Modernizing Ontario s Credit Union Legislative Framework

Transcription

1 Modernizing Ontario s Credit Union Legislative Framework Consultation Paper on a Proposed Capital Adequacy Framework November 2017

2 TABLE OF CONTENTS Introduction... 1 Structure of Paper... 1 How to Participate Overview of Capital Adequacy Requirements Basel III Potential Impact on Ontario Credit Unions Categories of Capital Criteria for Inclusion in Categories of Capital New Resolution Tool for the Prudential Regulator Minimum Capital Requirements Regulatory Adjustments Credit Risk Categories Transitional Arrangements Consultation Questions Glossary... Appendix A: Capital Conservation Buffer... Appendix B: CET1 - Basel III Criteria for Inclusion in CET1 Capital... Appendix C: AT1 - Basel III Criteria for Inclusion in AT1 capital... Appendix D: T2 - Basel III Criteria for Inclusion in T2 CapitaL...

3 INTRODUCTION In the 2016 Ontario Budget, the government announced its intention to implement the recommendations contained in the November 2015 report ( 2015 Report ) following the review of the Credit Unions and Caisses Populaires Act, 1994 ( CUCPA or the Act ). One of the recommendations in the 2015 Report was the adoption of updated capital adequacy requirements for Ontario credit unions based on Basel III principles, with appropriate adjustments to reflect the capital structure of credit unions. This consultation paper sets out a detailed proposal prepared by Ministry of Finance staff for implementing this recommendation. The purpose of this paper is to seek feedback from the credit union sector and other interested parties. This paper does not necessarily represent the position or views of the Government of Ontario. While developing the proposals contained in this document, the Ministry of Finance sought the input of the Deposit Insurance Corporation of Ontario (DICO) and the Financial Services Commission of Ontario (FSCO). DICO is the prudential regulator and deposit insurer for Ontario s credit union sector. FSCO is the market conduct regulator and is responsible for incorporating credit unions, approving changes to their charter, as well as for certain approvals under the Act, and for reviewing complaints against credit unions. STRUCTURE OF PAPER This consultation paper consists of ten sections discussing various aspects of the framework: Section 1 provides an overview of key elements of the existing capital adequacy standards in the CUCPA and the international capital adequacy standard Basel III that is considered a best practice for deposit-taking institutions globally Section 2 identifies the key changes that would be necessary in order to align Ontario s capital adequacy framework for credit unions more closely with Basel III Sections 3 to 9 describe specific measures being proposed to more closely align Ontario s capital adequacy framework for credit unions with Basel III, including proposed transitional measures to phase-in certain requirements discussed in Section 9 Section 10 poses a list of key consultation questions Throughout this consultation paper, reference is made to sections of the CUCPA and Ontario Regulation 237/09 made under the Act ( the General Regulation ), both of which can be accessed online at Please note that the term credit unions, as used throughout this paper, is intended to include caisses populaires. 1

4 HOW TO PARTICIPATE Your views are being sought on the proposals in this paper. Please see Section 10 for specific consultation questions. However, feedback need not be limited to the scope of the questions. Interested parties are invited to make written submissions by January 30, You may send comments by mail or to: Modernizing the CUCPA c/o Financial Services Policy Division Ministry of Finance 95 Grosvenor St, Frost Building North 4th Floor Toronto, ON M7A 1Z1 A copy of this consultation document can be reviewed online at Please note that this is a public consultation. All comments received will be considered public and may be used by the ministry to help evaluate and revise the legislative proposals. This may involve disclosing some or all comments or materials, or summaries of them, to other interested parties during and after the consultation. Personal information will not be disclosed without prior consent. All submissions received are subject to the Freedom of Information and Protection of Privacy Act. If you have any questions about this consultation or how any element of your submission may be used or disclosed, please contact: CUCPA.consultation@ontario.ca. After comments are reviewed and considered, it is anticipated that capital adequacy requirements will be incorporated into draft legislation to replace the existing CUCPA, for the government s consideration. If such legislation is enacted, further details regarding capital adequacy are anticipated to be incorporated into regulations made under the new legislation, or other instruments issued by the prudential regulator. 2

