Australian Prudential Regulation Authority instrument fixing charges No. 2 of 2007

Australian Prudential Regulation Authority instrument fixing charges No. 2 of 2007

Models-based capital adequacy requirements for ADIs – 2006-07

EXPLANATORY STATEMENT

Issued by the authority of the Australian Prudential Regulation Authority (APRA)

Australian Prudential Regulation Authority Act 1998, paragraph 51(1)(a)

This explanatory statement relates to the instrument fixing charges which is made under paragraph 51(1)(a) of the Australian Prudential Regulation Act 1998 (the APRA Act) and which is dated 16 May 2007 (the instrument).  The instrument, made by a delegate of APRA, imposes a charge for certain services provided by APRA relating to the fast-tracked development of the framework for implementing a models-based approach under The International Convergence of Capital Measurement and Capital Standards-A Revised Framework  (Basel II) for authorized deposit-taking institutions (ADIs) and to the accreditation of seven banks which have applied to APRA to utilize that approach to determine their capital adequacy requirements.

Background

Legislative framework

The APRA Act is administered by the APRA.  APRA has statutory responsibility for the prudential supervision of the superannuation industry, the life insurance and general insurance industries, and ADIs. ADIs include banks, building societies and credit unions.

Subsection 51(1) of the APRA Act provides that APRA may, by written instrument, fix charges to be paid to it by persons in respect of:

(a) services and facilities which APRA provides to such persons; and

(b) applications or requests made to APRA under laws of the Commonwealth.

(These paragraphs reflect the contents of paragraphs 51(1)(a) and (b).)

Subsection 51(2) of the APRA Act provides that a charge fixed under subsection 51(1) must be reasonably related to the costs and expenses incurred or to be incurred in relation to the matters to which the charge relates and must not be such as to amount to taxation.

Basel II

In June 2004, the Basel Committee on Banking Supervision (the Committee) released Basel II,  reforming the 1988 Basel Capital Accord (the 1988 Accord).  The 1988 Accord contains guidelines for assessing the capital adequacy of banks.  For over a decade, it has been the global benchmark for assessing banks’ capital adequacy.[1]  In Australia, the 1988 Accord guidelines are applied to all ADIs.

Since the introduction of the 1988 Accord, there has been substantial change in global financial markets and developments in risk measurement and management techniques.  The 1988 Accord has been criticised in recent years for its inability to deal with increasing innovation and sophistication in the marketplace as it is a relatively broad-brush “one size fits all” approach.  Against this background, the objective of Basel II is for capital adequacy guidelines that are more accurately aligned with the individual risk profile of institutions, lessen regulatory arbitrage opportunities and offer greater flexibility for supervisors to recognise or encourage the use of more sophisticated risk management techniques, where appropriate.  Basel II is more complex than the existing regime under the 1988 Accord.  It is comprised of a menu of methods for calculating capital adequacy for each risk class, ranging from standardised (default) methods, which are in essence more risk sensitive versions of the 1988 Accord, to more sophisticated methods which involve institutions adopting their own individualised internal risk assessment methodologies.

APRA has committed to implement Basel II in Australia.  APRA is broadly following the international timetable for the introduction of Basel II and will implement it for all Australian ADIs on 1 January 2008.  This long lead time is indicative of the extent of the reforms that will be effected by Basel II and the amount of regulatory development that will be required of APRA to implement the reforms, particularly in relation to the more sophisticated methods.

The implementation of Basel II in Australia will result in new prudential standards being made for ADIs under section 11AF of the Banking Act 1959.

Models-based approach under Basel II

One major innovation resulting from Basel II, as foreshadowed above, will be that ADIs will be able to determine their capital adequacy requirements using one of two methods: a standardised (default) method (the standardised method) or a models-based approach more closely aligned with an ADI’s individual risk profile (the models-based approach).  ADIs seeking to use the models-based approach will need APRA’s approval to do so.

The models-based approach will benefit those ADIs that seek to adopt it, because its effect will be to align more accurately their regulatory capital requirements with their individual risk profiles.  This will enable them to make more efficient use of their capital.  By allowing a more efficient allocation of capital in the financial industry, the models-based approach should also benefit the wider economy.

However, at least in the early years, only a small number of ADIs will be able to take advantage of the models-based approach because it requires the ADI to have highly sophisticated internal rating and risk management systems.

For a number of years the four major banks in Australia, being Australia and New Zealand Banking Group Limited, Commonwealth Bank of Australia, National Australia Bank Limited and Westpac Banking Corporation have been directly contributing to APRA’s development costs for the Basel II models-based approach.  These banks have been using internal rating systems for a considerable period, have also incorporated more quantitative elements and their risk management systems are highly developed.  For the same reason, Macquarie Bank Limited and St George Bank Limited last year commenced directly contributing to APRA’s development costs for the Basel II models-based approach. For 2006/07 Bank of Western Australia Ltd also meets that criteria.

Adoption of the models-based approach by other ADIs remains a far more uncertain proposition at this stage.  Their internal rating and risk management systems are not as developed as those of the above-mentioned seven banks.  Accordingly, the internal rating systems of these banks need to undergo further sophistication before it would be appropriate for them to adopt the models-based approach. Some of these institutions have indicated their intention to adopt the models-based approach at a later time.

APRA’s work relating to implementation of models-based approach

APRA’s work relating to the implementation of the standardised method and the alternative models-based approach, which are provided for by Basel II has three phases.  These can be depicted as follows:

Phase I commenced in the 2002-03 financial year and is continuing over the current financial year 2006-07.  It involves developing a policy and technical framework for both the standardised method and the models-based approach.  Phase II commenced in October 2005 and is a period in which a great deal of effort is required to examine individual ADIs’ models and provide the necessary approvals.  Finally, Phase III will involve the on-going monitoring of ADIs’ capital adequacy positions – in the case of ADIs using the models-based approach, this will be more intensive than for ADIs using the standardised method.

