition to macroeconomic indicators o excessive credit growth such as the credit-to-grossdomestic product (GDP) gap28, APRA’s review willbe inormed by input rom the supervisory visits it

conducts;

• any countercyclical buer will be appliedby extending the range o the capitalconservation buer. As an example, a one percent countercyclical buer added to a capitalconservation buer o 2.5 per cent would lead toa combined buer o 3.5 per cent; and

• the imposition o the countercyclical buer willbe publicly announced, and would apply to theAustralian exposures o locally incorporated ADIs.

To give ADIs time to adjust, APRA will announceany decision to raise the level o the capitalconservation buer to include a countercyclicalbuer at least 12 months ahead o the eectivedate rom which it will apply.

The countercyclical buer is subject to jurisdictionalreciprocity with respect to internationally active ADIs.Jurisdictional reciprocity means that host authoritiestake the lead in setting buer requirements that wouldapply to credit exposures held by institutions locatedin their jurisdiction. They would also be expected

to promptly inorm their oreign counterparts o decisions to apply the countercyclical buer so thatthose counterparts can require their banks to applythe buer to their group institutions.

28 Reer to Basel Committee’s Guidance for national authorities operating thecounter-cyclical buffer, December 2010: www.bis.org/publ/bcbs187.htm.

Home authorities will be responsible or ensuringthat the banks they supervise correctly calculate theirbuer requirements based on the geographic locationo their branch exposures. The home authoritieswill be able to require that the banks they supervisemaintain higher buers i they judge the hostauthorities’ buer to be insucient.

Thereore, the countercyclical buer is intended toapply to the Australian exposures o oreign ADIsoperating in Australia as branches where thoseoreign ADIs are subject to oshore regimes that have

introduced a countercyclical buer regime.APRA notes that, where potentially unsound growthin credit exposures is evident, it will continue itscurrent practice o identiying less prudent lendingpractices and taking appropriate supervisory steps,such as supervisory eedback to the relevant boardsand increasing the PCRs o ADIs undertaking excessivecredit growth.






The Basel Committee identied that one o theunderlying eatures o the global nancial crisis wasthe build-up o excessive on- and o-balance sheetleverage in the global banking system, despite theact that many banks still showed strong risk-basedcapital ratios. During the most severe part o thecrisis, the market orced the banking system to reduceits leverage in a manner that amplied downwardpressure on asset prices, urther exacerbating thepositive eedback loop between losses, declines inbank capital and contraction in credit availability.

To address this, Basel III introduces a simple,transparent, non-risk based leverage ratio that iscalibrated to act as a supplementary measure to therisk-based capital requirements. The leverage ratio isintended to:

• constrain the build-up o leverage in thebanking system, helping to avoid a destabilisingdeleveraging process that can damage thenancial system and the economy; and

• reinorce the risk-based requirements witha simple ‘backstop’ measure that provides

additional saeguards against model risk andmeasurement error.

APRA proposes to introduce the Basel III leverage ratioin its prudential capital regime.

5.1 Calculating the leverage ratio

The basis o calculation or the leverage ratio isthe average o the monthly leverage ratio overeach quarter based on the ollowing denitions o capital (the capital measure) and total exposure (the

exposure measure).As currently proposed, the capital measure or theleverage ratio will be based on the new Basel IIIdenition o Tier 1 capital. The Basel Committee willalso collect data to track the impact o using totalregulatory capital and Common Equity Tier 1. Itemsthat are ully deducted rom capital do not contributeto leverage and will thereore also be deducted romthe measure o exposure.

The exposure measure or the leverage ratio isintended to ollow the accounting measure o exposure. To be measured consistently with nancialaccounts:

• on-balance sheet, non-derivative exposuresare net o specic provisions and valuationadjustments (e.g. credit valuation adjustments);

• physical or nancial collateral, guarantees orcredit risk mitigation purchased is not allowed toreduce on-balance sheet exposures; and

•

netting o loans and deposits is not allowed.

5.2 Transitional arrangements

Basel III provides or a long transitional period or theleverage ratio, comprising a supervisory monitoringperiod that commenced on 1 January 2011 and aparallel run period rom 1 January 2013 to 1 January2017. During the parallel run period, a minimum Tier 1leverage ratio o three per cent will be tested andthe leverage ratio and its components, including itsbehaviour relative to the risk-based requirement, will

be monitored. Full disclosure o the leverage ratio andits components will commence on 1 January 2015.