5 1 OVERVIEW OF CAPITAL ADEQUACY REQUIREMENTS Current CUCPA Requirements and Basel II In order to ensure financial stability and protect depositors, the CUCPA requires that Ontario credit unions hold minimum levels of capital. The current capital requirements are comprised of two elements a leverage ratio test and a risk-based capital ratio test both of which are derived from international standards agreed upon in 2004 by the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland. These standards are often referred to as the Basel II capital rules. Although initially the Basel II accord was applied only to internationally active banks in the G10 countries, it has become a recognized standard in many jurisdictions for different types of deposit-taking institutions. The Basel II framework consists of three pillars: Basel III 1. Pillar 1 calculates the required minimum levels of capital based on credit, operational and market risks at individual institutions (including the leverage and risk-based capital ratio tests described above) 2. Pillar 2 requires capital for additional risks identified based on internal management processes 3. Pillar 3 requires enhanced disclosure to investors and the public, as well as reporting of risks and capital levels to cover those risks In 2010 and in subsequent years, the BCBS introduced further reforms to strengthen global capital rules to promote a more resilient financial institutions sector, commonly referred to as Basel III. This new standard reinforces the Pillar 1 requirements of Basel II by increasing the minimum required levels of higher quality capital, requiring capital conservation and countercyclical buffers, introducing contingent capital, enhancing risk coverage for certain transactions such as securitizations, and including off-balance sheet and other items in the leverage ratio test. Additional Basel III reforms, such as proposals for a model-based credit risk framework and a simplified market risk framework, are still under development. 1 Similar to Basel II, the Basel III standard was initially applied only to internationally active banks, but it has also become a recognized standard for other deposit-taking institutions globally, including credit unions. In Canada, this standard became effective for federally-regulated Canadian deposit-taking institutions in January 2013, and applies to federal credit unions. Quebec and Saskatchewan have also adopted capital rules in line with the Basel III standard that apply to credit unions in their provinces. 1 See 3

6 The Basel III standard acknowledges that the proposed framework is not tailored to the unique legal and capital structure of co-operative and mutual financial institutions, and provides some flexibility to jurisdictions in applying the Basel III criteria to such entities. Previous Feedback from Credit Union Sector and Scope of Current Consultation During consultations leading up to the 2015 Report, most Ontario credit unions indicated that they were generally supportive of a move towards stronger capital requirements. However, credit unions were concerned that they would not be able to meet the minimum Common Equity Tier 1 (CET1) capital requirements under the Basel III framework, due to their reliance on investment shares and the characteristics of such shares. This paper describes proposed changes to the existing capital framework under the CUCPA in order to harmonize with the Pillar 1 requirements of Basel III while making appropriate modifications to reflect Ontario s credit union sector. In developing these proposals, current practices for co-operative and mutual financial institutions in other jurisdictions across Canada and internationally were considered. Pillar 2 objectives are primarily achieved through DICO s Internal Capital Adequacy Assessment Process (ICAAP) 2, which applies to credit unions with more than $500 million in assets. Pillar 3 requirements will be further considered in the future as part of reviewing disclosure rules under the CUCPA. Requirements under the CUCPA that already satisfy Basel III requirements (e.g., operational risk charge rules) are not discussed in this paper. 2 BASEL III POTENTIAL IMPACT ON ONTARIO CREDIT UNIONS Adopting a capital adequacy framework based on Basel III principles would result in several key changes to Ontario s existing capital framework for credit unions. These changes would include: New categories of capital Increased minimum levels of capital for each category Expanded criteria for each category of capital A new resolution tool for the prudential regulator Additional regulatory adjustments to capital New risk-weighting rules, impacted by new credit risk requirements Augmented leverage ratio requirements Pillar 1 Sections 3 to 9 of this consultation paper discuss these changes in further detail. Basel III requirements from the BCBS document, Basel III: A global regulatory framework for more resilient banks and banking systems (revised version June 2011) and other related standards, are quoted and at times paraphrased in grey boxes, with references to specific paragraph numbers from the standard in square brackets. 2 See PROCESS-AND-STRESS-TESTING 4

7 3 CATEGORIES OF CAPITAL What is the current Ontario requirement? Currently, section 17 of the General Regulation prescribes two categories of capital Tier 1 and Tier 2. What is the Basel III standard? Total regulatory capital consists of the sum of the following categories: 1. Tier 1 capital, consisting of: a) Common Equity Tier 1 capital (CET1) b) Additional Tier 1 capital (AT1) 2. Tier 2 capital (T2) For each of the three categories above (1a, 1b and 2) there is a single set of criteria that instruments are required to meet before inclusion in the relevant category. [BCBS 2011, par 49] What is the proposed approach? It is proposed that the Basel III categories of regulatory capital CET1, AT1 and T2 be adopted for Ontario credit unions. The split in Tier 1 capital between CET1 and AT1 emphasizes the importance of CET1 as the highest quality of capital with specific characteristics, such as permanence, subordination, and loss-absorbency. These characteristics enable credit unions to withstand periodic shocks in the market. In order to better reflect the cooperative share capital structure of credit unions, this proposal defines the acronym CET1 as Core Equity Tier 1 instead of the Basel III term Common Equity Tier 1, which contemplates a joint-stock company structure. 5

