In APRA s view, Australian authorised deposit-taking. pacemaker. Feature

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1 Feature Global pacemaker When the Australian Prudential Regulation Authority (APRA) published the first of two consultation papers on local implementation of Basel III rules covering capital the most eye-catching proposal was an accelerated timeline for Australian adoption of new standards. Local banks say they are wellpositioned to match the schedule, which may help them sell global investors on the strength of their sector. B y L a u r e n c e D a v i s o n a n d T a r a S p e n c e r In APRA s view, Australian authorised deposit-taking institutions (ADIs) are well placed to meet the new global minimum capital requirements set out by Basel III guidelines. As a result, the regulator announced its plans for an accelerated implementation timetable for the local regime in the consultation paper it published on September 6. If APRA s initial stance is adopted, Australian banks will have to meet the Basel III common equity tier one (CET1) and overall tier one capital minimum standards by the beginning of 2013 two years ahead of the date proposed by the Basel Committee on Banking Supervision (Basel committee) for global implementation. BASEL III/ APRA MINIMUM CAPITAL IMPLEMENTATION TIMELINE ( PER CENT) CET1 Capital conservation buffer CET1 + conservation buffer Total tier 1 T1 + conservation buffer Total capital Total capital + conservation buffer / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /10.5 Source: australian prudential regulation authority September Meanwhile, capital conservation buffers will be introduced at their full minimum size at the start of 2016 according to APRA s proposals, compared with the Basel committee s expectation of a gradual increase of buffer requirements from 2016 to Various other capital standards will have to be met faster or with a shorter transition period than the global minimum (see table on this page). APRA says its confidence regarding the accelerated implementation timeline is based on the results of the most recent quantitative impact study information provided to the regulator by a number of the larger ADIs and on APRA s analysis of current capital ratios for other ADIs. Banks own published data appear to support the regulator s view. Every Australian Securities / / / / / / /10.5 Exchange-listed ADI had core tier one capital well in excess of the minimum Basel III standard under existing qualification criteria at the time of their most recent results (see chart on facing page). The only listed bank with any work to do is Bendigo and Adelaide Bank (Bendigo- Adelaide), which has nearly four and a half years to add 0.16 per cent to 1 0 k a n g a n e w s O C T O B E R

2 its combined tier one capital in order to meet the minimum tier one plus conservation buffer level. In the immediate aftermath of the publication of APRA s consultation document it appeared that the Australian banking industry might be prepared to oppose the accelerated implementation timeline. In a statement published on September 6, Australian Bankers Association (ABA) chief executive, Steven Münchenberg, said: We think that banks should be given the maximum time to transition to the new regime and we will be putting this view forward to APRA. The ABA s objection was not based on an expectation that the new standards would be difficult to meet, however, as Münchenberg added: We are pleased to see that APRA has stated that Australian banks and other ADIs will be well placed to meet the new minimum capital requirements, but this is not a reason to bring forward the new requirements. And individual banks appear comfortable with the faster implementation proposed by APRA. Rick Moscati, group treasurer at ANZ Banking Group (ANZ) in Melbourne, says it should be taken in stride by Australian banks. He explains: The key point is that all the major trading banks have Basel III core tier one ratios well in excess of the 4.5 per cent minimum already, so the early introduction in many ways is not significant. Having to meet the new standards by January was not unexpected nor is it, in itself, an additional constraint. The same message comes from Ross Aucutt, head of structured funding and capital management at Westpac Banking Corporation in Sydney. If the banks have enough capital, which APRA seems to think we do, there is no reason the early implementation of the policies would be problematic, he comments. Richard Fennell, Adelaide-based chief financial officer at Bendigo-Adelaide, also says the accelerated timeline was not unexpected. He adds: While more time would always be better, we are comfortable with the timeline. In fact, Moscati believes the accelerated timeline could be seen as a demonstration of strength from the Australian banking sector. This is certainly the conversation we have been having with all our debt investors, he reveals. We have for some time been disclosing our capital estimates under Basel III and it is clear from these presentations that we could comply with Basel criteria immediately. The APRA release formalises this position and is absolutely a position of strength for the Australian banking industry. The advantage of being able to take the message of sound capital positions to international investors is also seen by Nick Vamvakas, Melbourne-based chief financial officer at ME Bank. We don t think there will be any major impact on the banks domestically, he tells KangaNews. APRA is just pointing out that we