Based on the results o the parallel run period, theBasel Committee will make any nal adjustments to thedenition and calibration o the leverage ratio in therst hal o 2017, with a view to migrating the leverageratio to a Pillar 1 requirement on 1 January 2018.

APRA proposes to apply these transitionalarrangements.

Chapter 5 – Leverage ratio




To improve the transparency o regulatory capitaland market discipline, Basel III provides or the publicdisclosure o the ollowing items:

• a ull reconciliation o regulatory capital elementsback to the balance sheet in the audited nancialstatements;

• separate disclosure o all regulatory adjustments;

• a description o all limits and minima, identiyingthe positive and negative elements o capital towhich the limits and minima apply; and

• a description o the main eatures o capitalinstruments issued.

In addition to these enhanced transparencyrequirements, Basel III also requires ADIs to makeavailable on their websites the ull terms andconditions o all instruments included in regulatorycapital. Entities that disclose alternative ratios involvingcomponents o regulatory capital (e.g. ‘Equity Tier 1’,‘Core Tier 1’ or ‘Tangible Common Equity’ ratios) willbe required to accompany these with a comprehensiveexplanation o how these ratios are calculated.

The Basel Committee will issue more detailed Pillar3 disclosure requirements in 2011. When theseare released, APRA will consult on the detailedamendments to be made to Prudential Standard APS

330 Capital Adequacy: Public Disclosure of PrudentialInformation (APS 330). The existing requirement orthe main eatures o capital instruments to be easilyunderstood and publically disclosed under APS 330will be retained.

Chapter 6 – Prudential disclosure




Based on the results o the most recent quantitativeimpact study (QIS) inormation submitted to APRAby a number o the larger ADIs and APRA’s analysiso current capital ratios or other ADIs, APRA expectsADIs will be well placed to meet the new globalminimum capital requirements, without the need orany phasing-in. Accordingly, APRA proposes that, rom1 January 2013, all ADIs will be required to meet theollowing minimum requirements:

• a 4.5 per cent Common Equity Tier 1 ratio;

• a 6.0 per cent Tier 1 capital ratio; and

• an 8.0 per cent Total Capital ratio .

In meeting these minima, ADIs will also need to meettheir individual PCRs as determined by APRA, whichinclude any Pillar 2 supervisory adjustments.

Basel III provides transition or the treatment o capitalissued out o subsidiaries and held by third parties(e.g. minority interest). APRA does not considersuch transition necessary. Accordingly, such capitalthat is not eligible or inclusion in one o the threecomponents o capital on 1 January 2013 will be

excluded rom the determination o regulatory capitalrom that date.

7.2.2 Regulatory adjustments

The Basel Committee has also allowed or the Basel IIIchanges in the approach to deductions and otheradjustments to capital to be phased-in over a ve-yearperiod. Under APS 111, ADIs have been applying manyo the Basel III regulatory deductions or some time.Accordingly, APRA does not believe that the phase-in arrangements are necessary in Australia. APRA

proposes to require ADIs to implement the revisedregulatory adjustments in ull rom 1 January 2013.

7.2.3 Outstanding capital instruments thatno longer qualiy as non-common equity Tier 1capital or Tier 2 capital

A number o ADIs have issued non-common equityinstruments that currently qualiy as Tier 1 or Tier 2capital. Few, i any, o these instruments will meet allthe requirements or inclusion in regulatory capitaltreatment under Basel III.

APRA has previously conrmed that capitalinstruments issued prior to the announcement o the Basel III ramework will be eligible or transitionaltreatment beyond 2013.29 On 27 May 2011, APRAissued a letter to all locally-incorporated ADIs outlininginterim arrangements or Additional Tier 1capital instruments. APRA conrms that, until theend o 2012, eligible Tier 1 capital instruments mustcontinue to satisy all relevant criteria containedin APS 111. In addition, APRA conrms that it isprepared, on an interim basis, to accept newly issuedcapital instruments as being eligible or transitionaltreatment as Additional Tier 1 capital under the BaselIII ramework, on the basis that they meet the current

eligibility requirements in APS 111 and the criteria setout in the Attachment to that letter.30

Under the phase-out arrangements, recognition o capital instruments that no longer qualiy as non-common equity Tier 1 capital or Tier 2 capital willbe capped at 90 per cent rom 1 January 2013, withthe caps reducing by 10 percentage points in eachsubsequent year.

