Banking (prudential standard) determination No. 3 of 2006 Prudential Standard APS 110 Capital Adequacy (Cth)
Banking (prudential standard) determination No. 3 of 2006
Prudential standard APS 110 - Capital Adequacy
Banking Act 1959
I, John Francis Laker, Chair of APRA:
(a)under paragraphs 11AF(1)(a) and (b) of the Banking Act 1959 (the Act), DETERMINE the Prudential standard APS 110 - Capital Adequacy in the form set out in the Schedule, which shall apply to all authorised deposit-taking institutions (ADIs) and authorised non-operating holding companies (authorised NOHCs); and
(b)under subsection 11AF(3) of the Act, REVOKE the Prudential Standard APS 110 - Capital Adequacy (and related Guidance Notes), as varied, made by an instrument dated 25 November, 2002 entitled Making of Prudential Standards: APS 110 (Capital Adequacy); APS 111 (Capital Adequacy: Measurement of Capital); APS 221 (Large Exposures); APS 222 (Associations with Related Entities).
This instrument shall take effect from the later of 1 July 2006 and the date of registration on the Federal Register of Legislative Instruments.
Dated 30 May 2006
[Signed]
John Francis Laker
Chair
Interpretation
In this Determination
ADI has the meaning given in section 5 of the Act.
APRA means the Australian Prudential Regulation Authority.
authorised NOHC has the meaning given in section 5 of the Act.
Note 1 An ADI or authorised NOHC that does not comply with a standard may be issued with directions by APRA under paragraph 11CA(1)(a) of the Act. Non-compliance with a direction is an offence attracting a penalty of up to 250 penalty units for a body corporate (currently $27,500) for each day that the offence continues. Officers of the ADI or authorised NOHC may also be criminally liable (see section 11CG).
Note 2 Prudential Standard APS 110 - Capital Adequacy made on 25 November 2002 was varied by Banking (prudential standards) determination No. 2 of 2004 dated 15 December 2004.
Schedule
Prudential standard APS 110 - Capital Adequacy comprises the 14 pages commencing on the following page.
Prudential Standard APS 110
Capital Adequacy
Objective and key requirements of this Prudential Standard
This Prudential Standard aims to ensure that ADIs maintain adequate capital to support the risks associated with their activities on both a stand-alone and group basis.
This Prudential Standard outlines the overall framework adopted by APRA for assessing an ADI’s capital adequacy.
Authority and application
1. This Prudential Standard, made under section 11AF of the Banking Act 1959 (the Act), applies to all authorised deposit-taking institutions (ADIs) authorised under the Act. The Guidance Notes AGN 110.1 Conglomerate Group (AGN 110.1), AGN 110.2 Non-Consolidated Subsidiaries (AGN 110.2), AGN 110.3 Level 3 Assessment (AGN 110.3), AGN 110.4 Risk-based Capital Adequacy Framework (AGN 110.4), AGN 110.5 Higher Minimum Ratios (AGN 110.5) and AGN 110.6 Reductions in Capital (AGN 110.6) form part of this Prudential Standard.
2. Foreign ADIs (which have the same interpretation as in Division 1B of the Act) operating through branches in Australia are not subject to this Prudential Standard, Prudential Standards APS 111 Capital Adequacy: Measurement of Capital (APS 111), APS 112 Capital Adequacy: Credit Risk (APS 112) and APS 113 Capital Adequacy: Market Risk (APS 113). They must, however, be subject to comparable capital adequacy standards in their home country.