8 4 CRITERIA FOR INCLUSION IN CATEGORIES OF CAPITAL This section describes how Ontario could adopt the Basel III criteria for each category of credit union capital. 4.1 Tier 1 Capital What is the current Ontario requirement? Tier 1 capital of a credit union is currently described in subsection 17(2) of the General Regulation using amounts on the credit union s financial statements prepared as of the date of calculation of regulatory capital, including: Retained earnings Contributed surplus Membership shares Patronage shares other than those patronage shares that are redeemable within 12- months period following the date of calculation Qualifying shares which meet certain conditions described in subsection 17(4) of the General Regulation, other than qualifying shares that are redeemable within the 12 month period following the date of calculation (investment shares) Accumulated net after tax unrealized loss on available-for-sale equity securities reported in Other Comprehensive Income Certain deductions prescribed in subsection 16(1) of the General Regulation, including goodwill, certain amounts of intangible asset balances, and investments in subsidiaries that are financial institutions. See Section 7 for proposed amendments to regulatory adjustments. What is the Basel III standard? Basel III requires capital items included in each category of CET1, AT1 and T2 to have certain prescribed characteristics. This ensures that financial institutions hold sufficient high-quality capital with qualities of permanence and loss-absorbency that allows the financial institution to remain viable in the long-term. 6

9 4.1.1 Core Equity Tier 1 What is the Basel III standard? Basel III requires CET1 to consist of the sum of the following elements: Common shares issued by the bank that meet the criteria for classification as common shares for regulatory purposes (or the equivalent for non-joint stock companies) Stock surplus (share premium) resulting from the issue of instruments included in CET1 Retained earnings Accumulated other comprehensive income and other disclosed reserves Common shares issued by consolidated subsidiaries of the bank and held by third parties (i.e. minority interest) that meet the criteria for inclusion in CET1 capital Regulatory adjustments applied in the calculation of CET1 For an instrument to be included in CET1 capital, it must meet all of the criteria in Appendix B. Footnote 12 of the Basel III standard indicates that the criteria for classification in CET1 also apply to non-joint stock companies, which are defined as companies that do not issue common shares privately or publicly. The application of the criteria should preserve the quality of the instruments by requiring that they are deemed fully equivalent to common shares in terms of their capital quality and do not possess features which could cause the condition of the company to be weakened as a going concern during periods of market stress. [BCBS 2011, par 52-53] What is the proposed approach? It is proposed that CET1 for Ontario credit union capital consist of the sum of the following elements: Retained earnings Membership shares that satisfy the criteria set out in Appendix B with some modifications as described below Core capital shares that satisfy the criteria set out in Appendix B with some modifications as described below Accumulated net after tax unrealized loss on available-for-sale equity securities reported in Accumulated Other Comprehensive Income Common shares issued by consolidated subsidiaries of the credit union and held by third parties (i.e. minority interest) that satisfy the criteria set out in Appendix B Stock surplus (share premium) resulting from the issue of shares included in CET1 as is currently allowed under section 17 of the General Regulation Regulatory adjustments applied in the calculation of CET1 with modifications described in Section 7 7

10 These proposed components of CET1 are similar to what is allowed for federal credit unions under the Capital Adequacy Requirements Guideline issued by the Office of the Superintendent of Financial Institutions (OSFI). Membership shares One of the key challenges in modifying the Basel III standard to accommodate the unique capital structure of credit unions is the absence of common shares. The key characteristics of common shares that qualify them as the highest quality of capital are their permanence and claim to residual assets of the issuing institution. Permanence means that shareholders do not have any expectation that the issuing institution will redeem their shares in the future. Claim to residual assets means that shareholders would receive the remaining assets in the event of a dissolution after the claims of all creditors and priority shareholders have been satisfied. Currently under the CUCPA, membership shares have claims to residual assets of the credit union, similar to common shares. However, they do not have the required degree of permanence to be classified as CET1. In order to enhance the permanence of membership shares so that they could qualify as CET1, it is proposed that: All share redemptions would not be at the member s sole discretion and the credit union must have the unconditional right to refuse redemption All share redemptions would require prior approval by the prudential regulator. Further consideration will be given by the prudential regulator to the approval of normal course issuer bid redemptions Shares could not be redeemed if the redemption would result in the credit union failing to meet regulatory capital or liquidity requirements This modification would allow membership shares to meet the Basel III criteria 3 and 4 in Appendix B. Core capital shares In order to provide credit unions with opportunities to raise additional CET1 capital outside of retained earnings and membership shares, and to allow credit unions to convert existing investment shares into CET1-compliant capital, it is proposed that a new type of share core capital share be created that would qualify for inclusion in CET1. Core capital shares would need to meet all of the CET1 characteristics of permanence, subordination, and residual claims to assets detailed in Appendix B, as well as have the following features: Claims to residual assets: Core capital shares would be entitled to claims on the residual assets of a credit union that would rank equally with the claim entitlements of membership shares up to a specified cap. Any assets remaining after the cap is reached would be distributed exclusively to the credit union s members. This is in line with the approaches implemented by OSFI for federal credit unions, the European Union and other jurisdictions internationally 8