29 Reer Letters to ADIs dated 18 December 2009, 14 January 2010, 17September 2010 and 27 May 2011 ound at www.apra.gov.au/adi/Publications/Pages/other-inormation-or-adis.aspx.

30 www.apra.gov.au/adi/Publications/Documents/Basel-III-interim-Tier-1-criteria_FINAL.pd .

7.2 Basel III transition in Australia

7.2.1 Minimum capital ratios



http://www.apra.gov.au/adi/Publications/Documents/Basel-III-interim-Tier-1-criteria_FINAL.pdf









APRA proposes to adopt the Basel III phase-outarrangements or all noncomplying instruments.Outstanding noncomplying instruments will berequired to be phased-out no later than their rstavailable call date, where one exists. ADIs will berequired to notiy APRA beore 1 January 2013, inwriting, o the nominal amount o all such instrumentsoutstanding on 1 January 2013 and the rst availablecall date or such instruments. APRA expects ADIs toreplace this capital with ully complying instrumentsand to have eective capital management plans orthis purpose.

7.2.4 Capital conservation buer andcountercyclical buer

The Basel III timetable allows or the capitalconservation buer to be phased-in rom 1 January2016 and become ully eective on 1 January 2019.

APRA is o the view that, taking into account thetransition allowance or capital instruments that nolonger qualiy as Tier 1 and Tier 2, ADIs should beable to meet the minimum Basel III requirement o a Common Equity Tier 1 ratio (including the capitalconservation buer) o seven per cent by 1 January2016. APRA thereore proposes to implement thecapital conservation buer in ull rom that date. AllADIs are encouraged to maintain prudent earningsretention policies with a view to meeting the capitalconservation buer as soon as reasonably possible.

Under Basel III, APRA is required to pre-announce itsdecision to put in place any countercyclical buer andthe level o that buer by up to 12 months. APRA will,thereore, indicate in 2015 whether any countercyclicalbuer will apply rom 1 January 2016 and whether anyphasing-in o that buer is necessary.

Table 7.2 – Basel III transition in Australia

At 1 January

2013 2014 2015 2016 2017 2018 2019

Per cent

Min CET1 4.5 4.5 4.5 4.5 4.5 4.5 4.5

(2) Capital Conservation Buer 2.5* 2.5 2.5 2.5

(3) Min CET1 + Conservation Buer 4.5 4.5 4.5 7.0 7.0 7.0 7.0

(4) Phase in o deductions rom CET1 100 100 100 100 100 100 100

(5) Min T1 6.0 6.0 6.0 6.0 6.0 6.0 6.0

(6) Min T1 + Conservation buer 8.5 8.5 8.5 8.5

(7) Min Total Capital 8.0 8.0 8.0 8.0 8.0 8.0 8.0

(8) Min Total + Conservation Buer 8.0 8.0 8.0 10.5 10.5 10.5 10.5

(9) Instruments that no longer qualiy as

T1 or T2

Phased out over 10 year horizon beginning 2013 with recognition

capped at 90 per cent in 2013, the caps reducing by 10 per cent each

year, ending in 2023 or at rst available redemption date.

(10) Countercyclical Buer Up to an additional 2.5 per cent CET1 rom 1 January 2016.

(11) Leverage ratio

Supervisory monitoring rom 2011

Parallel run 2013 – 2017

Disclosure rom 2015

Migration to Pillar 1 2018

* This is the capped capital conservation buer amount.




To improve the quality o regulation, the AustralianGovernment requires all proposals to undergo apreliminary assessment to establish whether it is likelythat there will be business compliance costs. In orderto perorm a comprehensive cost-benet analysis,APRA welcomes inormation rom interested partieson the nancial impact o the proposed Basel IIIcapital reorms and any other substantive costsassociated with the proposed reorms. These costscould include the impact on balance sheets, prot andloss, and capital.

As part o the consultation process, APRA alsorequests respondents to provide an assessment o the compliance impact o the proposed changes.Given that APRA’s proposed requirements mayimpose some compliance and implementation costs,respondents may also indicate whether there are anyother regulations relating to ADI capital adequacy thatshould be improved or removed to reduce compliancecosts. In doing so, please explain what they are andwhy they need to be improved or removed.