Responsibility for capital management
3. Capital is the cornerstone of an ADI’s financial strength. It supports an ADI’s operations by providing a buffer to absorb unanticipated losses from its activities and, in the event of problems, enabling the ADI to continue to operate in a sound and viable manner while the problems are addressed or resolved. The Board of an ADI has the duty to ensure that the ADI maintains an appropriate level of capital commensurate with the level and extent of risks to which the ADI is exposed from its activities. To this end, the ADI must:
(a) have adequate systems and procedures in place to identify, measure, monitor and manage the risks arising from its activities on a continuous basis to ensure that capital is held at a level consistent with the ADI’s risk profile; and
(b) maintain and implement a capital management plan, consistent with the overall business plan, for managing its capital levels on an ongoing basis. Essentially, the plan must set out:
the ADI’s strategy for maintaining capital resources over time, for example, by outlining its capital needs for supporting the degree of risks involved in the ADI’s activities, how the required level of capital is to be met, as well as the means available for sourcing additional capital where required; and
actions and procedures for monitoring the ADI’s compliance with minimum regulatory capital adequacy requirements, including the setting of trigger ratios to alert management of, and avert, potential breaches to the minimum capital ratios required by APRA.
4. Where an ADI is a member of a conglomerate group (refer AGN 110.1), associations with other members in the group may expose the ADI to the potential of contagion risk – the possibility that difficulties encountered by individual entities in the group might be transmitted to the ADI (refer Prudential Standard APS 222 Associations with Related Entities). In determining stand-alone capital adequacy, the Board of the ADI must have regard to:
(a) group risks posed by other members in the group to the ADI;
(b) obligations (direct or indirect) arising from associations with group entities which might give rise to a call on the capital of the ADI; and
(c) the ability to readily extract capital from other members in the group should the need to recapitalise the ADI arise (this would include consideration of the integration of business within the group, the importance of subsidiaries to the group, the impact of taxation, regulatory requirements and other factors on the ability to realise investments in, or transfer surplus capital from, subsidiaries).
5. Aside from maintaining adequate capital on a stand-alone basis, ADIs that head a conglomerate group (refer AGN 110.1) must also satisfy APRA that the group as a whole has sufficient capital consistent with the group’s risk profile.[1] To this end, the Board of an ADI that heads a conglomerate group should:
(a) establish policies on group capital adequacy (which should have regard to the type and distribution of capital resources held by the group) and implement a group capital management plan (with coverage similar to those outlined in paragraph 3(b) above) to ensure that the group overall is adequately capitalised to cover the risks faced by the group and to meet regulatory, market and strategic needs;
(b) ensure that appropriate systems and adequate procedures are in place to identify, assess, measure and monitor group risks on a continuous basis; and
(c) ensure that the group has sufficient capital freely available to meet unexpected losses and adverse shocks impacting on the group.
[1] Where an ADI forms part of a conglomerate group headed by an authorised non-operating holding company, paragraph 5 applies to the ADI and its subsidiaries.
Measurement of capital adequacy
6. To ensure that ADIs are adequately capitalised on both a stand-alone and group basis, APRA adopts a tiered approach to the measurement of an ADI’s capital adequacy by assessing the ADI’s financial strength at three levels (refer illustrative diagram in the Attachment):
(a) Level 1 – the ADI on a stand-alone basis;
(b) Level 2 – the consolidated banking group i.e. the ADI and all its subsidiaries other than non-consolidated subsidiaries (refer AGN 110.2); and
(c) Level 3 – the conglomerate group at the widest level.
7. Level 1 and Level 2 assessments are applicable to all ADIs. Level 3 assessment applies only to ADIs prescribed by APRA (refer AGN 110.3).
8. Measurement of an ADI’s capital adequacy at each of the above three levels is based on:
(a) Level 1 & Level 2 – a risk-based capital adequacy framework based on the Basel Capital Accord (refer AGN 110.4); and
(b) Level 3 – the methodology agreed with APRA (refer AGN 110.3).
Minimum capital adequacy requirements
9. An ADI must, at a minimum, maintain a risk-based capital ratio (refer AGN 110.4) of 8 per cent at all times under Level 1 and Level 2. At least half of the ratio must take the form of Tier 1 capital (refer APS 111) i.e. a minimum Tier 1 capital ratio of 4 per cent must be maintained. Where considered appropriate, APRA may require an ADI to maintain a minimum capital ratio above 8 per cent (at least half of the ratio must take the form of Tier 1 capital) at Level 1 and Level 2 (refer AGN 110.5). APRA expects all ADIs, as part of their capital management plans (refer paragraphs 3(b) and 5(a) above), to target and maintain Level 1 and Level 2 capital ratios (both Tier 1 and total) above regulatory minimums.
