Capital Review Paper 2: What should qualify as bank capital? Issues and Options

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1 The Co operative Bank Ltd Cnr Featherston & Ballance Streets PO Box 54, Wellington 6140 Telephone (04) , Fax (04) SBS Bank, Head Office 51 Don Street, PO Box 835, Invercargill 9840, New Zealand. Ph , Fax , Freephone , TSB Bank Limited 120 Devon Street East, PO Box 240, New Plymouth 4340, New Zealand. Freephone , Nelson Building Society, Head Office 111 Trafalgar St, PO Box 62, Nelson, 7040 Freephone , 7 September 2017 Ian Woolford Manager, Financial Policy Prudential Supervision Department Reserve Bank of New Zealand PO Box 2498 Wellington 6140 Dear Ian, Capital Review Paper 2: What should qualify as bank capital? Issues and Options Thank you for the opportunity to provide feedback on the Issues Paper Capital Review Paper 2: What should qualify as bank capital? Issues and Options. This submission is supplemental and additional to the NZBA submission on the same paper and has been written on behalf of the NZ domestic Cooperatively and Community-Owned Banks and Nelson Building Society. The Co-operative Bank, SBS Bank and TSB Bank are members of the NZBA and support in principle the submission of the NZBA. However, there are some matters of specific relevance to this group that we wish to address in this short submission. As a result, we have not answered the specific questions in the Reserve Bank of New Zealand ( RBNZ ) issues paper as these are addressed in the NZBA submission. As New Zealand Owned Banks (and Building Societies) we believe we hold an important position in a banking industry that is dominated by Australian Owned banks. The ownership structure of our entities mandates that our primary objective is to return value to our Members and Communities and to operate in a way that ensures long-term sustainability and financial stability. One of the encumbrances to being able to create competitive tension in the financial system is our balance sheet scale and lower operating efficiencies that come with this. In our view, reduced access to capital is a key constraint in achieving highly efficient and scaled operations that will further strengthen the NZ banking environment and create a highly-competitive banking landscape for the consumer. For this reason we see this review as critically important and would make the following joint observations.

2 We recognise a benefit in the RBNZ preferred option in that it theoretically levels the playing field for all banks. Currently mutuals and banks with non-standard structures are penalised by existing capital requirements due to: 1) an inability of those with non-standard structures to convert capital instruments to common equity; and 2) the current tax treatment for capital instruments with write-off options which enforces a 28% regulatory capital hair-cut. Currently a tax hair-cut is applied from the time of issue to capital instruments which write-off rather than convert in the event of non-viability. This is not the case for instruments where the primary method is conversion and where the issuer obtains a binding ruling from the IRD, in which case a haircut at the point of issue is not required as there is no tax liability arising on conversion to equity. This gives an advantage to those banks which can offer conversion and penalises those that cannot. The RBNZ proposal suggests the removal of convertibility and intends that Tier 2 capital-raising in New Zealand has a hair-cut applied. This means that in theory at least, all banks will be treated alike in so far as tax is concerned in relation to Tier 2 instruments. The other matters of particular relevance to this group that we wish to raise are as follows: 1. As noted in our earlier submission, it is critical for competition and for diversification of capital funding, that a range of options is available to all banks, regardless of their size, through which they can raise capital. Raising Tier 1 capital is not straightforward and is time and cost intensive, especially for smaller banks such as mutually-owned and Trust-owned, non-listed banks and it is therefore vital that there are other options available that qualify as Additional Tier 1 ( AT1 ) and Tier 2 capital particularly for banks which are restricted in this way. Rather than restrict capital products, New Zealand would benefit from widening its requirements as have other jurisdictions, such as Canada, where parliament has enacted legislation that enables co-operatives and mutual organisations to issue alternative instruments that qualify as Tier 1 capital. In Australia, APRA modified its Capital Adequacy standard (APS 111) in 2014 specifically to allow for the issue of mutual equity interests in relation of Additional Tier 1 and Tier 2 capital instruments. As a group we have commissioned the law firm Russell McVeagh to undertake further work for us to outline the key attributes of these options including: 1) Core Capital Deferred Shares as allowed by the Bank of England and European Banking Authority; and 2) Mutual Equity Interests as allowed by APRA. We have attached this work as Appendix One to this submission. We have also attached as Appendix Two a summary of recent Australian submissions on Mutual Equity Interests. We support the exploration of such options here, which we believe would support diversification of capital sourcing and improve the financial stability of banking providers in New Zealand. We