Respondents are requested to use the Business Cost

Calculator (BCC) to estimate costs to ensure that thedata supplied to APRA can be aggregated and usedin an industry-wide assessment. APRA wouldappreciate being provided with the input to the BCCas well as the nal result. The BCC can be accessed atwww.nance.gov.au/obpr/bcc/index.html.

Chapter 8 – Request or cost-beneft analysis inormation

http://www.finance.gov.au/obpr/bcc/index.html

http://www.finance.gov.au/obpr/bcc/index.html




1. Represents the most subordinated claim inliquidation o the ADI.

2. Entitled to a claim on the residual assets that isproportional with its share o issued capital, aterall senior claims have been repaid in liquidation(i.e. has an unlimited and variable claim, not axed or capped claim).

3. Principal is perpetual and never repaid outsideo liquidation (setting aside discretionaryrepurchases or other means o eectivelyreducing capital in a discretionary manner that is

allowable under relevant law).

4. The ADI does nothing to create an expectationat issuance that the instrument will be boughtback, redeemed or cancelled and the statutoryor contractual terms do not provide any eaturewhich might give rise to such an expectation.

5. Distributions are paid out o distributableitems (retained earnings included). The level o distributions is not in any way tied or linked to theamount paid in at issuance and is not subject to a

contractual cap (except to the extent that an ADIis unable to pay distributions that exceed the levelo distributable items).

6. There are no circumstances under which thedistributions are obligatory. Non-payment isthereore not an event o deault.

7. Distributions are paid only ater all legal andcontractual obligations have been met andpayments on more senior capital instrumentshave been made. This means that there are nopreerential distributions, including in respect o

other elements classied as the highest qualityissued capital.

8. It is the issued capital that takes the rst andproportionately greatest share o any losses asthey occur.31 Within the highest quality capital,each instrument absorbs losses on a goingconcern basis proportionately and pari passu withall the others.

9. The paid-in amount is recognised as equity capital(i.e. not recognised as a liability) or determiningbalance sheet insolvency.

10. The paid-in amount is classied as equity underthe relevant accounting standards.

11. It is directly issued and paid-in and the ADIcannot directly or indirectly have unded thepurchase o the instrument.

12. The paid-in amount is neither secured norcovered by a guarantee o the issuer or relatedentity32 or subject to any other arrangement thatlegally or economically enhances the seniority o the claim.

13. It is only issued with the approval o the ownerso the issuing ADI, either given directly by the

owners or, i permitted by applicable law, given bythe Board o Directors or by other persons dulyauthorised by the owners.

14. It is clearly and separately disclosed on the ADI’sbalance sheet.

31 In cases where capital instruments have a permanent write-downeature, this criterion is still deemed to be met by common shares.

32 A related entity can include a parent company, a sister company, a

subsidiary or any other aliate. A holding company is a related entityirrespective o whether it orms part o the consolidated banking group.

Appendix 1 – Criteria or classifcation as common sharesor regulatory capital purposes




As outlined in Chapter 2.1.1, APRA proposes toadopt the Basel III denition o ‘accumulated othercomprehensive income and other disclosed reserves’and allow all unrealised gains and losses to be includedin determining Common Equity Tier 1. This will besubject to ADIs meeting the requirements in APS 111on the recognition o air values, and to additionalreporting requirements.

Specically, six months prior to the adoption date o AASB 933, APRA proposes that ADIs will be required tonotiy it, in writing, o the ollowing:

• the actual amortised cost and air value balancesor loans and deposits (under the previousstandard AASB 139 Financial Instruments:Recognition and Measurement (AASB 139))34 andthose balances restated, approximately, or anyplanned reclassications rom amortised cost toair value under AASB 9; and

• material reclassications o other nancial assetsand liabilities rom amortised cost to air value asa result o the adoption o AASB 9.