10. ADIs subject to Level 3 capital adequacy assessment must meet the minimum group-wide capital adequacy benchmarks agreed with APRA on a continuous basis. APRA may impose additional or higher Level 1 and/or Level 2 capital requirements on an ADI in a conglomerate group where it is not satisfied with the methodology for measuring the group’s capital adequacy at Level 3 (refer AGN 110.3).
Notification requirements
11. An ADI must inform APRA immediately of:
(a) any breach of the minimum capital adequacy requirements under paragraphs 9 and 10 and any potential breach of these requirements (e.g. breaches of trigger ratios), including remedial actions taken/planned to deal with the problem; and
(b) any concerns it has about its capital adequacy (whether at Level 1, 2 or 3), along with proposed measures to address these concerns.
Reductions in capital
12. Where an ADI proposes any reduction in its capital (whether at Level 1, 2 or 3), it must obtain APRA’s prior written consent (refer AGN 110.6).
Reporting
13. An ADI must provide APRA each quarter (or more frequently if required by APRA) with information on its Level 1 and Level 2 capital adequacy in a form to be determined by APRA from time to time.
14. ADIs subject to Level 3 capital adequacy assessment must provide APRA each quarter (or more frequently if required by APRA) with the group’s capital adequacy reports in a form agreed with APRA.
Attachment
Application of framework to a simple corporate structure
Level 1 – An ADI assessed on a stand-alone basis
Level 2 – An ADI and all its subsidiary entities (other than non-consolidated subsidiaries) assessed on a consolidated banking group basis
Level 3 – Entire group assessed
Guidance Note AGN 110.1
Conglomerate Group
1. For the purposes of Prudential Standard APS 110 Capital Adequacy (APS 110) and this Guidance Note, a conglomerate group is defined as a group of companies containing one or more locally incorporated authorised deposit-taking institutions (ADIs). Any reference to an ADI in APS 110 and this Guidance Note applies to each ADI member of a conglomerate group on an individual basis.
2. A conglomerate group must be headed by an ADI or an authorised non-operating holding company (NOHC)[2] and may include non-financial (commercial) as well as financial entities (regulated and unregulated). A “regulated entity” in a conglomerate group refers to any entity directly regulated by APRA or by an equivalent banking, insurance or similar prudential regulator overseas.
[2] APRA may not require a locally incorporated NOHC that directly owns only an ADI and no other entities to be authorised under the Banking Act 1959.
3. A foreign-owned locally incorporated ADI and its subsidiaries constitute a conglomerate group for the purposes of APS 110 and this Guidance Note. Alternatively, where the foreign-owned ADI has a locally incorporated NOHC parent, the conglomerate group will comprise the locally incorporated NOHC and all its subsidiaries. The ADI’s foreign parent(s), the foreign parent’s overseas based subsidiaries and their directly owned non-ADI entities operating in Australia do not form part of the conglomerate group. APRA, however, expects the foreign parent to be subject to regulatory oversight broadly consistent with that applied by APRA and, should the need arise, provide APRA with information concerning activities of their subsidiaries outside the Australian conglomerate group.
Guidance Note AGN 110.2
Non-Consolidated Subsidiaries
1. For the purposes of determining an authorised deposit-taking institution's (ADI’s) capital adequacy at the consolidated banking group level (i.e. Level 2), all banking and other financial activities (both regulated and unregulated) conducted within the banking group must be consolidated.
2. Consolidation at Level 2 should cover the global operations of an ADI and its subsidiary entities, as well as any other controlled banking entities, securities entities and other financial entities (e.g. finance companies, money market corporations, stockbrokers and leasing companies), except for entities involved in the following business activities:
(a) insurance businesses (including friendly societies and health funds);
(b) acting as manager, responsible entity, approved trustee, trustee or similar role in relation to funds management or the securitisation of assets; and
(c) non-financial (commercial) operations
or special purpose vehicles to which assets have been transferred in accordance with APRA's clean sale requirements as set out in Guidance Note AGN 120.3 Purchase and Supply of Assets.