are in a better position than other If the banks have enough capital, which APRA seems to think we do, there is no reason the early implementation of the policies would be problematic. Ross Aucutt Westpac Banking Corporation countries, so we can implement [Basel requirements] earlier. A longer timeline wouldn t really have mattered, and if we can prove as an industry that we can meet the requirements earlier, we will benefit internationally when we are looking to raise funds. Local interpretation The Australian regulator is positioning its overall approach to implementation of Basel III capital rules as conservative with no local concessions and, in some areas, a tighter regime in Australia than the minimum acceptable to the Basel committee. For instance, APRA s consultation document says: The Basel III reforms allow national supervisors to adopt a concessional treatment for certain other items in determining regulatory capital. APRA does not propose to exercise this discretion. One concern for some banks is that while APRA expects to set minimum capital levels in line with Basel norms, its proposals continue to vary in some areas related to how the level of particular types of capital is calculated. National Australia Bank (NAB) s half-year results from May 2011 highlight nine different areas in which APRA s calculation methodology differs from the Basel II-compliant rules of the UK s Financial Services Authority (FSA), with eight of those nine serving to reduce NAB s comparative tier one position. The largest discrepancy under which APRA applies a 20 per AUSTRALIAN LISTED BANKS TIER ONE CAPITAL per cent ANZ Bendigo- Adelaide Jul 11 Common equity BoQ CBA Source: KangaNews, from Australian Securities Exchange announcements NAB Other tier one Westpac 1 1

3 Feature One size fits all: APRA rules to be applied to all ADIs The Basel Committee on Banking Supervision (Basel Committee) suggests Basel III rules be applied to banks with global operations. However, Australia s regional authorised deposit-taking institutions (ADIs) appear comfortable with the local regulator s opinion that all Australian banks be covered by its interpretation of Basel III. The Australian Prudential Regulation Authority (APRA) s consultation document on capital proposes that its rules be applied to all ADIs. It says: The Basel III reforms are global minimum capital requirements for internationally-active banks. As with the implementation of the Basel II framework, however, APRA proposes to apply the capital requirements to all ADIs. The Australian regulator believes the benefits of the new rules will outweigh any implementation costs even for smaller ADIs. It continues: In APRA s view, the Basel III measures are prudentially sound, will improve the regulatory capital framework for ADIs and, by ensuring that all ADIs have adequate, highquality capital, will strengthen the protection available to depositors and the resilience of the Australian banking system as a whole. Application of rules to internationally-active banks stretches back to language used by the Basel committee in 2004 s Basel II framework. Basel III confirms that the same scope of application will apply for the new rules as it did with the old ones. A closer reading of the relevant paragraphs in the final version of the old rules suggests that the committee s intention was to prevent a get-out clause for smaller institutions. At no point are possible exemptions from international standards mentioned; if anything, extra stringency is expected. In the same paragraph as the internationally-active clause, the 2004 framework stresses: National authorities will be free to adopt arrangements that set higher levels of minimum capital. Moreover, they are free to put in place supplementary measures of capital adequacy for the banking organisations they charter. And it continues: Countries where risks in the local banking market are relatively high need to consider if banks should be required to hold additional capital over and above the Basel minimum. While the Australian banking system is not expected to be considered especially risky, the country s smaller ADIs do not appear to consider blanket application of Basel III rules to be unreasonable. ME Bank s chief financial officer, Nick Vamvakas, agrees that a level playing field for all Australian banks is appropriate. As far as ME Bank is concerned, we are very comfortable with the proposed rules, he says. We ve been through them in terms of what impact they would have directly on ME Bank. APRA has proven through the financial crisis that its conservative approach has worked, and I don t see that you could make an argument to say the rules shouldn t be applied across the board. cent loss given default floor on mortgages, compared with the FSA s 10 per cent level by itself entails a 0.86 per cent reduction in NAB s tier one ratio. Other significant areas in which NAB reported a discrepancy between Australian regulatory standards and those of the FSA include the calculations of interest rate risk in the banking book, the wealth value of business in force at acquisition, and the estimated final dividend net of estimated reinvestment. These reduce NAB s tier one capital by 0.3 per cent, 0.46 per cent and 0.32 per cent respectively, according to APRA rules. Meanwhile, the only area in which APRA s interpretation gives more tier one credit the level of eligible deferred fee income added just 0.07 per cent to NAB s tier one ratio in its May results. If we can prove as an industry that we can