Explanatory statement

accompanying

Instrument fixing charges to be paid to APRA

No 2 of 2005

Australian Prudential Regulation Authority Act 1998

_________________________________________________________________________

MODELS-BASED CAPITAL ADEQUACY REQUIREMENTS FOR ADI S  -  2004-05

The instrument to which this explanatory statement relates

1.   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 10 June 2005 (the instrument).

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

3.   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).)

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 June 2004, the Basel Committee on Banking Supervision (the Committee) released a Revised Framework for International Convergence of Capital Measurement and Capital Standards (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.

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 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.

8.   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 on1 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.

9.   The implementation of Basel II in Australia will continue to 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 11AF of the Banking Act 1959.

10.   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.

11.   The models-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 models-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 models-based approach.  This is because it can only be taken up by ADIs with highly sophisticated internal rating and risk management systems.

13.   During the past two years the four major banks in Australia, being Australia and New Zealand Banking Group Ltd, Commonwealth Bank of Australia, National Australia Bank Ltd and Westpac Banking Corporation, have been directly contributing to APRA’s development costs for Basel II.  These banks 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, they expect to be at the level required to meet the qualifying criteria for the models-based approach on day one of implementation.  Macquarie Bank Ltd and St George Bank Ltd now also expect to meet the criteria.

14.   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 six banks.  The internal rating systems of other ADIs 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 models-based approach upon initial implementation of Basel II.  Some medium-size ADIs may have the intention to adopt the models-based approach at a later time, 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 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 2004-05.  It involves developing a policy and technical framework for both the standardised method and the models-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 in October 2005.  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.

16.   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, in the same way as is done by the instrument, pursuant to a charging instrument made under subsection 51(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.  During the 2003-04 financial year the same four banks were each charged the amount of $375,000, pursuant to the charging instrument dated 13 January 2004.  The charges imposed by the present instrument relate to the work of continuing Phase I of the models-based approach during the 2004-05 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 imposed by the instrument is 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 Ltd and St George Bank Ltd.

These amounts have been set 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 models-based approach.  The higher charge imposed on the four major banks reflects the fact that the work relating to them is more resource-intensive for APRA than the work relating to the other two banks.

19.   The charge is imposed on those six ADIs that have been identified by APRA as the most likely users of the models-based approach and are prepared to co-operate with the requisite regulatory development.

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 total Basel II costs for the 2004-05 financial year have been estimated at about $2.15 million.

21.   APRA has decided not to charge the six banks the entire cost of $2.15 million, as part of that cost is attributable to developing the standardised method which the six banks do not intend to use.  Hence APRA considers it fair not to impose the entire cost on the six banks.

22.   APRA has estimated that approximately $350,000 of the entire cost of $2.15 million is attributable to development work relating to the standardised model.  Therefore, the balance of $1.8 million is being charged to the six banks.  Of this amount, $1,500,000 is charged to the four major banks (with each paying $375,000), while $300,000 is charged to the two other banks (with each paying $150,000).  GST of 10% is then added to these amounts.  The total amount recovered through the instrument is thus $1,980,000 (which comprises $1,800,000 plus GST).

The charge is reasonably related to the costs and expenses incurred

23.   As indicated above, the charge set by the instrument is fixed on a cost recovery basis for the services to which it applies.  It 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

24.   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

25.   The charge is imposed prospectively.  It is payable 14 days after receipt of APRA’s invoice.

Consultation

26.   Under section 17 of the Legislative Instruments Act 2003, APRA was required to undertake consultation in accordance with that section before making the instrument.

27.   APRA consulted the six banks on which the charges are imposed before making the instrument.  The banks were informed about the proposed charges, including their amount, and they indicated their willingness to pay the charges.

28.   APRA did not undertake any wider consultation, as the charges only impact on the six banks.

[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.