EXPLANATORY STATEMENT

Australian Prudential Regulation Authority Act 1998, section 51

INSTRUMENT FIXING CHARGES TO BE PAID TO APRA - CAPITAL

ADEQUACY REQUIREMENTS FOR ADIs (the instrument)

APRA's authority to fix charges

The Australian Prudential Regulation Authority Act 1998 (the APRA Act) is administered by the Australian Prudential Regulation Authority (APRA). APRA has statutory responsibility for the prudential supervision of the superannuation industry, the life insurance and general insurance industries, and authorised deposit-taking institutions (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 services and facilities which APRA provides to such persons, and in respect of applications or requests made to APRA under laws of the

Commonwealth. Such an instrument may also provide for the waiver or refund of such charges.

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.

Purpose of the instrument

The instrument, made by a delegate of APRA, imposes a charge for certain services provided by APRA relating to ADIs' capital adequacy requirements.

Background

The implementation of the Basel Capital Accord in Australia will be a major area of activity for APRA over the next few years. It will eventually result in new prudential standards being made

) for ADIs under section 1lAF of the Banking Act 1959.

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

APRA's work on the Basel Capital Accord will have three phases, and two streams. This can be depicted as follows:

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Phase I will involve developing a policy and technical framework for both the standardised method and the model-based approach. Phase II will be a period in which a great deal of effort will be required to examine individual ADs' models and provide the necessary approvals.

Finally, Phase III will involve the on-going monitoring of ADs' capital adequacy positions - in the case of ADIs using the model-based approach, this will be more intensive than for ADIs using the standardised approach. Phases II and III would seem to be readily suited to some sort of fee­ for-service charge.

While Phase I contains an element of policy development which is usually regarded as a public good, and therefore unlikely to be the subject of a fee-for-service charge, in this case there are grounds for imposing a charge in relation to the Phase I development of the model-based approach. That Phase I development will require an intense commitment of APRA's resources, which will primarily benefit a relatively small number of ADIs that will take advantage of the model-based approach. This is because the model-based approach will benefit those ADIs that elect to adopt it, while enhancing the effective operation of the capital adequacy requirements, by more accurately aligning regulatory capital requirements with their individual risk profiles. It can therefore be argued that these ADIs should reasonably be asked to pay for this work. If no charge

) were imposed on these ADIs, they would in effect be subsidised by the other ADIs that will not

·  be using the model-based approach, through the supervisory levy that all ADIs pay.

Moreover, imposition of the charge will enable APRA to expedite the undertaking of the work in Phase I, which it would not otherwise be able to do. This again will benefit the ADIs that wish to take advantage of the model-based approach as soon as possible.

At this stage, the four major Australian banks are the most likely institutions to adopt the model­ based approach to regulatory capital. The capacity of other ADIs to implement the model-based approach is far more uncertain at this stage, mainly because their internal rating systems and risk management systems are not as developed as those of the majors.

The major banks, on the other hand, have been utilising internal rating systems for a longer period of time and have also incorporated more quantitative elements. In general, their risk management systems are highly developed and, at this point in time, they will most likely be at the level required to meet the qualifying criteria for the model-based approach. These banks have invested significant resources in developing their risk management practices and are keen to

) ensure APRA is adequately resourced to develop the policy framework required for the introduction of the model-based approach. After consultation these banks have indicated that

they are prepared to co-operate with APRA to facilitate the development of the model-based approach.

The charges in this instrument relate to Phase I of the model-based approach for the 2002-03 financial year. At this stage, APRA is not able to accurately determine the costs involved with Phases II and III to allow a fee-for-service charge to be set for those phases.

Description of the charge and how it has been calculated

Description of the charge:

A fee of $250,000 as a contribution to APRA's development of an appropriate policy and establishment of its supervisory infrastructure and technical capacity required for the introduction of a model-based capital adequacy framework for ADIs with advanced systems.

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The fee is imposed on each of the ADIs that have been identified by APRA as the most likely users of the model-based approach and are prepared to co-operate with the requisite regulatory development. They are the Commonwealth Bank of Australia, National Australia Bank Ltd, Westpac Banking Corporation, and Australia and New Zealand Banking Group Ltd.

How the charge has been calculated:

The charge is based on the need to recover APRA's costs of carrying out the policy and technical development work. Those costs are based on the estimated APRA staff time involved. The levels of seniority of the staff concerned are determined and the mid-point salary of those levels is used in the calculation. Overhead costs are then added to the salary costs on a weighted average cost basis. On this basis, APRA's costs for the 2002-2003 financial year have been estimated at $1 million. The fee of $250,000 that is to be charged to each of the four banks will result in the recovery of those costs.

The charge is exclusive of GST.

) Charges must be reasonably related to the costs and expenses incurred

As indicated above, the charge set by the instrument is fixed on a cost recovery basis for the services to which it applies. The charge is based on estimated effort involved in the discharge of APRA's responsibilities and incorporates all the direct costs and appropriate overheads.

Charges must not amount to taxation

As the charge is reasonably related to the costs incurred by APRA in providing the services concerned, the charge does not constitute a tax.

No retrospectivity

The charge is prospective only.

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REGULATORY IMPACT STATEMENT:

Australian Prudential Regulation Authority Act 1998, section 51

INSTRUMENT FIXING CHARGES TO BE PAID TO APRA - CAPITAL

ADEQUACY REQUIREMENTS FOR ADIs (the instrument)

Identification of Issue

In January 2001, the Basel Committee on Banking Supervision released a second set of proposals for reforming the 1988 Basel Capital Accord, which for over a decade has been the global benchmark for assessing banks' capital adequacy1• In Australia, the existing Accord guidelines are applied to all authorised deposit-taking institutions (ADIs) - banks, building societies and credit unions.