meet the requirements earlier, we will benefit internationally when we are looking to raise funds. Nick Vamvakas ME Bank While these discrepancies are not a new phenomenon, banks see their continuation as a missed opportunity given the international harmonisation goal of Basel III. Without alignment of capital calculation, Australian banks believe they continue to be at a disadvantage internationally as their headline capital adequacy numbers look less impressive than those of peers from jurisdictions with less conservative local interpretations of qualification guidelines. The APRA position is in a number of respects more stringent than Basel criteria, Moscati tells KangaNews. Our long-held position is that full alignment would be the best approach measuring capital in the same manner with any additional stringency applied if required through the imposition of higher absolute capital targets, rather than losing it within the computation of capital. One of the benefits of Basel III is global transparency, and the situation would be more straightforward and investorfriendly under a fully-harmonised approach. Australian banks have adopted the practice of publishing in investor presentations their capital position 1 2 k a n g a n e w s o c t o b e r

4 according to standards set by offshore regulators generally the FSA alongside their APRA-approved levels, and bank sources say they expect to continue to do so. FSA-equivalent standards, under which the Australian banks tend to have even stronger tier one ratios (see chart on this page), allow investors to compare like with like, the banks argue. Despite these concerns, APRA s consultation document falls short of some bankers fears that the regulator might set out what the banks perceive to be an excessively restrictive regime of capital requirements for Australian ADIs. The fear was that APRA would toughen standards to meet Basel III levels where they do not already, while maintaining other rules that are already more onerous than international norms. The consultation document says: APRA seeks to ensure that its prudential capital framework is consistent with global standards. APRA therefore proposes to adopt the minimum Basel III requirements for the definition and measurement of capital, except in certain areas where there are strong in-principle reasons to continue APRA s current policies. Alignment will require APRA to take a stricter approach than at present in some areas but a less conservative approach in others. application BREADTH Indeed, in some areas APRA has apparently toned down its proposed requirements. Aucutt says: APRA has been clear in its views regarding the current capital overlays ADIs are required to hold, and it has removed some of the overlays where the regulator felt the Basel committee requirements were aligned with APRA s. There is also no mention in the consultation paper of loss absorbency in relation to non-capital instruments such as senior debt. The priority of the consultation document appears instead to be defining and strengthening the loss absorbency of tier one securities in a going concern situation and of tier two instruments in a gone concern situation. APRA says: A public sector injection of capital needed to avoid the failure of an ADI should not protect investors in regulatory capital instruments from incurring the loss they would have suffered had the public sector not chosen to intervene. To achieve this objective, the criteria for inclusion in regulatory capital have been enhanced to ensure that all regulatory capital instruments issued by ADIs are capable of absorbing losses. One area in which APRA does not intend to use the potential for a lighter-touch regulatory approach is in the australian major banks capital positions apra and fsa equivalents 16 per cent ANZ Source: KangaNews, from Australian Securities Exchange announcements 2011 range of institutions to which Basel III rules will be applied. While the Basel committee says global reforms are aimed at internationally-active banks, in Australia all ADIs will be subject to local interpretation of new capital rules. However, in general banks outside the Australian majors appear to be comfortable with the blanket application of new capital rules (see box on facing page). Tier one and two CBA Jun 11 Current APRA tier one NAB FSA tier one Westpac While the implementation deadlines APRA proposes, and some of the ways in which capital is calculated, are in many cases different from Basel committee guidelines, both capital-type definitions and their eventual minimum levels are the same. APRA s existing catch-all definition of tier one capital will be replaced by a two-level system, separating CET1 and additional tier one. The minimum total tier one requirement will increase to 6 per cent from 4 per cent of risk-weighted assets, with CET1 to account for at least 4.5 per cent of the whole. Meanwhile, tier two capital is likely to play a less significant role under Australia s Basel III regime. Again, APRA suggests that Basel committee recommendations are met. Those recommendations are that banks combined tier one and two capital equal at least 8 per cent of risk-weighted assets a minimum of 2 per cent tier two given the tier one baseline. Under current APRA rules, the combined level of both tiers is Full alignment would be the best approach, with any additional stringency applied if required through the imposition of higher absolute capital targets, rather than losing it within the computation of capital. Rick Moscati ANZ Banking Group 1 3