Ater the adoption o AASB 9, APRA proposes thatADIs will be required to notiy it whenever thereis a material reclassication o nancial assets andliabilities rom amortised cost to air value. APRA’sview is that loans and conventional banking businessmore generally should be measured at amortised cost.APRA reserves the right to make capital adjustments(among other things) where it considers that an ADI’spolicies and procedures or the use o air values donot comply with APRA’s prudential requirements and,in particular, are not reliable or aect adversely theADI’s saety and soundness.35

33 AASB 9 is scheduled to come into eect or annual reporting periodsbeginning on or ater 1 January 2015.

34 AASB 139 Financial Instruments: Recognition and Measurement35 The revised version o APS 111 that will take eect rom 1 January

2012, states ‘Where APRA considers that an ADI’s policies andprocedures or the use o air values are not reliable or aectadversely its saety and soundness, APRA may, in writing, require anADI to amend its policies and procedures, to make adjustments toair values o nancial instruments included in the measurement o capital adequacy (reer Attachment E), to discontinue use o air value

measures or regulatory reporting, or to hold higher levels o capital’(paragraph 55).

Fair value practicesAPRA also proposes to require additional reportingrom that required by IFRS 13 disclosures.36 Reporting will be required quarterly or nancialassets and liabilities. The proposed reports willcapture cumulative, gross unrealised gains and lossesrecognised on the Statement o Financial Position37 or air values that are valued using ‘Level 3’ (i.e.unobservable) inputs38, and detailed inormationabout Level 3 inputs.

APRA acknowledges that air value accountingusing Level 3 inputs may be necessary or assets andliabilities associated with complex products whereextant markets have temporarily or permanentlydisappeared. However, APRA considers that thereare ew, i any, cases where ADIs should enter newbusiness requiring air value accounting using level 3valuation methods. APRA invites submissions romADIs or other parties giving examples o where Level 3valuation methods may be necessary.

APRA’s view is that nancial asset and liabilityvaluations using Level 3 inputs are dicult to veriyand should be minimal within APRA-regulatedinstitutions. As stated above, APRA may increasean ADI’s capital requirements where more than aminimal proportion o an ADI’s capital is sourced romrevaluations undertaken using Level 3 inputs.

APRA also recognises that some Level 2 valuationsmay involve more complex products and valuationprocesses that include some use o unobservableinputs. APRA welcomes submissions on reportingo Level 2 valuations and the recognition o Level2 valuation practices given the spread o valuationapproaches that could be applied. APRA will alsoconsider extending its proposed reports to capture airvalue valuations based on Level 2 inputs.39

36 IFRS 13 is eective or annual reporting periods beginning on or ater 1January 2013.

37 This will involve greater disclosure than required under IFRS 13, whichonly requires net gains or losses at the end o the reporting periodincluded in prot and loss.

38 IFRS 13 denes Level 3 inputs as unobservable inputs or the asset orliability.

39 IFRS 13 denes Level 2 inputs as inputs other than quoted prices

included within Level 1 that are observable or the asset or liability,either directly or indirectly.

Appendix 2 – Unrealised gains and losses – additionalreporting




1. Issued and paid-in.2. Subordinated to depositors, general creditors and

subordinated debt o the ADI.

3. Is neither secured nor covered by a guarantee o the issuer or related entity or other arrangementthat legally or economically enhances theseniority o the claim vis-à-vis the ADI’s creditors.

4. Is perpetual (i.e. there is no maturity date andthere are no step-ups or other incentives toredeem).

5. May be callable at the initiative o the issuer onlyater a minimum o ve years:

(a) to exercise a call option an ADI must receiveprior supervisory approval; and

(b) an ADI must not do anything which createsan expectation that the call will be exercised;and

(c) an ADI must not exercise a call unless:

(i) it replaces the called instrument withcapital o the same or better quality andthe replacement o this capital is done atconditions which are sustainable or theincome capacity o the ADI;40 or

(ii) the ADI demonstrates that its capitalposition is well above its PCR ater thecall option is exercised.

6. Any repayment o principal (e.g. throughrepurchase or redemption) must be with priorsupervisory approval and ADIs should not assumeor create market expectations that supervisory

approval will be given.

40 Replacement issues can be concurrent with but not ater theinstrument is called.

7. Dividend/coupon discretion:(a) the ADI must have ull discretion at all times

to cancel distributions/payments;41

(b) cancellation o discretionary payments mustnot be an event o deault;

(c) ADIs must have ull access to cancelledpayments to meet obligations as they alldue; and

(d) cancellation o distributions/payments mustnot impose restrictions on the ADI except

in relation to distributions to commonstockholders.

8. Dividends/coupons must be paid out o distributable items.

9. The instrument cannot have a credit sensitivedividend eature (i.e. a dividend/coupon that isreset periodically based in whole or in part on theADI’s credit standing).