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 over 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 the Committee's reform proposals is to develop 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/encourage the use of more sophisticated risk management techniques (where appropriate). The new framework is more complex than the existing regime. It is comprised of a menu of calculation methods for each risk class ranging from simple, standardised (default) methods to more sophisticated approaches involving institutions' own internal risk assessment methodologies.

There has been no definite policy decision made by APRA to adopt the new Accord in Australia. Indeed, the Basel Committee's reform proposals will not be finalised until the end of 2003 with a forecast implementation date of 1 January 2007. In order to

) make the decision as to whether to introduce the new Accord, some degree of exploratory work is required. Notwithstanding this, if the model-based approaches are introduced for capital adequacy purposes, development of the required supervisory

infrastructure and technical expertise must commence during the current financial year.

The level of resources required for this activity is beyond that funded by current industry levies.

Objective

To ensure that APRA has adequate resources to effectively commence development of the supervisory infrastructure and technical capacity required for the introduction

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 (BIS). It consults widely with supervisory agencies in other countries and with industry on prudential matters.

of a specialised capital adequacy framework for ADIs with advanced risk management systems.

Identification of Options

Option 1 - Introduce a fee-for-service charge for all ADIs.

This option would result in all ADIs contributing to the development costs for the more sophisticated regulatory capital approaches that will potentially be available upon implementation of the new Accord.

Option 2 - Introduce a fee-for-service charge for a select group of ADIs.

Under this option, ADIs that have advanced risk management systems that will allow them to meet the qualifying criteria for the model-based approaches potentially available under the new Accord, will be contributing to the initial development costs of the necessary supervisory infrastructure.

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Impact Analysis

Impact group identification

Under option 1, it is likely that the 230 ADIs supervised by APRA, and APRA itself, will be affected by the fee-for-service proposal whereas under option 2, it is likely that only the four major Australian banks and APRA would be affected.

Assessment of Costs and Benefits

Option 1 - Introduce a fee-for-service charge for all ADIs.

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 services and facilities which APRA provides to such persons. Under this option, the development costs of

$1,000,000 (refer option 2 for breakdown of estimated costs) for the 30 June 2003

) financial year would be divided amongst 230 ADIs.

It would appear that this option is inconsistent with the provisions of subsection 51(1) in that smaller, less sophisticated ADIs would be charged for services and facilities not directly provided to them. As the model-based approaches are designed for institutions with advanced risk management systems, it is unlikely that smaller, less sophisticated ADIs will be able implement these for capital adequacy purposes.

Indeed, the majority of the 230 ADIs supervised by APRA have no intention of adopting the model-based approaches for regulatory capital purposes. They should therefore not be charged for the recovery of the costs associated with the commencement of the development of a model-based regulatory capital regime under a subsection 51(I) instrument.

This option is not considered to be an equitable alternative.

Option 2 - Introduce a fee-for-service charge for a select group of ADIs.

At this stage, the four major Australian banks are the most likely institutions to adopt the model-based approaches to regulatory capital if the new Accord is introduced.

Implementation of the model-based approaches by other ADIs is far more uncertain at this stage. Internal rating systems and risk management systems more generally, are not as developed, by comparison, to the majors. The internal rating systems that have been introduced by these institutions tend to be based more on subjective judgement rather than quantitative data. This questions their capacity to validate the accuracy and consistency of their rating systems and hence use the model-based approaches potentially available upon initial implementation of the new Accord. Smaller ADIs may have the intention to adopt the model-based approaches however their capacity, at this stage, is far less certain.

The major banks have been utilising internal rating systems for a longer period of time than the smaller ADIs and have also incorporated more quantitative elements. In general, their risk management systems are highly developed and at this point in time, will most likely be at the level required to meet the qualifying criteria for the model­ based approaches. These banks have invested significant resources in developing their risk management practices are very keen to ensure that APRA is adequately resourced to develop the policy framework required for the introduction of the model-based approaches.

Recovery of the costs associated with the commencement of the development of the supervisory infrastructure from the major banks is in the ambit of subsection 51(1) of the APRA Act. The cost of services and facilities being recovered under the instrument directly relate to the establishment of a capital adequacy regime that will enable them to use their own internal risk assessments as input in the regulatory capital charge.

APRA has undertaken a review of the development costs for the model-based approaches and has determined that approximately $1,000,000 in additional funding is

These costs will be divided equally between the four major Australian banks.

Option 2 is APRA's preferred option and is consider to be the most equitable alternative.

Consultation

APRA has held numerous industry briefing sessions. These sessions have included discussion of the increased supervisory resources associated with the development of

\  ..

the infrastructure and technical capacity required for the introduction of the model­ based approaches.

The banks' expectations are for an increase in required supervisory resources of up to

$2,000,000 in the latter phases of this project. The initial phases of the work will not require this level of expenditure, although the level of charges will need to be revisited in 2003-04.

Conclusion and recommended option

Option 2 is the preferred alternative. The initial cost of increased supervisory resources associated with the development of the model-based approaches will be funded by those institutions that will most likely have risk management systems at the level required to meet the qualifying criteria for use of the model-based approaches for regulatory capital purposes.

Implementation

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APRA will charge those institutions involved in the model-based approaches when the instrument is determined to ensure that development of these approaches for capital adequacy can be commenced as soon as possible.

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