3 would encourage the RBNZ to consider similar options that could be applicable in New Zealand and we would be happy to work with the RBNZ to progress this. 2. In relation to the RBNZ s preferred option relating to capital instruments, it is critical that the instruments are in a form that will have a suitable market. We would recommend that the RBNZ actively seeks consultation with fund management industry consultants, broking houses and larger authorised financial advisory firms as to likely demand for the capital instruments that the RBNZ has a preference for. 3. The consultation paper states that Tier 2 capital must be long term. It is important, in the absence of a definition, that the short-term nature of the New Zealand capital market, as well as the needs of investors, are taken into account when determining the minimum term. We think it is important that any Tier 2 product is structured as closely to the existing Tier 2 product as is possible i.e. 10-year non-call 5 with prior regulatory approval as a condition of the call at year 5. There is a concern that a minimum 10 year term may be imposed prior to triggering an ability to call the instrument. It is our view that such a structure would likely prevent any meaningful issuance which would leave New Zealand-owned banks with no viable method of raising capital. With this in mind, we request that the minimum term remains at 5 years. 4. We note that there is intended to be a 5 year transition period for existing instruments which would no longer qualify as capital under the preferred, proposed approach. We believe, given the uncertainty regarding the demand for replacement capital instruments, that there needs to be a longer transition period. A 10 year period would allow for a more orderly transition and for existing Tier 2 issues to be matured in accordance with their contractual terms and conditions in the event that call options could not be exercised. 5. The RBNZ states that, recognising retained earnings and reserves may warrant some review and clarification in the future. Given that retained earnings are not subject to future payments or accounting judgement but are an accumulation of earnings after the deduction of dividends, we do not agree with the RBNZ s comment that the value of undistributed earnings and reserves held as buffers against unexpected loss is less certain that ordinary share capital. Retained earnings are fully available to absorb losses and in many respects provide a more robust form of capital than any other form except common shares. It is our expectation that any change to the treatment of retained earnings and reserves should not be material. We request that, as retained earnings and reserves forms a substantial portion of equity for most banks, that any such review is addressed as quickly as possible. 6. Finally, while not part of the review, the consultation paper raises the non-objection process a number of times. The RBNZ states that concerns about non-compliance led to a non-objection process that undermines self-discipline and arguably market discipline as well.

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11 Appendix Two: Summary of Recent Australian Submissions on mutual equity interests Recent submissions in Australia (regarding reform to support cooperatives, mutual associations and member-owned firms) provide guidance on the benefits of allowing mutual equity interests ("MEIs") to be recognised as Common Equity Tier 1 ("CET1") capital. The key points are summarised below: Mutual Authorised-deposit Taking Institutions ("ADIs") are limited to relying on retained earnings for CET1 capital. Retained earnings are accumulated slowly due to highly competitive pricing offered to members and constant investment back into local communities. Access to regulatory capital is critical for the mutual sector's capacity to compete and grow. The lack of access to capital limits the flexibility of mutual ADIs to expand services and to make major investments in infrastructure, especially at a time of technological disruption. MEIs do not affect member participation or control of the business of a mutual ADI. This is because MEIs do not carry voting rights beyond a claim on the surplus assets of the mutual ADI for face value. There is potential for the issuance of MEIs by a mutual ADI to be beneficial for its members. As the face value has been contributed to the capital of the ADI, and a holder's claim on surplus assets is limited to the face value, MEIs do not dilute the interests of members in the capital of the mutual. Members must benefit when their mutual ADI is able to raise capital at a lower cost than debt funding. As mutual ADIs cannot otherwise issue common equity, an issuance of MEIs would provide permanent capital of the highest quality in the capital structure. As MEIs do not carry a right to vote, members continue to have an equal say in the conduct of the mutual ADI. The features that make MEIs attractive to mutual ADIs are likely to impact on the attractiveness to prospective investors. The lack of voting rights may lead to investors "pricing in" the risk of having no legal control. Since 2014, no customer owned banking institution has issued Additional Tier 1 or Tier 2 capital instruments, which convert to MEIs upon a trigger event. This is likely due to the complexity and uncertainty of MEIs and the difficulty of designing and selling an instrument that converts into something that does not currently exist. Examples from the UK show that it is possible to implement legislative and regulatory constraints that preserve the strength of a mutual ADI while allowing sufficient flexibility to make MEIs attractive to investors.