3. Group entities excluded from Level 2 consolidation are to be deducted from an ADI’s Level 2 capital in accordance with Prudential Standard APS 111 Capital Adequacy: Measurement of Capital and Guidance Note AGN 111.4 Capital Deductions.
Guidance Note AGN 110.3
Level 3 Assessment
1. Only authorised deposit-taking institutions (ADIs) prescribed by APRA will be subject to Level 3 capital adequacy assessment. APRA will identify conglomerate groups for which Level 2 assessment is deemed not sufficient for measuring an ADI’s capital adequacy on a group-wide basis. These could be financial conglomerates containing substantial banking and insurance activity, or mixed conglomerates containing significant banking and non-financial activity.
2. ADIs subject to Level 3 assessment will need to have an APRA-approved, group-wide capital calculation that corresponds to their corporate structure. Essentially, the capital calculation should have regard to all group members (whether ADIs, insurers or unregulated entities) and the capacity of any surplus capital to be moved around the group according to need. The capital calculation may be based on the methodologies of the Joint Forum, or the ADI’s own internal capital estimation and allocation models. The ADI will need to satisfy APRA that the conglomerate group of which it is a part has sufficient capital (as defined in Prudential Standard APS 111 Capital Adequacy: Measurement of Capital) for the risk profile of the group as a whole.
3. Prescribed ADIs should provide to APRA a description of their current policies with regard to group capital adequacy at Level 3, including the methodology used to measure capital adequacy of the entire group.
4. In determining capital levels for the conglomerate group, the Board of an ADI that heads the group should have regard to:
(a) the potential for risk to compound across the group (as well as any proven benefits of risk diversification);
(b) concentration of capital and risk within individual entities in the group;
(c) the capital needs of individual entities in the group;
(d) the nature of capital held by the group, including its maturity, servicing costs and any double counting or upgrading of capital within the group;
(e) the ability to readily transfer surplus or free capital within the group and the type of capital which would be available to individual entities from other group members if required (this would involve consideration of the impact of taxation, regulatory requirements and other factors impinging on the ability to transfer surplus capital among individual entities); and
(f) the integration of business within the group and the ability of the group to readily realise capital through the sale of business lines and/or individual member entities without adversely impacting the group’s on-going operations.
5. Unlike Level 1 and Level 2 capital adequacy assessments, there would be no prescribed minimum capital adequacy requirements for Level 3 assessment. Instead, ADIs prescribed under Level 3 would need to provide details of their own benchmarks and on an on-going basis, details of the extent to which these are exceeded by the conglomerate group. In instances where APRA is not satisfied with the group-wide assessment – for example, because the group’s internal benchmarks are deemed insufficiently prudent, or because APRA is not satisfied with the assumptions made (e.g. for diversification, or in relation to capital mobility) – APRA may impose additional or higher capital requirements on the ADI at Level 1 and/or Level 2.
Guidance Note AGN 110.4
Risk-based Capital Adequacy Framework
1. APRA’s approach to the assessment of an authorised deposit-taking institution's (ADI’s) capital adequacy at Level 1 (i.e. the stand-alone level) and Level 2 (i.e. the consolidated banking group level) is based on the risk-based capital adequacy framework set down in the Basel Capital Accord.
2. Consistent with the Basel framework, the approach provides for a quantitative measure of an ADI’s capital adequacy and focuses on three main elements:
(a) the credit risk associated with an ADI’s on- and off-balance sheet exposures;
(b) the market risk arising from an ADI’s trading activities; and
(c) the form and quality of capital held by the ADI to support these exposures.
3. APRA may adjust its risk-based capital adequacy framework in future to take account of developments to the Basel framework. Further elements or other types of risk may be added to this quantitative framework over time, such as the inclusion of a requirement to provide capital to cover operational risk.