11 Permanence: Similar redemption characteristics would apply to core capital shares as membership shares (as described above), including the requirement to obtain approval from the prudential regulator for redemptions Conversion: Core capital shares could be created as a result of amending the terms and conditions of investment shares These modifications would allow core capital shares to meet Basel III criteria 1, 2, and 8 in Appendix B in order to qualify for CET1. Contractual cap Distributions on CET1 shares may be subject to a contractual cap or restriction. This would be a departure from the Basel III framework in order to accommodate the structure of credit union shares. This approach is consistent with the approaches implemented by OSFI and the European Union in respect of credit unions. Accumulated other comprehensive income (AOCI) The impact of AOCI items on CET1 capital of credit unions is substantially the same between Basel III and the current requirements in the General Regulation Additional Tier 1 Capital What is the Basel III standard? Basel III requires that Additional Tier 1 (AT1) capital consists of the sum of the following elements: Instruments issued by the bank that meet the criteria for inclusion in AT1 capital (and are not included in CET1) Stock surplus (share premium) resulting from the issue of instruments included in AT1 capital Instruments issued by consolidated subsidiaries of the bank and held by third parties that meet the criteria for inclusion in AT1 capital and are not included in CET1 Regulatory adjustments applied in the calculation of AT1 capital The full list of AT1 criteria is detailed in Appendix C. [BCBS 2011, par 54] 9

12 What is the proposed approach? It is proposed that credit union AT1 capital consist of the sum of the following elements: Investment and patronage shares that meet the criteria set out in Appendix C with some modifications as described below Stock surplus (share premium) resulting from the issue of shares included in AT1 capital, as is currently allowed under section 17 of the General Regulation Common shares issued by consolidated subsidiaries of the credit union and held by third parties (i.e. minority interest) that meet the criteria for inclusion in Appendix C Regulatory adjustments applied in the calculation of Additional Tier 1 capital with modifications described in Section 7 Investment and other qualifying shares Most investment shares currently issued by Ontario credit unions would not qualify for AT1 treatment under Basel III, as they do not meet Basel III s definition of permanence. To address this issue, the government has announced its intention to include investment shares in the computation of AT1 capital, as recommended in the 2015 Report, provided that: All share redemptions be approved by the prudential regulator Shares redemptions would not be permitted if the redemption would result in the credit union failing to meet regulatory capital or liquidity requirements Any new investment shares issued should contain the provision that they cannot be redeemed at the member s sole discretion and the credit union must have an unconditional right to refuse redemption Existing investment shares outstanding would be included in Tier 1 capital for a grandfathered period of five years. Refer to Section 9 for transitional proposals It is proposed that the same criteria also apply to patronage shares so that they could qualify for inclusion in the computation of AT1 capital. These modifications would allow investment and patronage shares to meet Basel III criteria 4 in Appendix C relating to permanence. Some of the additional Basel III key criteria, set out in more detail in Appendix C, would impact the existing terms of investment and patronage shares: Shares would not contain a maturity date or other incentives for the credit union to redeem them (Criteria 4 in Appendix C). A credit union s actions must not create an expectation that a call will be exercised, and a credit union must not exercise a call unless: It replaces the called share with capital of the same or better quality, and the replacement of this capital reflects conditions which are sustainable for the income capacity of the credit union, or 10

13 The credit union demonstrates to the prudential regulator that its capital position would continue to exceed the minimum capital requirements after the call option is exercised (Criteria 5 in Appendix C) Classification as a liability Basel III AT1 Criteria 11 states that equity instruments classified as liabilities for accounting purposes may be automatically converted or written-down when a financial institution reaches a certain threshold of CET1 capital. It is proposed that this Basel III criterion not be adopted for Ontario credit unions, as such terms may reduce investor confidence in credit union shares. It is proposed that, in line with the approach adopted by OSFI, AT1 instruments are required to be classified as equity for accounting purposes, except for investment shares. 4.2 Tier 2 Capital What is the current Ontario requirement? Subsection 17(3) of the General Regulation describes items that are currently included in T2 capital. It is determined using amounts on the credit union s financial statements prepared as of the date of calculation of regulatory capital, including: Patronage shares that are redeemable within the 12-month period following the date of calculation Fully paid shares issued by the credit union, excluding membership shares, patronage shares and qualifying shares that are included in Tier 1 capital Subordinated indebtedness that cannot be redeemed or purchased for cancellation in the first five years after it is issued, and is not convertible into or exchangeable for a security other than a qualifying share The amount of any loan loss allowance, not including an individual loan loss allowance, up to a maximum of 0.75% of total assets for a Class 1 credit union and 1.25% of riskweighted assets for a Class 2 credit union. Effective January 1, 2018, the distinction between Class 1 and Class 2 credit unions will be eliminated and all existing Class 1 credit unions will be subject to the same loan loss allowance of 1.25% of total assets Accumulated net after tax unrealized gain on available-for-sale equity securities reported in Other Comprehensive Income Certain deductions set out in the current Capital Adequacy Guideline for Ontario s Credit Unions and Caisses Populaires 3, such as the accumulated actuarial losses for any defined benefit pension fund liability included on the balance sheet where the losses have been accounted for through AOCI. See Section 7 for proposed amendments to regulatory adjustments 3 See 11