Costs charged in relation to prior years

2002-03

APRA commenced work on Phase I of the models-based approach during the 2002-03 financial year.  APRA imposed charges on the four major banks for its work during that financial year, pursuant to a charging instrument made under paragraph 51(1)(a) of the APRA Act which was dated 16 November 2002[2].  The amount of that charge was $250,000 in respect of each of the four banks (giving a total of $1 million, exclusive of GST).  It was based on the same rationale and cost-recovery principles as are discussed in this explanatory statement. 

2003-04

During the 2003-04 financial year the same four banks were each charged the amount of $375,000 (giving a total of $ 1.5 million, exclusive of GST), pursuant to a charging instrument made under paragraph 51(1)(a) of the APRA Act which was dated 13 January 2004[3].  

2004-05

During the 2004-05 financial year charges imposed (by an instrument dated 10 June 2005[4]) in relation to the work of continuing Phase I of the models-based approach were two-tiered:

(a) $375,000 plus GST (which totals $412,500) imposed on each of the four major banks; and

(b) $150,000 plus GST (which totals $165,000) imposed on each of the other two banks, namely Macquarie Bank Limited and St George Bank Limited.

Thus the total cost recovery for the year 2004-05 amounted to $ 1.8 million (exclusive of GST).

2005-06

During the 2005-06 financial year charges imposed (by an instrument dated 25 May 2006[5]) in relation to the work of continuing Phase I of the models-based approach were two-tiered:

(a) $675,000 plus GST (which totals $742,500) imposed on each of the four major banks plus Macquarie Bank; and

(b) $500,000 plus GST (which totals $550,000) imposed on St George Bank Limited.

Thus the total cost recovery for the year 2005-06 amounted to $ 3.875 million (exclusive of GST).

Operation of Australian Prudential Regulation Authority instrument fixing charges No. 2 of 2007

The charge imposed by the current instrument is two-tiered:

(a) $575,000 plus GST (which totals $632,500) imposed on each of the four major banks, and on St George and Macquarie Bank Limited respectively; and

(b) $250,000 plus GST (which totals $275,000) imposed on Bank of Western Australia Ltd.

These amounts ($3.70 million plus GST, totaling $4,070,000) have been set as a contribution to APRA’s:

• Phase I work, being the continuing development of an appropriate policy and establishment of its supervisory infrastructure and technical capacity required for the introduction of the models-based approaches. 

• Phase II work, being assessment of applications made by the seven banks.

With little to distinguish the call on APRA’s resources by the original six applicants for accreditation, it is appropriate to recover equal amounts from them notwithstanding that they will not necessarily be accredited at the same time. The resources devoted to Bank of Western Australia Ltd have, however, been considerably less as its accreditation application has only recently been lodged.

The Phase II work has required the doubling of APRA resources working on the Basel II models-based approach.

How the charge has been calculated

The charge is based on the need to recover APRA’s costs of carrying out the policy, technical development work and assessing applications for model approval.  Those costs are based on the estimated APRA staff time involved.  In addition, direct overhead costs are added to the salary costs.  On this basis, APRA’s total costs in respect of the models-based approach for the 2006-07 financial year have been estimated at $3.70 million.

These costs do not include costs incurred in developing the standardized method. The standardized method will be used by all those ADIs who do not elect to use the models-based approach and this cost is therefore being recovered as financial sector levies from all applicable ADIs, which will benefit in due course,

The charges are reasonably related to the costs and expenses incurred

As indicated above, the charges set by the instrument are fixed on a cost recovery basis for the work to which they apply.  They are based on estimated effort involved in the discharge of APRA’s responsibilities and incorporate all the direct costs and appropriate overheads.

The charges do not amount to taxation

As the charges are reasonably related to the costs incurred by APRA in providing the services concerned, the charges do not constitute a tax.

The charges are not retrospective

The charges are imposed prospectively.  They are payable 14 days after receipt of APRA’s invoice.

Cost Recovery Impact Statement

A Cost Recovery Impact Statement (CRIS) has been prepared for this instrument.

Consultation

As part of annual consultation, each industry sector is made aware of APRA’s cost recovery process including the reduction of levies through direct user charging.

Before making the instrument, APRA informed the seven banks of the proposed charges.  The banks have raised no objection to the charges.

[1] The Basel Committee comprises central banks and bank supervisory agencies from G-10 countries and operates under the auspices of the Bank for International Settlements.  It consults widely with supervisory agencies in other countries and with industry on prudential matters.

[2] FRLI reference F2006BO1149 see http://www.comlaw.gov.au/ComLaw/Legislation/LegislativeInstrument1.nsf/0/51D6ABB7FCC9B408CA25708B001E3363?OpenDocument

[3] FRLI reference F2006BO1152 see http://www.comlaw.gov.au/ComLaw/Legislation/LegislativeInstrument1.nsf/0/A5960F982A4926B3CA2571CB001CCD03/$file/s51+13+January+2004+No.+1.doc

[4] FRLI reference F2005L01511, see http://www.comlaw.gov.au/comlaw/Legislation/LegislativeInstrument1.nsf/0/9D01E9020D4E11CDCA257020001EDD43?OpenDocument.

[5] FRLI reference F2006L01620, see  http://www.comlaw.gov.au/ComLaw/Legislation/LegislativeInstrument1.nsf/0/9860B443F44ED5F0CA25717900073AA0?OpenDocument.