5 Feature Chinks of light for tier one and two instruments The regulatory limbo in which tier one hybrid and tier two subordinated bonds have existed while Basel III rules are finalised is one factor that has largely halted their issuance since the onset of the financial crisis. While clarity on these instruments future is emerging, the demand for issuance largely remains to be tested. The most positive sign for subordinated and hybrid debt in Australia came at the end of August, when ANZ Banking Group (ANZ) increased the size of the convertible preference shares (CPS) transaction it launched earlier the same month. Having commenced the offer at a volume of A$750 million (US$772.3 million), on August 30 ANZ revealed that strong investor demand had led to an upsize to A$1.25 billion. The status of tier one instruments has been in question as part of the Basel III regulatory debate, but in its offering documents ANZ confirms that its CPS3 securities will constitute residual tier one capital under APRA [the Australian Prudential Regulation Authority] s current capital adequacy standards and will be eligible for transitional treatment as additional tier one capital when those standards are updated as part of the Basel III reforms. The structure of CPS3 is significantly different from that of CPS2 in one key respect. There are some changes around the dividend and the dividend stopper but ANZ s group treasurer, Rick Moscati, says these are not especially material. He adds: The fundamental difference is what is called the common equity capital trigger. Should ANZ s core tier one capital ratio decline to per cent or below at any point in the life of the transaction, conversion to ordinary shares would occur. The potential cost of this conversion and risk for investors has been reduced in APRA s consultation paper on capital. It was originally expected that the minimum conversion share price would be based on a 50 per cent decline from the level set at the convertible s issue, but APRA now proposes any required conversion be conducted with a share price decline of up to 80 per cent. In other words, if ANZ s share price at issue is A$20 it would in the event of a common equity ratio falling below the trigger point have had to convert at a minimum price of A$10 even if the market value of stock has declined beyond that level. But ANZ could now replace CPS3 with equity down to a share price of A$4. Other banks say the increased clarity around what will qualify as additional tier one capital is a positive. ME Bank s Now that there is certainty and understanding around the tier two requirements, both issuers and investors should be more comfortable to participate in deals. Richard Fennell Bendigo and Adelaide Bank chief financial officer, Nick Vamvakas, comments: The picture is now a lot clearer for those who want to get involved. There are not a whole lot of different hybrid instruments that we can deal with the types of eligible instruments are very transparent, as are the rules associated with them. So as an investor you know very clearly what you are getting into. Richard Fennell, chief financial officer at Bendigo and Adelaide Bank, adds: The hybrid requirements were quite well communicated in the lead up to [APRA s] announcement, but it is good to have greater certainty now. I believe this will lead to more deals being done in the hybrid space we ve seen very few deals executed over the last few years due to uncertainty around these rules. There had not been a domestic hybrid offering from an Australian bank since ANZ s CPS2 in December 2009, but Moscati says the factors supporting demand for the product from the retail investors that formed the overwhelming majority of its pre-crisis distribution profile have not changed. The confidence that there would be a market for CPS3 came from a couple of sources, Moscati tells KangaNews. There hadn t been any issuance in the Australian market for two years so it had been starved of product in part because also 8 per cent but the tier one minimum is lower, allowing up to 4 per cent of total capital to comprise tier two instruments. The requirements for a security to qualify as an additional tier one instrument under APRA s new rules are also likely to make hybrid instruments issued in future somewhat different in structure from those issued in the pre-crisis era. To be approved as a tier one instrument in future, APRA will demand that securities be able to absorb losses while the ADI remains a going concern. This means they will have to be subordinated, have fully discretionary non-cumulative dividends or coupons and have neither a maturity date nor an incentive to redeem. The regulator also proposes that innovative tier one features including step-ups and other incentives to redeem will be disallowed as they have over time eroded the quality of tier one. There is already a test case in the market, as ANZ launched Australia s first hybrid offer since 2009 in August. The bank 1 4 k a n g a n e w s o c t o b e r