14 What is the Basel III standard? Basel III requires that Tier 2 (T2) capital consist of the sum of the following elements: Instruments issued by the bank that meet the criteria for inclusion in T2 capital (and are not included in Tier 1 capital) Stock surplus (share premium) resulting from the issue of instruments included in T2 capital Instruments issued by consolidated subsidiaries of the bank and held by third parties that meet the criteria for inclusion in T2 capital and are not included in Tier 1 capital Certain loan loss provisions Regulatory adjustments applied in the calculation of T2 Capital The full list of T2 criteria is detailed in Appendix D. [BCBS 2011, par 57] What is the proposed approach? It is proposed that credit union T2 capital consist of the sum of the following elements: Investment, patronage and membership shares that meet the criteria set out in Appendix D Common shares issued by consolidated subsidiaries of the credit union and held by third parties (i.e. minority interest) that meet the criteria for inclusion in Appendix D Stock surplus (share premium) resulting from the issue of instruments included in T2 capital General loan loss allowance up to 1.25% of risk-weighted assets for all credit unions, which will, as of January 1, 2018, be allowed for all credit unions pursuant to paragraph 4 of subsection 17(3) of the General Regulation Regulatory adjustments applied in the calculation of T2 capital with proposed modifications described in Section 7 Generally, existing investment shares currently qualify for T2 capital treatment under Basel III. Some key characteristics of shares qualifying for T2 capital treatment, further detailed in Appendix D, are: The instrument must have a minimum original maturity date of 5 years and the issued capital balance would be amortized on a straight-line basis over 5 years to maturity (Criteria 4 in Appendix D) The shares should have the same call option characteristics as AT1 instruments described above (Criteria 5 in Appendix D) 12

15 5 NEW RESOLUTION TOOL FOR THE PRUDENTIAL REGULATOR What is the Basel III standard? Basel III requires a contingent capital term to be integrated within the share terms and conditions of all AT1 and T2 shares. The contingent capital term is a resolution tool that allows the prudential regulator to write-down or convert AT1 and T2 shares into CET1 shares when it is determined that a significant financial institution is about to become non-viable. The aim of this requirement is to recapitalize a systemically important financial institution (SIFI) with the goal of returning it to viability by the prudential regulator, and to ensure that all classes of capital instruments fully absorb losses at the point of non-viability before taxpayers are exposed to loss, where the government determines that it is in the public interest to rescue a non-viable institution. What is the proposed approach? In line with approaches adopted for credit unions by OSFI and the European Union, it is proposed that this Basel III requirement be adopted with some modifications. This would allow the prudential regulator, at the point of non-viability, to trigger full and permanent conversion of AT1 and T2 shares into non-voting core capital shares that are eligible for recognition as CET1 capital. This requirement would provide an additional resolution tool to the prudential regulator to be able to quickly and effectively restructure and recapitalize a systemically important credit union in Ontario. It is anticipated that the point of non-viability would be determined by the prudential regulator in accordance with criteria similar to those detailed in paragraphs 45 to 47 of OSFI s Capital Adequacy Requirements Guideline, Chapter 2. 6 MINIMUM CAPITAL REQUIREMENTS This section describes key proposed changes to Ontario s current risk-based capital and leverage ratios for credit unions. 6.1 Risk-based capital ratio What is the current Ontario requirement? Currently, the General Regulation imposes risk-based capital ratio requirements on Class 2 credit unions. Class 2 credit unions have assets greater than or equal to $50 million or engage in commercial lending, while Class 1 credit unions have total assets of less than $50 million or do not engage in commercial lending. Effective January 1, 2018, amendments to the General Regulation will eliminate the distinction between Class 1 and Class 2 credit unions, resulting in all credit unions being required to maintain a minimum risk-based capital ratio of 8%. The minimum risk-based capital ratio is currently calculated based on non-consolidated financial statements of the credit union, where a credit union s investments in subsidiaries are 13

16 recorded using the equity method of accounting as described in the Capital Adequacy Guideline for Ontario s Credit Unions and Caisses Populaires. Ontario does not currently have any capital conservation buffer or countercyclical buffer requirements for credit unions. What is the Basel III standard? CET 1 capital must be at least 4.5% of risk-weighted assets at all times A capital conservation buffer of 2.5% must be held in addition to the CET1 minimum capital requirement [BCBS June 2011, par 129] Total Tier 1 capital must be at least 6.0% of risk-weighted assets at all times Total Capital (Tier 1 capital plus Tier 2 capital) must be at least 8.0% of risk-weighted assets at all times [BCBS June 2011, par 50] The sum of the above would bring the minimum Total Capital requirement to 10.5%. In addition, a countercyclical buffer that varies between zero and 2.5% must be held in addition to the CET1 minimum capital requirement. [BCBS June 2011, par 142] Capital Conservation Buffer: Capital distribution constraints will be imposed on a bank when capital levels fall below 2.5%. [BCBS June 2011, par 129] The table reproduced in Appendix A shows the minimum capital conservation ratios a bank must meet at various levels of the CET1 capital ratio. [BCBS June 2011, par 131] This could include reducing dividend payments, share buybacks and staff bonus payments. Banks may also choose to raise new capital from the private sector as an alternative to conserving internally generated capital. The balance between these options should be discussed with supervisors as part of the capital planning process. [BCBS June 2011, par 124] The scope of application of the Basel Framework will include, on a fully consolidated basis, any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group. [BCBS June 2006, par 21] 14