10. The instrument cannot contribute to liabilitiesexceeding assets i such a balance sheet test orms

part o national insolvency law.

11. Instruments classied as liabilities or accountingpurposes must have principal loss absorptionthrough either (i) conversion to common sharesat an objective pre-specied trigger point or (ii)a write-down mechanism which allocates lossesto the instrument at a pre-specied trigger point.The write-down will have the ollowing eects:

(a) reduce the claim o the instrument inliquidation;

(b) reduce the amount re-paid when a call isexercised; and

(c) partially or ully reduce coupon/dividendpayments on the instrument.

41 A consequence o ull discretion at all times to cancel distributions/payments is that ‘dividend pushers’ are prohibited. An instrumentwith a dividend pusher obliges the issuing ADI to make a dividend/coupon payment on the instrument i it has made a payment onanother (typically more junior) capital instrument or share. Thisobligation is inconsistent with the requirement or ull discretion at alltimes. Furthermore, the term ‘cancel distributions/payments’ means

extinguish these payments. It does not permit eatures that require theADI to make distributions/payments in kind.

Appendix 3 – Criteria or inclusion in AdditionalTier 1 capital




12. Neither the ADI nor a related party over whichthe ADI exercises control or signicant infuencecan have purchased the instrument, and the ADIcannot have unded (directly or indirectly) thepurchase o the instrument.

13. The instrument cannot have any eatures thathinder recapitalisation, such as provisions thatrequire the issuer to compensate investors i anew instrument is issued at a lower price during aspecied time rame.

14. I the instrument is not issued out o an

operating entity or the holding company in theconsolidated group (e.g. a SPV), proceeds mustbe immediately available without limitation toan operating entity42 or the holding company inthe consolidated group in a orm which meets orexceeds all o the other criteria or inclusion inAdditional Tier 1 capital.

42 An operating entity is an entity set up to conduct business with clientswith the intention o earning a prot in its own right.




1. Issued and paid-in.2. Subordinated to depositors and general creditors

o the ADI.

3. Is neither secured nor covered by a guarantee o the issuer or related entity or other arrangementthat legally or economically enhances theseniority o the claim vis-à-vis depositors andgeneral ADI creditors.

4. Maturity:

(a) minimum original maturity o at least ve

years;

(b) recognition in regulatory capital in theremaining ve years beore maturity will beamortised on a straight line basis; and

(c) there are no step-ups or other incentives toredeem.

5. May be callable at the initiative o the issuer onlyater a minimum o ve years:

(a) to exercise a call option an ADI must receiveprior supervisory approval;

(b) an ADI must not do anything that creates anexpectation that the call will be exercised;43 and

(c) an ADI must not exercise a call unless:

(i) it replaces the called instrument withcapital o the same or better quality andthe replacement o this capital is done atconditions which are sustainable or theincome capacity o the ADI;44 or

(ii) the ADI demonstrates that its capitalposition is well above its PCR ater thecall option is exercised.

43 An option to call the instrument ater ve years but prior to the start o the amortisation period will not be viewed as an incentive to redeem aslong as the ADI does not do anything that creates an expectation thatthe call will be exercised at this point.

44 Replacement issues can be concurrent with but not ater theinstrument is called.

Appendix 4 – Criteria or inclusion in Tier 2 capital

6. The investor must have no rights to acceleratethe repayment o uture scheduled payments(coupon or principal), except in bankruptcy andliquidation.

7. The instrument cannot have a credit sensitivedividend eature (i.e. a dividend/coupon that isreset periodically based in whole or in part on theADI’s credit standing).

8. Neither the ADI nor a related party over whichthe ADI exercises control or signicant infuencecan have purchased the instrument, and the ADI

cannot have unded (directly or indirectly) thepurchase o the instrument

9. I the instrument is not issued out o anoperating entity or the holding company in theconsolidated group (e.g. a SPV), proceeds mustbe immediately available without limitation toan operating entity45 or the holding company inthe consolidated group in a orm which meets orexceeds all o the other criteria or inclusion inTier 2 capital.

45 An operating entity is an entity set up to conduct business with clientswith the intention o earning a prot in its own right.




