EXPLANATORY STATEMENT

Australian Prudential Regulation Authority Act 1998, section 51

INSTRUMENT FIXING CHARGES TO BE PAID TO APRA

No 1 of 2004

MODEL-BASED CAPITAL ADEQUACY REQUIREMENTS FOR ADls

PART 1 - EXPLANATORY STATEMENT

The instrument to which this explanatory statement relates

1.    This explanatory statement relates to the instrument (the instrument) made under paragraph 5l(l)(a) of the Australian Prudential Regulation Act 1998 (the APRA Act) which is entitled INSTRUMENT FIXING CHARGES TO BE PAID TO APRA (No 1 OF 2004)-MODEL-BASED CAPITAL

 ADEQUACY REQUIREMENTS FOR ADIs and which is dated 13 January 2004.

APRA's authority to fix charges

2.      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 (ADls). ADIs include banks, building societies and credit unions.

3.      Subsection 51(1) of the APRA Act provides that APRA may, by w1itten 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.

4.      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

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

Background

6.      In January 2001, the Basel Committee on Banking Supervision (the Committee) released a second set of proposals for reforming the 1988 Basel Capital Accord (the 1988 Accord). A revised, but still draft, document, the "Third Consultative Paper", was issued in April 2003. 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.

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.

7.      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 the Committee's 2001 reform proposals (the proposed new Accord) 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 or encourage the use of more sophisticated risk management techniques (where appropriate). The capital adequacy framework in the new Accord 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 individualized internal risk assessment methodologies.

8.      APRA has made the in-principle decision to adopt the new Accord in Australia. APRA intends to follow the international timetable for introduction of the new Accord which currently

) calls for finalisation of the proposed changes to the capital adequacy guidelines by mid-2004 and

full implementation by 1 January 2007. This long lead time is indicative of the extent of the reforms that will be effected by the new Accord and the amount of regulatory development that will be required of APRA to implement the reforms, particularly in relation to the more sophisticated methods.

9.      The implementation of the new Accord in Australia is 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.

10.      One major innovation resulting from the new Accord, 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 model-based approach more closely aligned with an ADI's individual risk profile (the model-based approach). ADIs seeking to use the model-based approach will need APRA's approval to do so.

11.      The model-based approach will benefit those ADIs that elect to adopt it, because its effect

  will be to more accurately align 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 model-based approach should also benefit the wider economy.

12.      However, at least in the early years, only a small number of ADIs will be able to take advantage of the model-based approach. This is because it can only be taken up by ADIs with highly sophisticated internal rating and risk management systems.

13.       At this stage, the four major Australian banks are the most likely institutions to adopt the model-based approach upon initial introduction of the new Accord. They have been using internal rating systems for a considerable period 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 approach on day one of implementation.

14.       Adoption of the model-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 major banks. The internal rating systems of these institutions tend to be based more on subjective judgement rather than quantitative data. This diminishes their capacity to validate the accuracy and consistency of their rating systems and hence to use the model-based approach upon initial implementation of the new Accord. Some medium-size ADIs may have the intention to adopt the model-based approach, however, their capacity to do so at this stage remains uncertain.

15.       APRA's work relating to the implementation of the standardised method and the alternative model-based approach which are provided for by the new Accord has three phases. These can be depicted as follows:

)

Phase I commenced in the 2002-03 financial year and will continue over the current financial year 2003-04 and financial year 2004-05. It involves 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 ADIs' models and provide the necessary approvals. Phase II is expected to commence towards the end of the 2004- 05 financial year. Finally, Phase III will involve the on-going monitoring of ADIs' capital adequacy positions - in the case of ADIs using the model-based approach, this will be more intensive than for ADIs using the standardised method.

16.      APRA commenced work on Phase I of the model-based approach during the 2002-03 financial year. APRA imposed charges on the four major banks for its work during that financial year, in the same way as is done by the instrument, pursuant to a charging instrument made under subsection 5 I(1) which was dated 16 November 2002. The amount of that charge was $250,000 in respect of each of the four banks (giving a total of $1 million). It was based on the same

  rationale and cost-recovery principles as are discussed in this explanatory statement. The charges imposed by the present instrument relate to the work of continuing Phase I of the model-based

approach during the 2003-04 financial year.

17.      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

18.      The charge consists of a fee of $375,000, as a contribution to APRA's continuing development of an appropriate policy and establishment of its supervisory infrastructure and technical capacity required for the introduction of the model-based approach.

19.      The charge 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 Australia and New Zealand Banking Group Ltd, Commonwealth Bank of Australia, National Australia Bank Ltd and Westpac Banking Corporation.

How the charge has been calculated

20.      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. Overhead costs are added to the salary costs on a weighted average cost basis. On this basis, APRA's costs for the 2003-04 financial year have been estimated at $1.9 million.

21.      APRA has decided not to charge the four banks the entire cost of $1.9 million but has decided to absorb $400,000 of that amount. APRA is mainly funded out of the annual supervisory levy which is paid by all regulated institutions, including ADIs. Hence the $400,000 cost not charged to the four banks will ultimately be funded from the supervisory levy.

22.       The rationale for APRA absorbing $400,000 of the cost is that although the policy development work involved in Phase I will initially and directly benefit only the four banks, from a longer-term perspective it will also benefit other ADIs that adopt the model-based approach in

future. Furthermore, to the extent that the introduction of the model-based approach will make

)  the financial system more efficient, the Phase I work will indirectly benefit the wider financial system and society as a whole. Hence APRA considers it fair not to impose the whole of the cost

on the four banks.

23.      This leaves the balance of $1.5 million to be recovered from the four banks. Thus, a fee of

$375,000 (being a quarter of $1.5 million) is charged to each of the four banks by the instrument.

24.      The charge is exclusive of GST.

The charge is reasonably related to the costs and expenses incurred

25.       As indicated above, the charge set by the instrument is fixed on a cost recovery basis for the services to which it applies. (Indeed, as has just been explained, the charge recovers less than the full cost of the services.) The charge is based on estimated effort involved in the discharge of APRA's responsibilities and incorporates all the direct costs and appropriate overheads.

The charge does not amount to taxation

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

The charge is not retrospective

27.      The charge is imposed prospectively. It is payable 28 days after receipt of APRA's invoice.