17 What is the proposed approach? Consistent with Basel III, it is proposed that the minimum risk-based capital ratio requirements for Ontario credit unions be specified for each of CET1, Total Tier 1 Capital (consisting of both CET1 and AT1), and Total Regulatory Capital (consisting of CET, AT1 and T2) classes of capital, as well as a capital conservation buffer as illustrated in the table below (discussed below). The proposed risk-based capital ratio requirements would be subject to a transition period which is described in Section 9 of this paper. Minimum Risk-Weighted Capital (as a % of risk-weighted assets) after transition period Core Equity Tier 1 (CET1) Total Tier 1 Capital (CET1 + AT1) Total Regulatory Capital (CET1 + AT1 + T2) Minimum ratio 4.5% 6.0% 8.0% Capital conservation buffer Minimum plus capital conservation buffer 0% 2.5% 2.5% 4.5% 8.5% 10.5% Furthermore, it is proposed that these minimum requirements be applied to credit unions on a consolidated basis as stated in Basel III. Therefore, the asset base to which the minimum requirements would be applied would include the assets of most types of subsidiaries, which would be risk-weighted based on the credit risk of the counterparty. This would render the current requirement in the Capital Adequacy Guideline for Ontario s Credit Unions and Caisses Populaires to report investments in subsidiaries on an equity basis unnecessary. Capital Conservation Buffer and Distribution Constraints It is proposed that Ontario adopt a capital conservation buffer that applies to credit union Total Tier 1 Capital rather than CET1 capital. This adjustment is being proposed with the understanding that credit unions only issue investment and membership shares to their members, which reduces their ability to raise CET1 capital compared to other companies that can issue common shares to the public. Consideration will be given to applying the capital conservation buffer to CET1 capital in the future, once credit unions begin to meet phase-in Basel III requirements. It is proposed that credit unions be restricted from making distributions when they do not meet minimum capital conservation requirements throughout the transition period and afterwards. The table below shows an example of restrictions on distributions that would be imposed on a credit union in year 10 when it falls below the minimum capital required at various levels of Total Tier 1 capital: 15

18 Individual credit union minimum capital conservation requirements Year 10 Column A Total Tier 1 Capital Column B % of Distributable Earnings (CET1 + AT1) Ratio < 6.5% 0% >6.5% - 7.0% 20% >7.0% - 7.5% 40% >7.5% - 8.0% 60% >8.0% - 8.5% 80% >8.5% 100% [Based on table in BCBS June 2011, par 131] The table above is based on the Basel III table Individual bank minimum capital conservation standards (reproduced in Appendix A), but deviates from that table in the following ways: The minimum Total Tier 1 capital ratio in Column A is higher than what is required under Basel III. This is proposed as the buffer would be applied to Total Tier 1 capital, rather than CET1 capital The title of Column B has been modified from the title in the Basel III table Minimum Capital Conservation Ratios for clarity A capital conversion requirement for 80% of distributable earnings has been added to give more flexibility to credit unions that fall into this range, whereas Basel III does not include a requirement for that level of capital In accordance with the table, a credit union with Total Tier 1 capital (CET1 + AT1) in a range set out in Column A, would not be able to distribute more than the corresponding percentage of distributable earnings set out in Column B, in the subsequent financial year. Such distributions could include dividends, share buybacks, discretionary bonus payments, and share payments that deplete Total Tier 1 capital. Furthermore, a credit union would not be able to make distributions on instruments included in regulatory capital when its retained earning position is negative, or where such distributions would result in retained earnings becoming negative. The credit union must retain all earnings until it returns to a positive retained earnings position (refer to Criteria 5 in Appendix B and Criteria 8 in Appendix C). If the credit union wishes to make payments in excess of the constraints imposed, it would have the option of raising capital equal to the amount above the constraint that it wishes to distribute, subject to the prudential regulator s approval [based on BCBS June 2011 par 124, 131]. Consistent with Basel III, it is proposed that credit unions that are aware of events that may deplete their capital conservation buffers be required to prepare capital conservation plans and 16