6 there had been so much uncertainty about regulatory rules. Recent volatility in equity markets has also served as a forceful reminder to investors that a greater allocation to fixed income-style securities might be sensible, while potential margin declines on term deposits also puts CPS3 in a good space. The margin on CPS3 was set at 310 basis points over the bank bill swap rate (BBSW) on August 30 the tight end of its indicative margin of basis points over BBSW and exactly the same margin as CPS2 achieved. Tier two prospects A resumption of public tier two issuance appears further away. There have been a handful of small subordinated transactions from Australian banks subsequent to the financial crisis most recently a A$200 million, 10-year non-call five from Bank of Queensland in May this year but they have not been widely distributed. While borrowers are hopeful about subordinated debt, they say it remains a regulatory grey area to some extent. I still believe there will be a role for tier two instruments; they are considered in the APRA discussion paper and rules for them are emerging, Moscati says. That said, there is some ambiguity in the short term about what works and what doesn t work, and there are not formal transition rules at this point in time. ME Bank has a small volume of subordinated debt coming up for maturity, and Vamvakas tells KangaNews the bank would like to replace it. But complete regulatory clarity is just one barrier to doing so. He explains: I really hope that getting an understandable and final regulatory approach will get a healthy subordinated market going again. The key question is whether there is enough demand out there for subordinated debt. Fennell is relatively optimistic. Now that there is certainty and understanding around the tier two requirements, both issuers and investors should be more comfortable to participate in deals, he comments. We are confident there will be reasonable demand for subordinated debt, but it is important to note that to a large extent demand will be driven by price: there will be demand for relatively highyielding debt securities. For Ross Aucutt, head of structured funding and capital management at Westpac Banking Corporation, reviving demand for hybrid and subordinated debt will come down to the quality of work the issuers themselves do. We will have to educate investors as to what the new features are and what risks are involved with holding such products, he explains. The key factor is the premium investors will ask for. Over time I think demand will be there but it is a question of whether pricing will work for issuers. says the differences in structure between the new security and its previous similar offer differences which were required in order to gain APRA approval for the new deal were manageable. And while there are still questions about likely demand for subordinated instruments in future, ANZ has been able to increase the size of its offering (see box on p14). On tier two, APRA is proposing the removal of the existing definitions of upper and lower tier two as part of a simplification of the framework covering the instruments, in line with Basel III criteria. Tier two instruments will need to meet the minimum criteria of being subordinated to depositors and general creditors and having an original maturity of at least five years. Transition and response With the qualification standards for tier one and two instruments set to change, APRA has also set out proposals for transition to the new rules. Its consultation document acknowledges: A number of ADIs have issued non-common equity instruments that currently qualify as tier one or two capital. Few, if any, of these instruments will meet all the requirements for inclusion in regulatory capital treatment under Basel III. The regulator now confirms that existing tier one instruments will continue to remain eligible until the end of 2012 if they satisfy all relevant criteria under APRA s existing APS111 prudential standard. The same status will apply to instruments issued during the period leading up to Basel III implementation including, it would appear, the open tier one offering from ANZ. From the beginning of 2013 a phase-out will begin, with APRA proposing that recognition of capital instruments that no longer qualify as non-common equity tier one capital or tier two capital will be capped at 90 per cent from January , with the caps reducing by 10 percentage points in each subsequent year. The deadline for written submissions in response to APRA s latest proposals is December However, while the ABA s statement says the association and its members will be analysing in detail the impact of the proposals in the paper and will be providing advice to APRA during the current consultation period, individual banks suggest their responses to the discussion paper are likely to be limited. Vamvakas tells KangaNews ME Bank is yet to decide what it will take back to the regulator. Overall, we are happy with what has emerged from this consultation. In terms of putting a submission back into APRA, we have looked at the document relative to where we stand and we are weighing up whether there is anything we particularly want to communicate back. Fennell says Bendigo-Adelaide does not have any great concerns regarding the consultation paper. However, while he notes that the bank is still completing its formal analysis, there are elements of Basel III that still need to be disclosed. For example, we are not yet aware of what the implications are for local, systemically-important financial institutions, and if we would even be included in that category, he says. The key goal, Fennell adds, is that capital rules must not make legitimate banking business hard to conduct. The reality is that ADIs are being asked to hold significantly greater capital. The key risk that APRA must consider is that it may encourage shadow banking if the amount of capital required to be held becomes so punitive it reduces the return investors are likely to get, he says. 1 5