4. Under the risk-based capital adequacy framework, an ADI’s Level 1 and Level 2 capital adequacy is measured by means of a risk-based capital ratio calculated by dividing its eligible capital base by its total risk-weighted exposures i.e.
risk-based capital ratio = eligible capital base
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total risk-weighted exposures
5. The definition of eligible “capital base” (the numerator of the risk-based capital ratio), including qualifying criteria for individual capital elements to be included in an ADI’s Level 1 and Level 2 capital base, is set out in Prudential Standard APS 111 Capital Adequacy: Measurement of Capital.
6. An ADI’s “total risk-weighted exposures” (the denominator of the risk-based capital ratio) at Level 1 and Level 2 is calculated as the sum of the total risk-weighted on- and off-balance sheet credit exposures and the “adjusted” market risk exposures, determined in accordance with the requirements and procedures set out in Prudential Standard APS 112 Capital Adequacy: Credit Risk (APS 112) and Prudential Standard APS 113 Capital Adequacy: Market Risk (APS 113) respectively.
7. To ensure consistency in the calculation of capital requirements for credit and market risks, the amount of market risk capital charge (for both specific and general market risk) determined in accordance with APS 113 must be adjusted by multiplying it by a constant factor of 12.5 (i.e. the reciprocal of the minimum capital ratio of 8 per cent)[3] to obtain an equivalent risk-weighted exposure. The resulting figure is then added to the risk-weighted credit exposures, calculated in accordance with APS 112, to derive the total risk-weighted exposures.
[3] ADIs required by APRA to maintain a minimum capital ratio above 8 per cent should still use a multiplication factor of 12.5.
Guidance Note AGN 110.5
Higher Minimum Ratios
1. In assessing an authorised deposit-taking institution's (ADI’s) overall capital adequacy at Level 1 and Level 2, APRA will take account of other risk factors that have not been incorporated or accounted for quantitatively in the risk-based capital adequacy framework to ensure that the minimum capital adequacy requirements for the ADI are broadly proportional to its overall risk profiles at Level 1 and Level 2. These factors include, for example, credit risk concentrations, profitability, liquidity,[4] off-balance sheet exposures, concentration of particular types of assets or liabilities, operational risk and the effectiveness of the ADI’s management systems for monitoring and controlling risks.
[4] An ADI’s participation in an APRA-certified industry support arrangements will be considered as a risk mitigant.
2. APRA will consider the above factors in deciding how much capital an ADI needs to hold above the minimum 8 per cent requirement at Level 1 and/or Level 2. All newly established ADIs are generally subject to a higher minimum risk-based capital ratio, both at Level 1 and Level 2, in their formative years.
Guidance Note AGN 110.6
Reductions in Capital
For the purpose of Prudential Standard APS 110 Capital Adequacy, a reduction in an authorised deposit-taking institution's (ADI’s) capital (whether at Level 1, 2 or 3) includes:
(a) share buyback or the redemption, repurchase or repayment of any qualifying Tier 1 and Tier 2 capital instruments issued by the ADI or by other entities included in the calculation of the ADI’s Level 2 or 3 capital adequacy;
(b) trading in the ADI’s own shares or capital instruments (refer Guidance Note AGN 111.4 Capital Deductions);
(c) payment of dividends on ordinary shares that exceeds an ADI’s after-tax earnings, after including any payments on more senior capital instruments, in the financial year to which they relate (refer Prudential Standard APS 111 Capital Adequacy: Measurement of Capital (APS 111)); and
(d) dividend or interest payments (whether whole or partial) on Upper Tier 2, Innovative Tier 1 and Non-innovative Residual Tier 1 capital that exceed an ADI’s after-tax earnings, including any payments made on more senior capital instruments, calculated before any such payments are applied in the financial year to which they relate (refer APS 111).
An ADI proposing a capital reduction (whether at Level 1, 2 or 3) should provide APRA with a relevant capital plan covering the respective level(s). The plan should extend for at least two years.
To obtain APRA’s approval for any proposed reduction in its capital (whether at Level 1, 2 or 3), an ADI will need to satisfy APRA that the ADI’s capital (at Level 1, 2 or 3 as appropriate) after the proposed reduction will remain adequate for its future needs.
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