19 submit such plans to the prudential regulator, unless the regulator authorizes otherwise. Additional Basel III capital conservation buffer requirements are detailed in Appendix A. It is proposed that the Basel III countercyclical buffer requirements not be considered until credit unions have started to phase in the new proposed minimum capital requirements discussed in this paper. 6.2 Leverage ratio What is the current Ontario requirement? Class 1 credit unions must maintain a leverage ratio of at least 5%, while Class 2 credit unions must maintain a leverage ratio of a least 4%. Effective January 1, 2018, this distinction will be eliminated and all credit unions will be subject to the same leverage ratio requirement of 4%. What is the Basel III standard? The Basel III leverage ratio framework is set out in the document Basel III leverage ratio framework and disclosure requirements (January 2014). The ratio is defined as Tier 1 capital divided by the exposure measure, which includes on-balance and off-balance sheet items, derivative exposures, and securities financing transaction exposures. The minimum leverage ratio requirement is 3%. [BCBS January 2014, par 6, 7, 10, 12, 14] What is the proposed approach? The government has announced its intention to support the recommendations in the 2015 Report to maintain the minimum leverage ratio at 4% and to include off balance-sheet assets in the exposure measure. Off-balance sheet assets include commitments (including liquidity facilities) whether or not unconditionally cancellable, direct credit substitutes, acceptances, standby letters of credit and trade letters of credit. However, off-balance sheet assets exclude mortgages that have been pooled and sold under the National Housing Act Mortgage Backed Securities (NHA MBS) Program and derecognized under IFRS. Further to the recommendation made in the 2015 Report, it is proposed that the following changes be made to the methodology by which the leverage ratio is determined in order to more closely align Ontario s framework with Basel III: Only Tier 1 Capital would be considered in the leverage ratio, as opposed to Total Regulatory Capital (Tier 1 and Tier 2), as currently permitted under section 15 of the General Regulation 17

20 Derivatives and securities financing transaction exposures would be included in the exposure measure. Securities financing transaction exposures include items such as repurchase agreements, reverse repurchase agreements, security lending and borrowing, and margin lending transactions, where the value of the transactions depends on market valuations and the transactions are often subject to margin agreements 7 REGULATORY ADJUSTMENTS This section describes the key proposed changes to the regulatory adjustments under the CUCPA to more closely align with regulatory adjustments required under Basel III. As explained earlier in Section 6.1, it is proposed that these regulatory adjustments would apply to credit unions on a consolidated basis, which would include the assets of most types of subsidiaries. 7.1 Intangible assets CET1 deduction What is the current Ontario requirement? Section 16 of the General Regulation specifies that the portion of intangible assets (other than goodwill) that is greater than 5% of Tier 1 capital must be deducted from total assets of the credit union. The amount that is deducted is risk-weighted at 0%, while the amount that is not deducted is risk-weighted at 100% for the purposes of calculating the risk-based capital ratio and the leverage ratio. Some examples of intangible assets include mortgage servicing rights, core deposit intangible assets, computer software and banking systems. What is the Basel III standard? Goodwill and all other intangibles must be deducted in the calculation of CET1 With the exception of mortgage servicing rights, the full amount is to be deducted net of any associated deferred tax liability which would be extinguished if the intangible assets become impaired or derecognized under the relevant accounting standards. The amount to be deducted in respect of mortgage servicing rights is set out in the threshold deductions section (see Section 7.7 for details). [BCBS June 2011 par 67, 87-89] 18

21 What is the proposed approach? It is proposed that, consistent with Basel III, all intangible assets be deducted from CET1 capital. Goodwill will continue to be fully deducted as per the current requirements. These amount that are deducted would be risk-weighted at 0%. Mortgage servicing rights would be subject to a threshold deduction described in Section Deferred tax assets What is the current Ontario requirement? Under section 18 of the General Regulation, deferred tax assets (DTAs) are risk-weighted at 100%. What is the Basel III standard? DTAs that rely on future profitability of the bank to be realized are to be deducted in the calculation of CET1 Where these DTAs relate to temporary differences (e.g. allowance for credit losses) the amount to be deducted is set out in the threshold deductions section (see Section 7.7 for details). [BCBS 2006 par 69, 87, 89] What is the proposed approach? In order to align with Basel III, it is proposed that different treatments be prescribed to different types of DTAs, as follows: A full CET1 deduction would be required for DTAs that relate to permanent differences (e.g., those relating to operating losses, such as the carry forward of unused tax losses, or unused tax credits) A threshold deduction would be required for DTAs that relate to temporary differences relying on future profitability of the credit union (e.g., allowance for credit losses), as described in Section 7.7 DTAs arising from temporary differences that the credit union could realize through loss carry-backs would be 100% risk-weighted, which is consistent with the current requirement 19

22 7.3 Deferred gain on sale of securitization transactions What is the current Ontario requirement? Under section 18 of the General Regulation, equity capital resulting from securitization transactions (e.g., capitalized future margin income, deferred gains on sale) are risk-weighted at 100%. What is the Basel III standard? In the calculation of CET1, derecognise any increase in equity capital resulting from a securitisation transaction, such as that associated with expected future margin income (FMI) resulting in a gain-on-sale. [BCBS June 2011 par 74] What is the proposed approach? It is proposed that deferred gains related to securitization transactions be deducted from CET Investments in own shares What is the current Ontario requirement? Sections 61 and 64 of the CUCPA allow credit unions to hold their own shares through the realization of security in various circumstances, such as when member s account is liquidated. What is the Basel III standard? All of a bank s investments in its own common shares, whether held directly or indirectly, will be deducted in the calculation of CET1 (unless already derecognised under the relevant accounting standards). In addition, any own shares which the bank could be contractually obliged to purchase should be deducted in the calculation of CET1. [BCBS June 2011 par 78] What is the proposed approach? It is proposed that any shares in a credit union owned by that credit union be excluded from CET1 capital. 20