Appendix 5 – Minority interest and other capital issuedout o consolidated subsidiaries that is held by third parties

Common shares issued by consolidatedsubsidiaries

In line with the Basel III rules text, APRA proposesto allow recognition in Common Equity Tier 1 o minority interest arising rom the issue o commonshares by a ully consolidated subsidiary o the ADIonly i:

• the instrument giving rise to the minority interestwould, i issued by the ADI, meet all o the criteriaor classication as common shares or regulatory

capital purposes; and• the subsidiary that issued the instrument is itsel

an ADI (or overseas equivalent).

The amount o minority interest recognised inconsolidated Common Equity Tier 1 will be the totalamount o minority interest meeting the two criteriaabove, less the amount o the surplus Common EquityTier 1 o the subsidiary attributable to the minorityshareholders, where:

• surplus Common Equity Tier 1 o the subsidiaryis calculated as the Common Equity Tier 1 o thesubsidiary minus the lower o:

– the minimum Common Equity Tier 1requirement o the subsidiary plus the capitalconservation buer (e.g. seven per cent o risk-weighted assets); and

– the portion o the consolidated minimumCommon Equity Tier 1 requirement plus thecapital conservation buer (e.g. seven percent o consolidated risk-weighted assets)that relates to the subsidiary; and

• the amount o the surplus Common Equity Tier1 that is attributable to the minority shareholdersis calculated by multiplying the surplus CommonEquity Tier 1 by the percentage o CommonEquity Tier 1 that is held by minority shareholders.

Tier 1 qualiying capital issued byconsolidated subsidiaries

APRA proposes to allow recognition o Tier 1 capitalinstruments issued by a ully consolidated subsidiaryo the ADI to third-party investors (including amountso common shares and Additional Tier 1 instrumentsissued by consolidated subsidiaries) only i theinstruments would, i issued by the ADI, meet all o the criteria or classication as Tier 1 capital.

The amount o this capital that will be recognised in

Tier 1 will be the total Tier 1 o the subsidiary issuedto third parties minus the amount o the surplus Tier1 o the subsidiary attributable to the third-partyinvestors, where:

• surplus Tier 1 o the subsidiary is calculated as theTier 1 o the subsidiary minus the lower o:

– the minimum Tier 1 requirement o thesubsidiary plus the capital conservationbuer (e.g. 8.5 per cent o risk-weightedassets); and

– the portion o the consolidated minimumTier 1 requirement plus the capitalconservation buer (e.g. 8.5 per cent o consolidated risk-weighted assets) thatrelates to the subsidiary; and

• the amount o the surplus Tier 1 that isattributable to the third-party investors iscalculated by multiplying the surplus Tier 1 by thepercentage o Tier 1 that is held by third-partyinvestors.

The amount o this Tier 1 capital that will be

recognised in Additional Tier 1 will exclude amountsrecognised in Common Equity Tier 1 as outlinedabove.




Tier 1 and Tier 2 qualiying capitalissued by consolidated subsidiaries

Total capital instruments (i.e. Tier 1 and Tier 2 capitalinstruments) issued by a ully consolidated subsidiaryo the ADI to third-party investors (including amountso common shares and Tier 1 qualiying capital issuedby consolidated subsidiaries) may receive recognitionin Total Capital only i the instruments would, i issuedby the ADI, meet all o the criteria or classication asTier 1 or Tier 2 capital.

The amount o this capital that will be recognisedin consolidated Total Capital will be the total capitalinstruments o the subsidiary issued to third partiesminus the amount o the surplus Total Capital o the subsidiary attributable to the third-partyinvestors where:

• surplus Total Capital o the subsidiary is calculatedas the Total Capital o the subsidiary minus thelower o:

– the minimum Total Capital requirement o the subsidiary plus the capital conservation

buer (e.g. 10.5 per cent o risk-weightedassets);

– the portion o the consolidated minimumTotal Capital requirement plus the capitalconservation buer (e.g. 10.5 per cent o consolidated risk-weighted assets) thatrelates to the subsidiary; and

• the amount o the surplus Total Capital thatis attributable to the third-party investors iscalculated by multiplying the surplus Total Capitalby the percentage o Total Capital that is held bythird-party investors.

The amount o this Total Capital that will berecognised in Tier 2 will exclude amounts recognisedin Common Equity Tier 1 under common sharesissued by consolidated subsidiaries and amountsrecognised in Additional Tier 1 under Tier 1 qualiyingcapital issued by consolidated subsidiaries.



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APRA_Basel III Discussion Paper_06092011

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