23 7.5 Reciprocal cross-holdings of shares What is the current Ontario requirement? Credit unions are not permitted to invest in other credit unions without approval from the prudential regulator under section of the Act. In addition, there is currently no deduction of share cross-holdings between credit unions under the CUCPA. What is the Basel III standard? Reciprocal cross holdings of capital that are designed to artificially inflate the capital position of banks will be deducted in full. Banks must apply a corresponding deduction approach to such investments in the capital of other banks, other financial institutions and insurance entities. This means the deduction should be applied to the same component of capital for which the capital would qualify if it was issued by the bank itself. [BCBS June 2011 par 67] What is the proposed approach? There is no evidence that credit unions are currently cross-holding capital with other financial institutions, but as a best practice it is proposed that this Basel III principle be adopted. As a result, any reciprocal cross-holdings of capital between credit unions and financial institutions would be deducted from the same component of capital. 7.6 Investments in the capital of unconsolidated banking, financial and insurance entities What is the current Ontario requirement? Credit unions must report significant investments in financial institutions that are not subsidiaries using the equity method of accounting, as required by the Capital Adequacy Guideline for Ontario s Credit Unions and Caisses Populaires. Paragraph 8 of subsection 18(2) of the General Regulation specifies that such investments are risk-weighted at 0%. Non-significant investments in financial institutions are risk-weighted according to the credit risk of the counterparty. 21

24 What is the Basel III standard? Basel III prescribes different treatment to investments in unconsolidated entities based on degree of control over the entity. Non-significant investments in unconsolidated banking, financial and insurance entities (10% or less) The regulatory adjustment described in this section applies to investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation and where the bank does not own more than 10% of the issued common share capital of the entity [BCBS June 2011 par 80]. Examples of the types of activities that financial entities might be involved in include financial leasing, issuing credit cards, portfolio management, investment advisory, custodial and safekeeping services and other similar activities that are ancillary to the business of banking. [BCBS FAQs #7 p.10] If the total of all holdings listed above in aggregate exceed 10% of the bank s common equity (after applying all other regulatory adjustments in full listed prior to this one) then the amount above 10% is required to be deducted, applying a corresponding deduction approach. This means the deduction should be applied to the same component of capital for which the capital would qualify if it was issued by the bank itself [BCBS June 2011 par 81] Amounts below the threshold, which are not deducted, will continue to be risk-weighted. Thus, instruments in the banking book should be treated as per the standardised approach. For the application of riskweighting the amount of the holdings must be allocated on a pro rata basis between those below and those above the threshold. [BCBS June 2011 par 83] Significant investments in unconsolidated banking, financial and insurance entities (over 10%) The regulatory adjustment described in this section applies to investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation where the bank owns more than 10% of the issued common share capital of the issuing entity or where the entity is an affiliate of the bank [BCBS June 2011 par 84] All investments included above that are not common shares must be fully deducted following a corresponding deduction approach. This means the deduction should be applied to the same tier of capital for which the capital would qualify if it was issued by the bank itself [BCBS June 2011 par 85] Investments included above that are common shares will be subject to the threshold treatment described in Section 7.7. [BCBS June 2011 par 86] What is the proposed approach? It is proposed that the Basel III approach for non-significant and significant investments be adopted, including the 10% threshold for defining whether an investment is significant for regulatory capital purposes. It is proposed that these investment rules exclude investments in 22

25 centrals and leagues, which is necessary as many credit unions hold significant deposits in their centrals or leagues. 7.7 Threshold deductions What is the current Ontario requirement? There is currently a threshold deduction for intangible assets with balances exceeding 5% of Tier 1 capital of a credit union, which is set out in subsection 16(1) of the General Regulation. What is the Basel III standard? Instead of a full deduction, the following items may each receive limited recognition when calculating CET1, with recognition capped at 10% of the bank s common equity (after the application of all regulatory adjustments): Significant investments in the common shares of unconsolidated financial institutions (banks, insurance and other financial entities) Mortgage servicing rights DTAs that arise from temporary differences [BCBS June 2011 par 87] The remaining 90% of each of the three items that are not deducted in the calculation of CET1 will be riskweighted at 250%. [BCBS June 2011 par 89] What is the proposed approach? As discussed in Section 7.1, 7.2 and 7.6, it is proposed that a threshold deduction be adopted for mortgage servicing rights, deferred tax assets arising from temporary differences that rely on future profitability, and significant investments in financial institutions. As a result, the balance of each type of asset with a value above 10% of a credit union s CET1 capital would be deducted from CET1 capital, and the amount not deducted would be risk-weighted at 250%. 23